7588 / What is a futures contract?

Futures contracts are bought and sold (i.e., traded) on at least one of the various commodities or futures exchanges. All terms and provisions of a futures contract, except price and delivery month, are fixed by the bylaws and rules of the exchange. Price and delivery month are agreed upon when the trade is made on the floor of the exchange. Although all futures contracts originate between a buyer and seller, the exchange’s clearing organization, at the end of each business day, substitutes itself as the “other party” of each contract written that day. (That is, the clearing organization creates two new futures contracts by becoming the buyer to each seller and the seller to each buyer.) Once written, futures contracts traded on a domestic exchange are subject to a “variations margin” under which they are marked to market daily (see Q 7591).

Until the date trading in futures contracts for a particular commodity and delivery month stops, an owner of a contract for that commodity and delivery month may close out the contract by making an offsetting purchase or sale (as the case may be) on the exchange of another futures contract. Once trading stops, the owners of “short” futures contracts (i.e., contracts to sell) are required to make delivery of the underlying commodity to the owners of the “long” futures contracts (i.e., contracts to buy) for that commodity and month on the basis of match-ups established by the clearing organization. Futures contracts traded on a domestic exchange are subject to regulation by the Commodity Futures Trading Commission (CFTC).

A taxpayer who enters into a futures contract to deliver property that is the same as or substantially identical to an appreciated financial position that he or she holds (see Q 7617) will generally be treated as having made a constructive sale of that position, unless certain requirements are met for closing out the futures contract¹ (see Q 7617 to Q 7621).

A taxpayer who enters into a futures contract to acquire an equity interest in a pass-through entity may be subject to the “constructive ownership” rules under IRC Section 1260 (see Q 7597 to Q 7598).

Special rules apply to securities futures contracts (see Q 7579 and Q 7580).