What is a Futures Contract?

A futures contract is a standardised, legally binding contract to buy or sell specified assets (like commodities, currencies, or stocks) on a set future date at a predetermined price. Contracts like these are used to hedge against price risk (e.g., fixing crop prices for farmers) or speculate on price movements. This contract obligates both parties to execute the trade at expiration, either physically or through cash. This article provides an overview of what is futures contract in the stock market. 

Futures Contract Example 

The following is a futures contract example to better understand its working: 

Consider the situation of a wheat farmer who is concerned about the future price of wheat. A farmer enters into a futures contract to sell a certain quantity of wheat to a buyer at a fixed price, with delivery scheduled for six months in the future. 

• At expiration, the farmer benefits if the price of wheat is below the contract price because he is able to sell the wheat at a higher, pre-agreed price. 
   
• A farmer may lose out on the potential profits if the price of wheat rises beyond the contract price, as the sale is locked in at a lower price.

 How Futures Contract Work? 

Here’s how futures contract works: 

• A standardised agreement specifies quantity, quality, and delivery, which makes them tradable.  
• A percentage of the contract value (margin) is deposited with the broker as collateral by both the buyer and the seller.  
• Price changes are settled on a daily basis, moving funds from the margin account of the individual who incurred losses to the one who gained.  
• Contracts have set expiration dates (monthly/quarterly).  
• Depending on the type of contract, settlement can be either physical (delivery) or cash. 

Types of Futures Contracts 

Having understood Futures contract meaning along with an example, let’s know its types: 

1. Agricultural Futures 

Agricultural Futures were the initial futures contracts offered on exchanges like the Chicago Mercantile Exchange. Beyond grain futures, markets also feature tradable futures contracts for fibres like cotton, lumber, milk, coffee, sugar, and even livestock. 

2. Energy Futures  

These Futures offer exposure to widely used fuels and energy products, including crude oil and natural gas. 

3. Metal Futures  

Metal Futures involve trading contracts related to industrial metals such as gold, steel, and copper. 

4. Currency Futures 

Currency Futures allow exposure to fluctuations in exchange rates and interest rates for various national currencies. 

5. Financial futures  

Financial futures encompass contracts that involve the anticipated value of a security or index at a future date. There are also futures for debt instruments such as Treasury bonds. 

 Features of Futures Contracts 

The key features of futures contracts are: 

1. Regulation of Commodity Futures Markets in India: The Forward Markets Commission (FMC) oversees and regulates commodity futures markets in India. It has authority over granting or withdrawing recognition for commodity markets involved in forward dealings. 

2. Versatility of Futures Contracts: Futures contracts apply to various asset classes, including exchanges, commodities, currencies, and indices. 

3. Standardisation of Futures Contracts: Unlike forward contracts, futures contracts are standardised, specifying quantities like 1000 barrels of oil. Prices must be locked in according to the specified unit or multiples thereof. Efficiency in trading and price locking traders can efficiently determine the futures price of stocks or index values using futures contracts. To lock in prices, traders need to buy or sell contracts in multiples, providing flexibility. 

4. Future Supply and Demand: Futures contracts play a crucial role in assessing the future supply and demand of shares based on their current and future prices. 

5. Margin Trading for Accessibility: Futures are traded on margin, allowing participants with limited funds to engage in trades. 

Smaller margin payments, rather than the entire value of physical holdings, enable broader participation. 

6. Roles of Market Participants: Producers or hedgers use futures contracts to hedge against price fluctuations in underlying assets. Speculators bet on price movements of underlying assets through futures contracts. 

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Advantages & Disadvantages of Futures Contracts 

Futures contracts are financial agreements between two parties to buy or sell an asset at a predetermined future date and price. These contracts are commonly used in financial markets for hedging and speculation. Here are some pros and cons of futures contracts: 

 Futures Contract vs Forward Contract 

Futures contracts and forward contracts differ in the following ways: 

Disclaimer: All investments are subject to market risks, economic conditions, regulatory changes, and other external factors. Returns are not guaranteed and may vary based on market performance and investment tenure. Investors should assess their risk tolerance and financial objectives, conduct their own research, and consult a qualified financial advisor before making any investment decisions. 

Conclusion 

By speculating on future prices, futures contracts can offer an effective way to diversify the portfolio and secure a favourable return. Futures contracts can be traded across a variety of underlying assets, making them an effective tool for hedging potential losses across various asset classes. It is also possible to obtain the underlying asset before the contract expires. Today's financial landscape requires staying informed, so using a reliable stock market app can provide real-time updates and trend analysis.