What is a Futures Contract?

What is a Futures Contract?

A futures contract is an agreement between two parties to purchase or sell a specific commodity, asset, or security at a pre-established price during a designated future timeframe. These contracts adhere to standardised specifications in terms of quality and quantity to streamline trading on a futures exchange. 

A futures contract enables an investor to make speculative bets on the future movement of a security, commodity, or financial instrument, utilising leverage in either a long or short position. In this article, we will take a closer look at various types of futures contracts, features of futures contracts and other important factors along with examples. 

Understanding Futures Contracts

Futures represent derivative financial agreements in which the involved parties commit to trade an asset at a specified future date and price. In this arrangement, the buyer is obligated to buy, and the seller is obligated to sell the underlying asset at the agreed-upon price, irrespective of the prevailing market price upon expiration.

These underlying assets encompass physical commodities or various financial instruments. The contracts outline the quantity of the underlying asset and adhere to standardisation to ease trading on a futures exchange. Futures contracts serve purposes such as hedging against risks or engaging in speculative trading activities.

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Table of Content

  1. Understanding Futures Contracts
  2. Futures Contract Example
  3. Features of Futures Contracts
  4. Types of Futures Contracts
  5. Risks associated with Futures Contract
  6. Pros & Cons of Future Contracts

Futures Contract Example

Consider an oil producer seeking to sell oil but nurturing concerns about potential future declines in oil prices. To safeguard against the risk of price drops and ensure a predetermined selling price, the oil producer may opt for a futures contract. By utilising futures contracts, the oil producer can fix the selling price of the oil, ensuring that upon the contract's expiration, the oil is delivered to the buyer at the agreed-upon price.

Conversely, a manufacturing company reliant on oil for their production may adopt a similar strategy. Being proactive and forward-thinking, the company, desiring a steady monthly supply of oil, might employ a futures contract. This enables the company to establish a set price for the oil in the contract, assuring the cost of their oil supply. As the contract reaches its expiration, the company is committed to receiving the oil at the agreed-upon price.

Features of Futures Contracts

Futures contracts are standardised financial agreements to buy or sell a specific amount of an underlying asset at a predetermined price on a specified future date. Here are some key features of futures contracts:

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 

Future 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.

Types of Futures Contracts

There are various types of futures contracts, catering to a wide range of underlying assets. Here are some common 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.

Risks associated with Futures Contract

Futures contracts present opportunities for financial gains, but they also entail inherent risks that traders and investors must acknowledge. Here are some primary risks associated with futures contracts, accompanied by concise explanations:

1. Margin Call Risk

The possibility of having to deposit additional margin if the market moves unfavourably, with failure to meet margin calls potentially leading to forced liquidation of the position.

2. Expiration Risk

Futures contracts have fixed expiration dates, and failure to close or roll over positions before expiry may result in delivery obligations or cash settlement at less favourable prices.

3. Interest Rate Risk

Sensitivity of interest rate futures to changes in interest rates, impacting the profitability of the position.

4. Systemic Risk

The interconnectedness of futures markets with broader financial markets makes them susceptible to events affecting the overall financial landscape and influencing individual positions.

5. Delivery Risk

For physically settled futures contracts, the risk of complications related to the delivery of the underlying asset, including issues with quality or logistics.

6. Global Events Risk

Exposure to international events such as political developments, natural disasters, or economic crises can affect commodity and currency futures.

Pros & Cons of Future 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:

Advantages of Future ContractsDisadvantages of Future Contracts
1. In futures investments, the commission for trade activities is lower compared to alternative investment options.1. Certain investment approaches may entail elevated risks owing to the leverage associated with futures contracts.
2. These financial instruments offer substantial liquidity.2. These strategies adhere to predefined standards for specified amounts and terms, offering limited flexibility in investment options.
3. Futures contracts enable the reversal of positions, allowing the opening of both short and long positions.3. Futures contracts generally allow only partial hedging.
4. They offer significant leverage, allowing for maximum gains with limited investments.4.The potential downside of reduced commission charges is that traders may engage in excessive trading, leading to over-trading

Engaging in futures contracts offers an excellent means to broaden your portfolio and secure favourable returns through informed speculation on future prices. With the ability to trade futures across a variety of underlying assets, these contracts serve as an effective tool for hedging potential losses in different asset classes. Moreover, one can take possession of the underlying asset before the contract's expiry date. Considering the significance of staying informed in today's dynamic financial landscape, utilising a reliable stock market app can provide real-time updates and analysis of market trends.

FAQs on Futures Contracts

It is called a futures contract because it represents an agreement to buy or sell an asset at a predetermined future date and price.

Futures contracts work by allowing parties to lock in a price for the future delivery of an asset, providing a means of hedging or speculating on price movements.

Whether futures contracts are a good investment depends on individual risk tolerance, financial goals, and market knowledge.

While both involve agreements to buy or sell assets in the future, futures and forwards differ in terms of standardisation and exchange trading.

When you buy a futures contract, you are agreeing to purchase the underlying asset at a specified price on a predetermined future date, potentially gaining or losing based on subsequent market price movements.