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Futures Contract: All You Need to Know
Trading in the derivatives market is a great way to profit if you have captured the concepts right! A derivative market is where you engage in financial contracts based on an underlying asset. While involved in a derivative contract, you will transfer the risk associated with the asset to another person willing to take it.
Published on 17 March 2023
Different contracts exist in the derivatives market, such as futures, forwards, options, and swaps. We will discuss the futures contract in a little detail here.
What is a Futures Contract?
A futures contract is a derivative contract wherein two parties mutually agree to buy and sell a particular underlying asset of a predefined quantity at a specified price on a future date. The underlying asset in the futures contract can be stocks, commodities, interest rates, currencies, etc. The exchange is held and managed by a recognised stock exchange. Therefore, future contracts are standardised.
How Do Futures Contract Work?
The first person engaging in the agreement will purchase a futures contract to sell or buy an underlying asset at a future date based on the agreed price. On the other hand, the second person will agree to purchase or sell the underlying asset at the agreed price on the same date.
For example, petroleum dealers buy a futures contract for a certain quantity of petroleum from the supplier for a future date to protect themselves against excessive price risk. So, if the petroleum prices increase, the dealer benefits by getting the required quantity of petrol at the agreed price rather than the high current price.
The stock exchange functions as a mediator between the two parties. Both the parties have to pay an amount before engaging in the contract referred to as the margin.
As the prices in the futures contract keep changing almost every day, the differences based on the prices from the margin are settled daily. If the margin gets completely used up, the party concerned has to replenish the fund back into the account.
This process, called the marking to market, is extremely significant in the futures contract. As the differences keep settling, only the spot price on the day of delivery defines the actual difference.
Unlike in the options contract, the parties are obliged to settle the contract in futures trade. In options contracts, the parties have the right but not the obligation to execute the contract.
Important Terms in the Futures Contract
Here are a few important terms that you need to understand.
- Delivery date - The future date on which the payment and delivery of the underlying asset happen.
- Long position - The buyer in the contract is referred to as holding a long position.
- Short position - The seller in the contract is referred to as holding a short position.
Futures Contract Example
Speculation
Investors speculate on the future values of the underlying asset. Let us consider a futures example, wherein a speculator feels the oil price will increase from ₹120 per kg to ₹150 per kg over the next three months. The speculator can purchase a futures contract at a strike price of ₹150 per kg based on the lot size with an expiration date three months from now. When the price increases to around ₹145, the speculator can decide to square off the position by selling the futures contract to make a reasonable profit.
Hedging
Many parties use the futures contract as a hedging tool to protect their positions. For example, let us consider a producer growing corn in his field wants to protect himself against probable loss in prices. So, to make profits on his harvest, the producer can lock in the price of corn at a specific price for a future date based on the futures contract to the interested investors. Therefore, if corn prices fall, the producer will be protected from any adverse effect when the contract gets settled.
How are Futures Contract Settled?
There are two ways the parties will settle a futures agreement on the delivery date.
- If the futures contract is based on a commodity, the seller will deliver the commodity to the buyer.
- If the futures contract is based on cash settlement, such as in the stock trading futures, the trader who made the loss will transfer the difference in amount to the trader who made the profit.
Pros and Cons of Futures Contract
Before trading on futures, it is important to understand the pros and cons for making better gains.
Pros of a futures contract are:
- A futures contract can be based on a wide variety of assets. Therefore, you get different options based on your financial position.
- The futures market is highly liquid. Investors can easily move in and out of their long or short position.
- A smart strategy on futures contracts can protect your business.
Cons of a futures contract are:
- Future contracts have an expiration date. You might have speculated that the oil price might increase on a future date. However, the increase might not happen before or on the expiration date due to various political or economical reasons. It leads to a loss on the premium you have paid.
Supply and demand can be affected by natural disasters. For example, you might have purchased a futures contract to protect your position against an increase in wheat prices. However, suppose if there is a cyclone affecting your area, you might have lost the yield along with the loss over the futures contract.
Conclusion
A futures contract is a way to engage in profitable trading experiences. However, it requires extensive knowledge of the price pattern of the underlying asset. Therefore, the sensitivity to price fluctuation is a major consideration. With the aid of good brokerage services, you can gain expertise over the futures contract. As a result, you can benefit from greater leverage than a standard stock trading account and earn profits higher than your expectations!
Also Read: Stock Market Fluctuation
