Futures Contract Details

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Futures Contract Details

Every futures contract is an agreement that represents a specific quantity of the underlying commodity to be delivered some time in the future for a pre-agreed price.

Unlike options, buyers and sellers of futures contracts are obligated to take or make delivery of the underlying asset on settlement date.

Futures Contract Specifications

The Underlying

Each futures contract represents a specific underlying asset to be delivered on the delivery date. Besides commodities, other instruments such as interest rates, currencies and stock indices are also traded in the futures exchanges.

Exchange

The futures exchange where the futures contract is traded. Some of the world’s largest futures exchanges include:

Symbol

Each futures contract traded in a futures exchange is identified by a unique ticker symbol.

Contract Size (or Trading Unit)

The contract size states the amount and unit of the underlying commodity represented by each futures contract (E.g. 1000 barrels of crude oil or 50 troy ounces of platinum).

Price Quotation

The quoted price of a futures contract is the agreed price (per unit) of the underlying asset that the buyer has to pay to the seller in order to take delivery of the goods. Correspondingly, it is also the price at which the seller must sell the underlying asset to the buyer. Depending on the type of futures contract, the price can be quoted in cents, dollars or even in a foreign currency.

Grade of Deliverable

The grade not only specifies the quality of the underlying but also the manner and the exact place(s) of delivery.

Delivery Date

Each futures contract has a specific delivery date where the seller of the futures contract is required to make delivery of the underlying product being traded and the buyer of the futures contract is required to take delivery.

Last Trading Day

Trading shuts down some time before the delivery date to give the futures contract seller sufficient time to prepare the underlying products for delivery. Futures positions which have not been closed out (offset) before end of the last trading day will have to be settled by making or taking delivery of the underlying product.

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Delivery Months

Every futures contract has standardized months at which the underlying can be traded for delivery.

Futures Trading

One can trade futures contracts via a regulated futures exchange.

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Futures Contract

What Is a Futures Contract?

A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange. The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.

Key Takeaways

  • Futures contracts are financial derivatives that oblige the buyer to purchase some underlying asset (or the seller to sell that asset) at a predetermined future price and date.
  • A futures contract allows an investor to speculate on the direction of a security, commodity, or a financial instrument, either long or short, using leverage.
  • Futures are also often used to hedge the price movement of the underlying asset to help prevent losses from unfavorable price change.

How Do Futures Contracts Work?

Understanding Futures Contracts

Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. Here, the buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.

Underlying assets include physical commodities or other financial instruments. Futures contracts detail the quantity of the underlying asset and are standardized to facilitate trading on a futures exchange. Futures can be used for hedging or trade speculation.

“Futures contract” and “futures” refer to the same thing. For example, you might hear somebody say they bought oil futures, which means the same thing as an oil futures contract. When someone says “futures contract,” they’re typically referring to a specific type of future, such as oil, gold, bonds or S&P 500 index futures. The term “futures” is more general, and is often used to refer to the whole market, such as “They’re a futures trader.”

Futures contracts are standardized, unlike forward contracts. Forwards are similar types of agreements that lock in a future price in the present, but forwards are traded over-the-counter (OTC) and have customizable terms that are arrived at between the counterparties. Futures contracts, on the other hand, will each have the same terms regardless of who is the counterparty.

Example of Futures Contracts

Futures contracts are used by two categories of market participants: hedgers and speculators. Producers or purchasers of an underlying asset hedge or guarantee the price at which the commodity is sold or purchased, while portfolio managers and traders may also make a bet on the price movements of an underlying asset using futures.

An oil producer needs to sell their oil. They may use futures contracts do it. This way they can lock in a price they will sell at, and then deliver the oil to the buyer when the futures contract expires. Similarly, a manufacturing company may need oil for making widgets. Since they like to plan ahead and always have oil coming in each month, they too may use futures contracts. This way they know in advance the price they will pay for oil (the futures contract price) and they know they will be taking delivery of the oil once the contract expires.

Futures are available on many different types of assets. There are futures contracts on stock exchange indexes, commodities, and currencies.

Mechanics of a Futures Contract

Imagine an oil producer plans to produce one million barrels of oil over the next year. It will be ready for delivery in 12 months. Assume the current price is $75 per barrel. The producer could produce the oil, and then sell it at the current market prices one year from today.

Given the volatility of oil prices, the market price at that time could be very different than the current price. If oil producer thinks oil will be higher in one year, they may opt not to lock in a price now. But, if they think $75 is a good price, they could lock-in a guaranteed sale price by entering into a futures contract.

A mathematical model is used to price futures, which takes into account the current spot price, the risk-free rate of return, time to maturity, storage costs, dividends, dividend yields, and convenience yields. Assume that the one-year oil futures contracts are priced at $78 per barrel. By entering into this contract, in one year the producer is obligated to deliver one million barrels of oil and is guaranteed to receive $78 million. The $78 price per barrel is received regardless of where spot market prices are at the time.

Contracts are standardized. For example, one oil contract on the Chicago Mercantile Exchange (CME) is for 1,000 barrels of oil. Therefore, if someone wanted to lock in a price (selling or buying) on 100,000 barrels of oil, they would need to buy/sell 100 contracts. To lock in a price on one million barrels of oil/they would need to buy/sell 1,000 contracts.

The futures markets are regulated by the Commodity Futures Trading Commission (CFTC). The CFTC is a federal agency created by Congress in 1974 to ensure the integrity of futures market pricing, including preventing abusive trading practices, fraud, and regulating brokerage firms engaged in futures trading.

What is Futures Contract? Examples, History and Types of Future Contracts

Futures Contract Definition:

A “Futures Contract is an agreement between two anonymous market participants”, a seller and a buyer. Here, the seller undertakes to deliver a standardized quantity of a particular financial instrument (or a commodity) at a certain price and a specified future date. On the other hand, the buyer undertakes to accept the goods underlying the futures contract of delivery date. Volume and generic trading futures contracts are standardized:

Standardized Amount: Each futures contract is a standardized quantity, e.g. Rs.100, or Rs.50 per federal futures contract, or 100 ounces per gold contract.

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Specific Financial Instrument: The contract specifications define not only the underlying financial instrument – for example, BUND-future or gold, but also its quality such as coupon interest and life of the interest rate of contract, or the purity of the gold.

Certain Price: This is the future contract price that must be paid later for the financial instrument is predetermined.

Future Time: There are 3 or more calendar months a year, during which a possible delivery must take place for each financial instrument. A related futures contract is traded for each of the calendar months.

Futures Contract Example:

There is an expiry date for all Futures Contracts. As in India, All the future contracts are expired on every month last Thursday. For example: Suppose you buy NIFTY future contract with a lot size of 50 on 1 st February 2020 of one month expiry at Rs. 7200. This means that future contract will get expire on 25 th February 2020 (last Thursday of the Month). Margin required to buy the future contract is around 11%; which means to buy the future contract you will require Rs.39,600 (Rs.7200 * 50 (lot size) * 11%). If NIFTY moves 50 points upside and reaches to 7250; which means that you are making profit of Rs.2,500 (50 * 50 (lot size)). You can sell the future contract even before expiry. If you sell with rise of 50 points in future market, then you are making Rs.2,500 as a profit out of it.

Types of Futures Contract:

There are various different types of Future Contracts for different class of assets available in the future market. This includes: Stock Futures, Currency Futures, Commodities Futures and Index Futures. You can trade in any of the contracts wherever you are comfortable and wherever you possess a strong knowledge on it. It is highly recommended that you should gain sound knowledge and perform paper trading before you actually start investing and trading in the future market.

History of Futures Contract:

The futures contracts are born in Japan around 1600 and the aim of these contracts was to ensure the price of a crop if a weather adversity comes. The first traded products included the futures commodities, such as rice.

The mechanism was simple, the producer wanted to set a price before harvesting the crop , as if there was an unfavorable climatic conditions, the farmer could lose their harvest unable to sell anything. Thus they made ​​sure to sell their crop at a price. This today is known as a short sale because the farmer sells his crop to grow before a contract price.

Brief History of Futures Contracts:

Once reached maturity, or harvesting of the raw material, they could be faced with three situations:

1. The market price (the rest of farmers) is equal to the previously agreed because there have been normal circumstances (no weather problems or exceptionally good harvests).

2. The market price is higher than the agreed price; in this case the buyer is more beneficial as it negotiated a price below the price at harvest. The farmer can get hurt because the crop could be sold at a higher price, and this higher price, due to a bad harvest could be due to adverse weather conditions, a plague … Being able to get the farmer to have heavy losses.

3. The market price is below the agreed: In this case the buyer loses because it paid a premium price for raw materials, whereas if they had waited could have bought cheaper. The farmer gets away for surely there must have been a plentiful harvest and given the offer, he was able to sell at a price above the market price for the previous agreement made.

As you can see in this overview it is a question of assessing the value of time and the risk (probability of a loss). Generally and currently, the derivatives are used to hedge risks, using valuation methods.

Benefits of Organized Future Market:

Also as you can imagine the reader, if this market was not organized enough for a strong impassive to breach the contract in cases 2 and 3, first by the farmer, because there would be willing to sell the crop at a lower price market and in the third case because the buyer would not be willing to buy more expensive than the market price. This need for organization culminates in 1848 in Chicago, creating the Chicago Board of Trade (CBOT), which was a pioneer in the stock trading in futures contracts. At the time the contracts were settled by physical delivery, as expected.

The first futures contracts, as I said, were commodities (rice, corn, wheat, cotton …) and in the 80s, it began trading other products such as wood or some metals. And in the 90s they began to negotiate contracts on government bonds in the India, and later the first stock indices. Currently, the futures contracts include the widest range of traded products.

Conclusion:

In short, performing of the contract at a later date is in itself a business method that is common and practiced by everyone. So the unique character of the futures markets is not the time period but the fact that the contracts are standardized.

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