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A futures contract is a legal agreement to buy or sell a fixed quantity of an asset at a predetermined price on a specified future date. These contracts are standardised and traded on recognised exchanges, unlike private deals negotiated directly between two parties.
Investors turn to futures for one of two purposes: to guard against a price movement or to stake a position on where that price is likely to go. This article lists out what futures are, the mechanics behind them, and their defining features.
Key Takeaways
- Entering a futures contract fixes the price for delivery or settlement on a set future date.
- What separates a future from a forward is standardisation.
- A comparatively modest deposit, known as margin, is enough to control a sizeable futures position.
- Because exchanges revalue open positions each trading day under mark-to-market settlement, gains and losses appear in an account well ahead of the contract's actual expiry.
- The underlying assets could be agricultural commodities, metals, currencies, interest rate instruments, and stock indices.
What is a Futures Contract?
Imagine two parties settling, in the present, on a price for an asset that will only actually be exchanged much later. That, in essence, describes a futures contract.
One side commits to buying, the other to selling, a fixed quantity of that asset at a price agreed in advance, with delivery or settlement falling due on a stated future date.
Almost any asset with a sufficiently large market can serve as the underlying: cotton, crude oil, gold, currencies, and stock indices are common examples.
What sets a futures contract apart from an informal deal is standardisation.
An exchange fixes the exact quantity, quality, and expiry date for every contract of a given type, so a cotton futures contract bought in Ahmedabad looks identical to one bought in Mumbai.
Why do People use Futures Contracts?
There are two broad reasons to enter a futures contract: hedging and speculation.
Hedging means protecting yourself against a price movement you cannot control. Producers and buyers of a commodity often turn to futures for exactly this reason.
Say a company needs a steady supply of crude oil each month for its operations. Rather than worry about oil prices spiking unexpectedly, it can buy oil futures now and know precisely what it will pay when the contract matures.
The oil producer on the other side of that trade benefits too, since selling futures locks in a price for output it hasn't even produced yet.
A speculator's motives are quite different. Taking actual delivery of a thousand barrels of oil holds no appeal for them whatsoever.
What matters is a conviction that price will shift in a particular direction, and the intention to profit from being proved right.
How Futures Work
Take the case of a cotton farmer in Gujarat expecting to bring in a harvest of 100 tonnes over the next 6 months, with sale likely around March. Cotton is currently changing hands at ₹58,000 per tonne in the spot market.
Two options are open to this farmer:
- Wait and sell at whatever price the market happens to offer in March.
- Lock in a price now, through a futures contract, and sidestep the uncertainty of where prices might drift between now and harvest.
Agricultural prices can swing considerably, so the spot price come March could look very different from today's figure.
A farmer anticipating higher prices ahead might well choose not to lock anything in just yet. Should ₹58,000 per tonne strike them as a reasonable price, however, securing it in advance through a futures contract becomes the sensible course.
A pricing model determines the futures rate, weighing in the spot price alongside the risk-free rate of return, the time remaining to expiry, storage costs, and convenience yields.
Take the 6-month cotton contract, priced at ₹60,500 per tonne. Signing this contract obliges the farmer to deliver 100 tonnes come March, and in return, a sale value of ₹60,50,000 is locked in from the outset.
That figure holds regardless of the spot price at expiry. Whether cotton rises to ₹65,000 per tonne or falls to ₹52,000, the farmer still receives ₹60,500 per tonne as agreed.
Types of Underlying Assets in Futures
The range of assets underlying a futures contract include:
- Agricultural commodities, such as cotton, wheat, and corn.
- Energy products, including crude oil and natural gas
- Precious metals, including gold and silver.
- Currencies, based on the value of one currency against another.
- Interest rate instruments, including government bonds and Treasury securities.
- Stock index futures and equity futures, based on a market index or individual stocks.
Each market draws its own mix of hedgers and speculators, though the contract mechanics stay largely the same.
Features of a Futures Contract
- Standardisation: The exchange fixes quantity, quality, and expiry, leaving price as the only negotiable term.
- Exchange trading: Futures trade on a recognised exchange, not privately between two parties.
- Margin requirement: Traders deposit margin before opening a position and maintain it as the contract's value moves.
- Leverage: Margin is only a fraction of the contract's full value, so a small deposit controls a large position, magnifying gains as well as losses.
- Mark-to-market settlement: Exchanges revalue open positions daily, passing profits or losses between accounts.
- Settlement at expiry: Depending on the contract, this happens through cash settlement or physical delivery.
How Futures Differ From Forward Contracts
People sometimes use "futures" and "forwards" interchangeably, but they are not the same.
A forward is a private, over-the-counter arrangement, with terms the two parties negotiate themselves.
A futures contract is standardised and traded through an exchange, with a clearing corporation acting as an intermediary to reduce the risk of either side defaulting.
|
Feature |
Forward contract |
Futures contract |
|
Where it is traded |
Privately, over the counter |
On a recognised exchange |
|
Contract terms |
Customised by the two parties |
Standardised by the exchange |
|
Settlement |
Usually at maturity, as agreed |
Marked to market daily, final settlement at expiry |
|
Counterparty risk |
Higher, since parties deal directly |
Lower, due to exchange clearing |
|
Liquidity |
Often limited |
Often higher for actively traded contracts |
If your needs are unusual, say an odd contract size or a specific delivery location, a forward might suit you better.
If you value the ability to exit a position quickly, with confidence the other side will deliver, futures are generally the safer route.
Also Read About: What Is a Forward Contract?
Advantages of Trading Futures
-
Hedging against volatility: Locking in today's price shelters your budget or revenue from whatever swings the market has in store later on.
-
Liquidity: Contracts that see heavy trading activity are generally easier to move in and out of when the moment calls for it.
-
Exposure without handling: An asset class becomes accessible without the burden of storing, transporting or physically managing the underlying item itself.
Limitations of Futures Trading
-
Leverage risk: Since margin is only a portion of a contract's value, even a small price move can produce a large gain or loss relative to what you put in.
-
Margin call risk: If the market moves against your position, your broker may ask for more funds to maintain it. Fail to provide them, and your position could be reduced or closed, often at a loss.
-
Expiry risk: Holding a contract until expiry may mean cash settlement or physical delivery, depending on its terms, so it helps to know which applies before you trade.
-
Systemic risk: Markets are connected. A geopolitical event or economic shock in one corner of the world can ripple into prices you're trading, sometimes with little warning.
Conclusion
Futures contracts offer a genuine trade-off. Buying and selling them opens the door to price speculation on one hand, and to risk mitigation against a potential market downturn on the other. This makes futures a versatile tool for a range of market participants. That versatility, though, comes with strings attached. A hedge taken on the wrong side of a move can compound losses rather than contain them.
