A futures contract is an agreement to buy or sell a specified quantity of a specified asset on a future date for a specified price.
A futures contract is quite similar to a forward contract. It involves two parties who enter into a transaction to buy or sell a product at a particular price at a future date. This contract would also result in either party’s gain or loss. The most notable difference between the two is where they are being traded.
A futures contract is traded on a stock exchange, while a forward contract is traded privately, i.e., between two parties without the involvement of an exchange. Futures are exchange-traded derivatives, while forward are over-the-counter derivatives.
The parties to a futures contract have long and short positions as described below: –
- The party that agrees to buy in anticipation of a possible increase in the price of an underlying asset is said to have a long position.
- The party that agrees to sell in anticipation of a possible decline in the price of an underlying asset is said to have a short position.
Futures could be on underlying assets like equity, indices, currency, commodity, interest rate, etc.
Specifications of Futures Contract
The terms of each contract are standardized in a legal document called the ‘contract specification.’ This is because an exchange would not be financially viable to satisfy every trader’s requirements regarding particular underlying assets. So instead, the contract specifications allow participants to take positions on general price movements in any market.
The price is agreed upon between buyer and seller. The sole element of the futures contract is open to negotiation. However, the exchange specifies the minimum permitted movement in price and the quotation, e.g., the futures price of Nifty for two months expiry contract on NSE and minimum price movement per tick on NSE.
The exchange also lays down the fixed future date. Although it is a set day within the month, the fixed future date is often referred to as the expiry month.
A futures contract could be based on various underlying like individual shares, stock market indices, commodities, commodity futures, currency, etc.
As long as the contracts have a common underlying asset and an expected delivery date, the contract is said to be fungible, i.e., identical to and substitutable with others traded on the same exchange.
Examples of Futures Contracts
- Equity Futures: Futures on TCS, WIPRO, RELIANCE, etc.
- Index Futures: Futures on Nifty, Bank Nifty, Financial Services NIFTY, etc.
- Currency Futures: Futures on USDINR, GBPINR, etc.
- Commodity Futures: Futures on GOLD, Silver, Crude Oil, etc.
Trading Futures at an Exchange
Futures are contracts traded on a recognized stock exchange like NSE, BSE, or MCX in India and on NYSE, LSE, and global exchanges. Trading futures on an exchange requires a margin amount. Margin is an initial deposit to execute a futures contract. This deposit could vary depending on an underlying and range from 10-20% of a futures contract value or even more.
Margin amount signifies a trader’s willingness to stand good on any price change. A price change could be in favor or against. Since it is merely a deposit, a trader returns the margin money after a futures contract is settled.
A trader is always required to keep the margin at a certain level. However, the margin requirement may vary from one underlying asset to another. For example, suppose losses occur, and the margin account balance drops below the margin threshold or minimum requirement level; in that case, the trader needs to deposit an additional amount into the margin account to cover the losses and restore the margin up to the original levels. This is referred to as a margin call.
Note: If losses occur, the losses are taken out of the margin amount, and the trader would get only the residual amount.
The fact that futures contracts operate on margin. It makes it a highly leveraged financial instrument. A relatively small price movement in an underlying asset could result in a heavy fluctuation in a futures contract. This leverage should be closely monitored. Leveraged trading could work for or against a derivatives trader.
Conclusion: Futures, an Evolvement from a Forward Contract
Futures exchanges are transparent, settle, and guarantee all the transactions on their exchanges. An exchange facilitates the trading process between buyers and sellers; however, it does not take buy or sell positions. Clearing houses record all the transactions and guarantee timely payments on the futures contracts. Therefore, there is no need for the purchaser of a futures contract to check the seller’s creditworthiness.
Futures positions are opened by going long (i.e., buying a futures contract) or short (i.e., selling a futures contract). By opening a long futures position, the trader becomes exposed to changes in the futures price, and the position will incur profits or losses as a result of the movement in price. Holding the contract to expiry will oblige the trader to meet the delivery obligations. If the asset price rises, the futures buyer will have made a profit. The trader will take delivery at the lower price and be able to sell the asset in the cash market at the higher price. Conversely, if the price is lower than the agreed price, the trader’s counterparty (the futures seller) will make a profit.