What Are Future Contracts And How Do They Work?

What Are Futures Contracts?

A legal agreement involving the sale and purchase of a certain commodity, asset, or security at a predetermined price at some point in the future is known as a future contract. To facilitate their trade on the futures exchange, future contracts are standardized to check for quantity and quality. The individual who will purchase the future contract will take on the obligation to both purchase and/or receive the underlying asset, once the future contract will expire. The seller of this contract takes on the obligation to provide and deliver the asset that is underlying it by the time the expiration date comes around.

Hence, in simpler words, futures are financial derivatives that oblige the buyer to purchase some security, or a seller to sell that security, to some predetermined future date and price. Future contracts allow an investor to speculate what direction a commodity, security, or financial instrument, whether short or long, will move in with the help of leverage. Future contracts are also often employed with the goal of heading price movements of the underlying asset so one can aid in preventing losses from price changes that are rather unfavourable.

What Is Future Trading?

Future contracts are financial contracts that are derivative in nature, where both parties involved are meant to transact an asset at a predetermined future date and price. To follow the protocol of futures trading, a buyer must purchase while the seller sells the underlying at a price that is set, regardless of the prevailing market price as well as its expiration date. Underlying assets include financial instruments or physical commodities. Future contracts also detail the quantity at which the underlying asset is standardized to facilitate trading using a futures exchange.

Futures can be employed with the goal of trade speculation or hedging. When one says, “futures” and “future contract,” these are both referring to the same thing. As an instance, you may hear somebody claim that they purchased oil futures, which means the same thing as buying an oil future contract. In fact, when someone uses the term ‘future contract,’ they are often referring to a certain type of future like gold, bonds, oil, or S&P 500 index futures.

When it comes to investing in oil, future contracts may also be among the most direct ways to invest. The term futures is a rather general way often used to refer to the entire market. Unlike forward contracts, as mentioned earlier, future contracts are standardized. In fact, forwards or forward contracts are similar types of agreements that lock in a future price in the present. However, forwards are traded over-the-counter (OTC) and have terms that are customizable which both counter-parties arrive at. Alternatively, a future contract will have the same terms of selling and purchase, irrespective of who the counter-party is.

Features Of Future Contract

Now that we understand how future contracts work, here are some features of future contracts.

  • Commodity futures markets in India are regulated by the FMC — Forward Markets Commission. This governing body regulates aspects such as withdrawing or granting recognition of any commodity markets engaged in forward dealings.
  • Available for many different types of asset classes. A future contract can work across exchanges, commodities or currencies, and indices.
  • Unlike a forward contract, a future contract is standardized. As an example, once a contract states that it applies to 1000 barrels of oil, one will have to lock in their price as per that unit or in multiples of it. If one wanted to lock in a price, they would need to sell or purchase a hundred separate contracts. To lock in the price of a million barrels of oil, one would need to buy or sell a thousand such contracts. Future contracts allow a hedge to shift risks toward speculators.
  • Traders also get an efficient idea of what the futures price of a stock or the value of its index is likely to become.
  • Future contracts can mainly aid in determining the future supply and demand of shares, which will be based on their current future price.
  • Since futures are traded on margin trading, they allow those without sufficient funds to carry out and participate in trades. One can do so by paying a smaller margin rather than the entire value of the physical holdings.
  • Future contracts are employed by two types of market participants: speculators and hedgers. Those who produce or purchase an underlying asset hedge are known as producers or purchases. These individuals also guarantee the price at which the commodity will be purchased or sold. Alternatively, those who may bet on the price movements of the underlying asset through the use of futures.

Future Contract Example

To put this into perspective, an oil producer is required to sell their oil, and they can use a future contract to do so. With the aid of future contracts, the oil producer can lock in the price at which they will sell, and thereby deliver the oil to their buyer, once the future contract expires. On the other hand, a manufacturing company may require oil to use for making widgets.

Since this company prepares well by planning ahead and prefers to have oil coming in each month, they may also employ the use of a future contract. This way the company knows the price at which they will receive oil, based on the price set in their future contract. They know that they will be taking up the delivery of that oil once their contract expires.

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