What Are Future Contracts And How Do They Work?

Last Updated: 29 Dec 2022

Derivative Trading has proved to be highly profitable for investors looking to diversify their portfolios by investing in other asset classes. Among derivatives, some choose options trading while some prefer Futures trading. However, given the complexity of futures contracts, you need to understand everything regarding the financial instrument.

What Is Future Trading?

A Futures contract is a legal agreement involving the sale and purchase of a certain commodity, asset, or security at a predetermined price and date in the future. To facilitate their trade on the futures exchange, futures contracts are standardised to check for quantity and quality.
The individual who purchases the future contract is obliged to purchase and/or receive the underlying asset before the futures contract expires. The seller of this contract takes on the obligation to provide and deliver the asset on which the futures contract is based to the buyer at the time the futures contract is exercised.
Future contracts allow an investor to speculate the direction in which the underlying assets such as a commodity, security, or financial instrument will move. These contracts are often purchased with the goal of hedging price movements of the underlying asset to prevent losses from rather unfavourable price changes.

Understanding Futures Contracts: What Is Future Trading?

Futures contracts are financial contracts with derivative nature, where both parties involved are meant to transact an asset at a predetermined future date and price. When you trade using Futures Contracts, the process is known as Futures Trading.
To follow the protocol of futures trading, a buyer must purchase while the seller sells the underlying asset at a price that is set, regardless of the prevailing market price as well as its expiration date. Future contracts also detail the quantity at which the underlying asset is standardised to facilitate trading using a futures exchange.
When people say, “futures” and “future contract,” they are 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 futures contract. When someone uses the term ‘future contract,’ they are often referring to a certain type of futures like gold, bonds, oil, or S&P 500 index futures.

The Difference Between Futures and Forwards Contract

The term futures is a rather general way often used to refer to the entire market. Unlike forward contracts, as mentioned earlier, futures contracts are standardised. 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 customisable. Alternatively, a future contract will have the same terms of selling and purchase, irrespective of the counterparty.

Features Of Future Contracts

Here are some amazing features of futures 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 futures contract is standardised. 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 wants 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. 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 is 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 hedgers. These individuals also guarantee the price at which the commodity will be purchased or sold. Alternatively, those who bet on the price movements of the underlying asset through the use of futures are known as speculators.

Futures Contract Example

Here is an example of a futures contract for a better understanding:

Suppose an oil producer wants to sell oil but fears that the oil prices may fall in the future. To ensure the oil producer gets a predetermined price and not incur a loss, a futures contract can be used. With the aid of future contracts, the oil producer can lock in the price at which the oil will sell thereby delivering the oil to the 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.

Conclusion

Futures Contracts are a great way to diversify your portfolio and ensure you make good profits by using your knowledge and speculating on future prices. As you can trade in Futures based on numerous types of underlying assets, you can use a futures contract to effectively hedge your losses in other asset classes and take delivery of the underlying asset before the expiry date.