by In finance, a futures contract (sometimes called futures) is a standardized legal agreement to buy or sell something at a predetermined price at a specified time in the future, between parties not known to each other. The asset transacted is usually a commodity or financial instrument. The predetermined price the parties agree to buy and sell the asset for is known as the forward price. The specified time in the future which is when delivery and payment occur is known as the delivery date. Because it is a function of an underlying asset, a futures contract is a derivative product.
Contracts are negotiated at futures exchanges, which act as a marketplace between buyers and sellers. The buyer of a contract is said to be the long position holder, and the selling party is said to be the short position holder. As both parties risk their counter-party walking away if the price goes against them, the contract may involve both parties lodging a margin of the value of the contract with a mutually trusted third party. For example, in gold futures trading, the margin varies between 2% and 20% depending on the volatility of the spot market.
The first futures contracts were negotiated for agricultural commodities, and later futures contracts were negotiated for natural resources such as oil. Financial futures were introduced in 1972, and in recent decades, currency futures, interest rate futures and stock market index futures have played an increasingly large role in the overall futures markets. Even organ futures have been proposed to increase the supply of transplant organs.
Expiration
Expiration (also known as maturity or expiry date) refers to the last trading day of the futures contract. After the expiry of a futures contract, final settlement and delivery is made according to the rules laid down by the exchange in the contract specifications document.
Contract Size
Contract size, or lot size, is the minimum tradable size of a contract. It is often one unit of the defined contract.
Initial Margin
Initial margin is the minimum collateral required by the exchange before a trader is allowed to take a position. Initial margins can be paid in various forms as laid down by the exchange and varies from commodity to commodity as well as from time to time. The level of initial margin is dependent on the price volatility of the contract. More volatile commodities generally have higher margin requirements.
Price Quotation
Price Quotation is the units in which the traded price of a contract is displayed. It can be different from the trading size of a contract and is often based on industry practices and conventions.
Tick Size
Tick Size is the minimum movement allowed by the exchange in Price Quotation.
Tick Value
Tick Value refers to the minimum profit or loss that can arise from holding a position of one contract. Tick value depends on the size of the contract and its tick size. While it is often explicitly mentioned in contract specifications, it can be calculated by the formula:
Tick Value = Contract Size x Tick Size
Mark to Market
Mark to market refers to the process by which the exchange calculates and values all open positions according to pre-defined rules and regulations. Mark-to-market is an essential feature of exchange-traded futures contracts whereby the exchange ensures that all profit and losses are recognized by pricing them according to accurate market conditions. It is also an important feature for the risk management of positions of participants.
Delivery Date
Delivery date or delivery period refers to the time specified by the exchange during or by which the seller has to make delivery according to contract specifications and regulations. Delivery date is often later than expiry date of a contract, especially in case of physically delivered commodities.
Daily Settlement
Daily settlement refers to the process whereby the exchange debits and credits all accounts with daily profits and losses as calculated by the mark-to-market process. Daily settlement is necessary in order to recover losses and pay profits to respective accounts.
Advantages and risks of futures contracts:
The existence and the utility of a futures market benefits a lot of market participants:
- It allows hedgers to shift risks to speculators.
- It gives traders an efficient idea of what the futures price of a stock or value of an index is likely to be.
- Based on the current future price, it helps in determining the future demand and supply of the shares.
- Since it is based on margin trading, it allows small speculators to participate and trade in the futures market by paying a small margin instead of the entire value of physical holdings.
However, you must be aware of the risks involved too. The main risk stems from the temptation to speculate excessively due to a high leverage factor, which could amplify losses in the same way as it multiplies profits. Further, as derivative products are slightly more complicated than stocks or tracking an index, lack of knowledge among market participants could lead to losses.
Stock futures:
Stock futures are derivative contracts that give you the power to buy or sell a set of stocks at a fixed price by a certain date. Once you buy the contract, you are obligated to uphold the terms of the agreement.
Here are some more characteristics of futures contracts:
- Lot/Contract size: In the derivatives market, contracts cannot be traded for a single share. Instead, every stock futures contract consists of a fixed lot of the underlying share. The size of this lot is determined by the exchange on which it is traded on. It differs from stock to stock. For instance, a Reliance Industries Ltd. (RIL) futures contract has a lot of 250 RIL shares, i.e., when you buy one futures contract of RIL, you are actually futures trading 250 shares of RIL. Similarly, the lot size for Infosys is 125 shares.*
- Expiry: All three maturities are traded simultaneously on the exchange and expire on the last Thursday of their respective contract months. If the last Thursday of the month is a holiday, they expire on the previous business day. In this system, as near-month contracts expire, the middle-month (2 month) contracts become near-month (1 month) contracts and the far-month (3 month) contracts become middle-month contracts.
- Duration: Contract is an agreement for a transaction in the future. How far in the future is decided by the contract duration. Futures contracts are available in durations of 1 month, 2 months and 3 months. These are called near month, middle month and far month, respectively. Once the contracts expire, another contract is introduced for each of the three durations. The month in which it expires is called the contract month. New contracts are issued on the day after expiry.
- Example: If you want to purchase a single July futures contract of ABC Ltd., you would have to do so at the price at which the July futures contracts are currently available in the derivatives market. Let’s say that ABC Ltd July futures trading are at Rs 1,000 per share. This means, you are agreeing to buy/sell at a fixed price of Rs 1,000 per share on the last Thursday in July. However, it is not necessary that the price of the stock in the cash market on Thursday has to be Rs 1,000. It could be Rs 992 or Rs 1,005 or anything else, depending on the prevailing market conditions. This difference in prices can be taken advantage of to make profits.
Participant
Eligible contract participants like financial institutions, insurance companies, and investment management firms have sufficient regulatory status
