What Is a Futures Contract?

Introduction

A futures contract is an agreement between two parties to buy or sell a specific asset at a predetermined price and date in the future. It is a type of derivative, or a financial contract that derives its value from another asset. Futures contracts can have several benefits for investors, but also come with several risks. In this article, we'll take a look at exactly what a futures contract is, detail the potential benefits and risks, and explore the practical reasons for using such an investment.

History of Futures Trading

Futures trading has a long and varied history. The concept of buying and selling commodities on a regulated future date first emerged in Japan as early as the 17th century. Known as “Dojima Rice Exchange”, this primitive form of futures trading was continued until the late 19th century. It was however, its use in the early Chicago Board of Trade (CBOT) that would popularize its use and shape the modern world of futures trading.

Origins

In the mid-1800s, grain traders in Chicago needed a way to protect themselves from price volatility in the grain market. To achieve this, they established forward contracts for the sale of grain at a future delivery date. After two grain traders were unable to meet their obligations to each other, the CBOT was established in 1848 to provide a formalized means for futures trading. This enabled buyers and sellers of commodities to meet and transact on a regulated exchange.

Modern Futures Trading

Since then, the futures trading industry has grown significantly. Today, it is divided into three distinct categories – agricultural, energy, and metal commodities. While initially used as a hedging instrument, futures are also now used for speculating. The introduction of electronic platforms has made futures trading more accessible than ever before and has enabled traders to take advantage of a variety of market movements.

• Price volatility in the grain market of mid-1800s Chicago led to the development of forward contracts on the Chicago Board of Trade.
• This primitive form of futures trading later grew into the modern industry, which is divided into agricultural, energy, and metal commodities.
• Futures contracts are now used both as hedging instruments and for speculation.
• The introduction of electronic platforms has made futures trading more accessible to traders.

Contract Specifications

A futures contract is a legally-binding agreement between two parties to purchase or sell a specific asset at a predetermined price on a specific date. As such, each contract has several specifications for both parties to fulfill on delivery date. These include delivery dates, quality standards, and cash and physical delivery options.

Delivery Dates

The delivery date of a futures contract is the date by which the asset must be delivered. This date is agreed upon by both parties when the contract is made and will be clearly stated in the contract. Delivery can occur on or before the delivery date, but any agreement that exceeds this date must be re-established.

Quality Standards

Since a futures contract is legally-binding, both parties must agree to the quality standards of the asset being delivered.

Quality standards may include the cost, age, or condition of the asset, and may be subject to industry or regional standards. Quality standards must be specified in the contract and agreed upon by both parties to ensure both meet their obligations.

Cash and Physical Delivery Options

When making a futures contract, both parties must agree on the method of delivery. The two primary methods of delivery are cash and physical delivery. Cash delivery involves the exchange of money for the delivery of the asset, while physical delivery requires the physical exchange of the asset. Both options can be used, depending on the specific asset being traded.

In addition, cash and physical delivery can be combined, which involves the delivery of the asset alongside a cash payment to make up any difference between the agreed-upon price of the asset and the current market price.

Executing Futures Contracts

A futures contract is an agreement between two parties to buy or sell an asset at a predetermined price and date. Execution of a futures contract requires a market participant to enter an order specifying the type and quantity of the contract they want to purchase. There are various types of market participants that can execute futures contracts, including commercial entities, individuals, institutional investors, and market makers.

Types of Market Participants

The different types of market participants that can execute futures contracts are primarily divided into two categories: commercial and non-commercial. Commercial entities are companies or organizations that use futures contracts to hedge and reduce the risk of price fluctuations. Non-commercial participants include individuals, institutional investors, and market makers. Individuals typically use futures contracts as speculative instruments to make investments. Institutional investors use futures contracts for portfolio diversification, hedging, and to take advantage of price movements. Market makers provide liquidity to the market by providing both bids and offers for contracts.

Products Traded

Futures contracts are traded on a variety of commodities, financial products, and indices. These products are listed on futures exchanges and each contract has standardized characteristics including size, quality, quantity, and delivery date. Popular commodities traded on futures exchanges include energy, precious metals, soft commodities, and foreign exchange. Financial products such as bonds, interest rates, and stock indices are also traded in futures markets, while some exchanges offer weather derivatives.

Execution Process

The execution process for futures contracts begins when a market participant places an order with an exchange. The order specifies the terms of the contract and is typically executed at the best available price. The exchange then matches the order with one of its market makers, who is responsible for providing liquidity. The contract is then executed, and the market participant must deposit sufficient funds to cover the purchase. This process is known as margin and is typically set at 20-50% of the value of the underlying asset.

Once the contract is executed, the buyer is under an obligation to purchase the underlying asset, and the seller is obligated to deliver it. The buyer is obligated to pay the seller the purchase price at the delivery date. The contract is closed either when delivery has taken place or when a new contract is purchased to offset the original position.

Clearing and Settlement Process

The clearing and settlement process for futures contracts can be a daunting task for somebody unfamiliar with the process. It is important to understand the procedures put in place to keep a futures contract from expiring in order to protect both parties in the contract.

Contract Clearing

Contract clearing involves several steps. Upon entering a futures contract, the contract is matched with a clearing broker. This broker will then guarantee the obligations of both buyers and sellers. Documents related to the contract such as margin calls and daily settlement prices will be exchanged between the clearing broker and both parties of the contract. Once all documents are exchanged, the trade is considered to be cleared and the legal obligations contained in the contract are considered to be active.

Payment and Delivery

Payment and delivery obligations, as specified in the futures contract, are completed at the end of the clearing and settlement process. This process begins when the clearing broker informs both parties of the final settlement price of the contract. This settlement price is the price agreed upon to settle the contract, which is determined by the daily closing price or the final trade price of the underlying asset.

After the final settlement price is determined, both parties will exchange payment and/or underlying assets in order to meet the obligations of the contract. At this point, the contract is considered to be fully settled and delivery of the underlying asset may take place.

Hedging Strategies

Hedging strategies are used to reduce risk by offsetting potential losses with gains from other markets. In the context of futures contracts, hedging involves taking a long or short position in the market to protect against potential losses from a price movement in an unwanted direction.

Long Position

A long position in a futures contract means that an investor purchases a contract with the expectation that market prices will increase in the future. This allows the investor to lock in a lower price and sell the contract later at a higher price, securing a profit from the difference in price.

Short Position

A short position in a futures contract means that an investor sells a contract with the expectation that market prices will decrease in the future. This allows the investor to buy the contract later at a lower price and make a profit from the difference in price.

Conclusion

In conclusion, a futures contract is an agreement between two parties to buy or sell an asset at a predetermined time in the future. It allows traders to speculate on the future direction of the price of commodities, currencies, stocks, and other financial instruments. It also provides traders with leverage and can be used to act on expectations of price movements in different asset classes.

Summary

Futures contracts offer traders a way to speculate on and manage risk in markets, allowing them to take advantage of price movements in different asset classes. The contract is an agreement between two parties to buy or sell an asset at a predetermined time in the future and is settled in cash.

Key Points

In summary, some key points regarding futures contracts are as follows:

• Futures contracts are used to manage risk and to take advantage of price movements in different asset classes.
• The contract entails an agreement between two parties to buy or sell an asset at a predetermined time in the future.
• Futures contracts can be used to speculate on the future direction of price movements in financial instruments such as commodities, stocks and currencies.
• Traders can use leverage to increase the size of their positions and increase their profits.

Moving Forward

Futures contracts are a useful trading tool for speculating on price movements, managing risk, and taking advantage of leverage. To become proficient in trading futures, traders must have knowledge of trading strategies and have a good understanding of market sentiment and risk management techniques.