9. How are futures contract really executed?

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A futures contract is a contract between two parties where both parties agree to buy and sell a particular asset of specific quantity and at a predetermined price, at a specified date in future.

The payment and delivery of the asset is made on the future date termed as delivery date. The buyer in the futures contract is known as to hold a long position or simply long. The seller in the futures contracts is said to be having a short position or simply short.

The underlying asset in a futures contract could be commodities, stocks, currencies, interest rates and bond. The futures contract is held at a recognized stock exchange. The exchange acts as mediator and facilitator between the parties. In the beginning both the parties are required by the exchange to put beforehand a nominal account as part of a contract known as the margin.

Since the futures prices are bound to change every day, the differences in prices are settled on a daily basis from the margin. If the margin is used up, the contractor has to replenish the margin back in the account. This process is called marking to market. Thus, on the day of delivery it is only the spot price that is used to decide the difference as all other differences had been previously settled.

Understanding Futures Contracts

Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. Here, the buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.

Underlying assets include physical commodities or other financial instruments. Futures contracts detail the quantity of the underlying asset and are standardized to facilitate trading on a futures exchange. Futures can be used for hedging or trade speculation.

"Futures contract" and "futures" refer to the same thing. For example, you might hear somebody say they bought oil futures, which means the same thing as an oil futures contract. When someone says "futures contract," they're typically referring to a specific type of future, such as oil, gold, bonds or S&P 500 index futures. Futures contracts are also one of the most direct ways to invest in oil. The term "futures" is more general, and is often used to refer to the whole market, such as "They're a futures trader."

Futures contracts are standardized, unlike forward contracts. Forwards are similar types of agreements that lock in a future price in the present, but forwards are traded over-the-counter (OTC) and have customizable terms that are arrived at between the counterparties. Futures contracts, on the other hand, will each have the same terms regardless of who is the counterparty.

Example of Futures Contracts

Futures contracts are used by two categories of market participants: hedgers and speculators. Producers or purchasers of an underlying asset hedge or guarantee the price at which the commodity is sold or purchased, while portfolio managers and traders may also make a bet on the price movements of an underlying asset using futures.

An oil producer needs to sell their oil. They may use futures contracts do it. This way they can lock in a price they will sell at, and then deliver the oil to the buyer when the futures contract expires. Similarly, a manufacturing company may need oil for making widgets. Since they like to plan ahead and always have oil coming in each month, they too may use futures contracts. This way they know in advance the price they will pay for oil (the futures contract price) and they know they will be taking delivery of the oil once the contract expires.

Futures are available on many different types of assets. There are futures contracts on stock exchange indexes, commodities, and currencies.

Mechanics of a Futures Contract

Let’s say you work in a company making baked goods and want to purchase large amounts of wheat at frequent intervals. You will need 100 quintals a month down the line. However, wheat prices are volatile, and to protect yourself; you enter into this type of contract to purchase 100 quintals of wheat at Rs 2,000 a quintal a month down the line. In the meantime, wheat prices go up to Rs 2,500 a quintal. However, you will still be able to buy it at Rs 2,000. Thus, you would have saved Rs 50,000 because of this type of contract! However, if wheat prices fall to Rs 1,500, you would have lost Rs 50,000.

This is an example of someone who wants to hedge against an increase in prices. This is a prevalent form of hedging and is undertaken by large and small organisations as well as by governments. For example, a country that imports large amounts of petroleum will hedge against price rise by going in for oil futures. Similarly, a large chocolate maker will hedge against an increase in the prices of cocoa by going for cocoa futures.

Wrapping up

Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume. 

Now that you understand - How are futures contracts really executed? it’s only logical that we move on to the next Module - Using Options Greeks.

A Quick Recap

  • Futures contracts are financial derivatives that oblige the buyer to purchase some underlying asset (or the seller to sell that asset) at a predetermined future price and date.
  • A futures contract allows an investor to speculate on the direction of a security, commodity, or a financial instrument, either long or short, using leverage.
  • Futures are also often used to hedge the price movement of the underlying asset to help prevent losses from unfavorable price change.
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