What is Futures Contract & How Do they Work?

What is a Futures Contract?

Futures contracts are exchange-traded derivatives traded in a centralized intermediary, for example, the National Stock Exchange of India (NSE). As a contract, it has similarities with another derivative contract – the forward contract. In both cases, counterparties agree to trade a security or an asset at a pre-decided price in the future. However, the significant difference with a forward contract is that a futures contract is standardized in terms of lot size or contract size, expiry date, thus allowing less room for personalization. The exchange on which the contract is tradable determines and regulates its conditions.

Additional read: What is the difference between a forward and a future contract?

Who can Trade Futures Contract?

• Hedgers: They use this type of contract to protect themselves from the future price rise. The goal here is to prevent losses rather than to bet on the price movement of an asset. Here, the buyer and the seller would lock the price of an asset and honour the contract. That would be regardless of the price at a future date. If the price decreases, the seller would profit on the hedge that would balance out the losses of selling that asset in an open market.
• Speculators: They use this type of contract to predict and profit on the price movement of an asset. They are positioned for a profit if the price is directed towards a higher price at expiration than the original contract price. If it's the other way around, they may choose an offsetting position to eliminate risks and losses associated with the original contract. Here, the contract is cash-settled instead of the physical delivery of the asset from the seller to the buyer.

Types of Futures Contract

While the derivatives market commonly associate futures with commodities like corn, wheat, crude oil, etc., futures are traded for other kinds of assets, too, like:

• Stock index futures: A contract where the underlying asset is a specified quality of an individual stock. For example, S&P 500.
• Currency futures: A contract where the underlying currency is a specified quantity of that currency. For example, euro or dollar.
• Interest rate futures: A contract where the underlying currency is a specified quantity of an interest-bearing asset. For example, treasury bills or treasury bonds.
• Precious metal futures: A contract where the underlying currency is a specified quantity of gold or silver or any other precious metal.  

Additional read: What are Currency Futures?

Advantages of Futures Contract

• Hedging: Because future contracts allow risk tolerance and protection from price volatility, they ensure access and flow of capital to all investors
• Low margin: Investors have to uphold only 5% - 10% of the contract value
• No time decay: Futures markets usually trade in asset classes whose value do not depreciate over time, like gold.
• Low counterparty risk: Unlike a forward contract, a clearing house's standardization and regulation of a futures contract make it less prone to a credit default.
• High liquidity: Futures markets trade in assets that can most readily be converted into cash.

Disadvantages of Futures Contract

• Leverage: Because futures contracts offer a shallow margin, investors can lose money much more quickly if the price movement is not in the right direction.
• Less control over future pitfalls: Future contracts offer little room to predict and control future damage like currency downfall due to politics.
• Fixed expiration dates: Asset value may look less attractive as the expiration date approaches. But being regulated, that date should remain unchanged.

Conclusion:

Future contracts are an attractive instrument to gain access to the capital market with little upfront costs. Being regulated allows less room for counterparty risks. However, investors need to tread cautiously and follow the market closely to gain maximum profit with minimal margin.

Disclaimer

ICICI Securities Ltd. ( I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Centre, H. T. Parekh Marg, Churchgate, Mumbai - 400020, India, Tel No : 022 - 2288 2460, 022 - 2288 2470. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The contents herein above are solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investments in securities market are subject to market risks, read all the related documents carefully before investing. The contents herein mentioned are solely for informational and educational purpose.