What is a futures contract

If the exchange participant simply buys stocks, he completes the usual transaction: pays money and immediately receives the desired product. There are other types of trading operations, when the seller and the buyer agree in advance on prices for deliveries, which will not be carried out immediately, but in the very distant future. One such transaction is the conclusion of a futures contract.

What is a futures contract?

A futures contract (futures) is a derivative financial instrument traded on specialized exchanges. This is a kind of agreement, according to which the seller gives an obligation to deliver the underlying asset, and the buyer agrees to pay it in the future at the price that was determined at the time of the transaction.

Futures markets began work in the middle of the XIX century. About a century, futures trading was usually carried out with precious metals and agricultural products. Only in the second half of the last century, stock indices, financial instruments, mortgage-backed securities, and also petroleum products came into circulation. The appearance of the futures gave participants of market operations the confidence that the fulfillment of obligations under the transaction will be made regardless of changes in market prices. Forming future prices, futures contracts to a certain extent set the pace for economic development, which to a large extent determines their value.

Assets underlying the futures contract are standardized. Dates and characteristics of deliveries are predefined. The specification of the futures contract indicates the place of delivery, for example, a depository for securities or a warehouse for the goods, as well as other details of the transaction (quantity, quality, labeling and packaging). Because futures are traded on an organized exchange, it is easy for buyers and sellers to find each other. Parties to the contract are liable to the exchange until the futures are settled. If after the expiration of the contract the required product will be absent from the seller, the exchange has the right to fine it.

Leading world futures exchanges:

• New York Mercantile Exchange;

• Chicago Mercantile Exchange;

• London Financial Futures and Options Exchange;

• London Metal Exchange;

• Australian stock exchange;

• Singapore Exchange.

Categories and types of futures contracts

In accordance with the assets for which the transaction is concluded, the following main categories of futures contracts are distinguished:

• grocery;

• agricultural;

• on energy;

• on precious metals;

• currency

• financial.

Futures contracts can be deliverable when the underlying asset is required to be physically provided, as well as settlement, when, upon expiration of the contract, mutual settlements between the parties to the transaction occur and the price difference is paid. Currently, most futures contracts are settlement, that is, do not provide for the supply of goods in the physical sense. In general, as applied to futures, the term “product” has a broad definition. It can mean a financial instrument and even a stock quote.

Futures contract specification

The specification for the futures contract indicates:

• name of the contract;

• type of contract;

• the amount of the underlying asset stipulated by the contract;

• asset delivery date;

• minimum size of price changes;

• cost of a minimum step.

Futures operations

The futures purchase operation is called the opening of a long position, and the sale operation is called the opening of a short position. Standardization of contracts allows purchases and sales within the same exchange to cover each other. To open a position, you need to make an initial deposit, also called guarantee security. Recalculation of mutual obligations usually occurs after each day. The difference between the price of opening and closing a position goes to the investor's account or is debited. Since differences have already been settled on the difference, at the beginning of the next trading day, opening a position on a futures contract is taken into account at the closing price of the previous trading session.

As in any transaction, when concluding a futures contract, there are two parties (seller and buyer). A key feature of futures is a “commitment”. If an option gives only the right, but does not oblige to purchase an asset after the expiration of the contract, then stricter rules apply to the futures. A futures transaction places certain obligations on both parties to a financial agreement.

Buying and selling futures contracts on the exchange is carried out in portions of the asset (product). Such portions are called lots. This is the difference between futures and forward transactions, where the quantity of goods can be any and is determined by agreement between the parties.

The life of a futures contract is limited. With the onset of the last trading day, it is no longer possible to conclude futures transactions on this date. Then the exchange sets the next term, after which a new futures contract begins to be traded.

Functions and parameters of the futures contract

Futures Contract Functions:

• determination of the fair price for a financial asset (raw materials, goods, currency);

• financial risk insurance (hedging);

• speculative transactions in order to obtain benefits;

• study of opinions on price dynamics.

Futures Contract Parameters:

• instrument (subject of the contract);

• date of performance;

• exchange where the contract is sold;

• asset unit

• deposit margin (the amount paid to cover potential losses).