Futures Contract Definition:
A “Futures Contract is an agreement between two anonymous market participants”, a seller and a buyer. Here, the seller undertakes to deliver a standardized quantity of a particular financial instrument (or a commodity) at a certain price and a specified future date. On the other hand, the buyer undertakes to accept the goods underlying the futures contract of delivery date. Volume and generic trading futures contracts are standardized:
Standardized Amount: Each futures contract is a standardized quantity, e.g. Rs.100, or Rs.50 per federal futures contract, or 100 ounces per gold contract.
Specific Financial Instrument: The contract specifications define not only the underlying financial instrument – for example, BUND-future or gold, but also its quality such as coupon interest and life of the interest rate of contract, or the purity of the gold.
Certain Price: This is the future contract price that must be paid later for the financial instrument is predetermined.
Future Time: There are 3 or more calendar months a year, during which a possible delivery must take place for each financial instrument. A related futures contract is traded for each of the calendar months.
Futures Contract Example:
There is an expiry date for all Futures Contracts. As in India, All the future contracts are expired on every month last Thursday. For example: Suppose you buy NIFTY future contract with a lot size of 50 on 1st February 2016 of one month expiry at Rs. 7200. This means that future contract will get expire on 25th February 2016 (last Thursday of the Month). Margin required to buy the future contract is around 11%; which means to buy the future contract you will require Rs.39,600 (Rs.7200 * 50 (lot size) * 11%). If NIFTY moves 50 points upside and reaches to 7250; which means that you are making profit of Rs.2,500 (50 * 50 (lot size)). You can sell the future contract even before expiry. If you sell with rise of 50 points in future market, then you are making Rs.2,500 as a profit out of it.
Types of Futures Contract:
There are various different types of Future Contracts for different class of assets available in the future market. This includes: Stock Futures, Currency Futures, Commodities Futures and Index Futures. You can trade in any of the contracts wherever you are comfortable and wherever you possess a strong knowledge on it. It is highly recommended that you should gain sound knowledge and perform paper trading before you actually start investing and trading in the future market.
History of Futures Contract:
The futures contracts are born in Japan around 1600 and the aim of these contracts was to ensure the price of a crop if a weather adversity comes. The first traded products included the futures commodities, such as rice.
The mechanism was simple, the producer wanted to set a price before harvesting the crop , as if there was an unfavorable climatic conditions, the farmer could lose their harvest unable to sell anything. Thus they made sure to sell their crop at a price. This today is known as a short sale because the farmer sells his crop to grow before a contract price.
Brief History of Futures Contracts:
Once reached maturity, or harvesting of the raw material, they could be faced with three situations:
1. The market price (the rest of farmers) is equal to the previously agreed because there have been normal circumstances (no weather problems or exceptionally good harvests).
2. The market price is higher than the agreed price; in this case the buyer is more beneficial as it negotiated a price below the price at harvest. The farmer can get hurt because the crop could be sold at a higher price, and this higher price, due to a bad harvest could be due to adverse weather conditions, a plague … Being able to get the farmer to have heavy losses.
3. The market price is below the agreed: In this case the buyer loses because it paid a premium price for raw materials, whereas if they had waited could have bought cheaper. The farmer gets away for surely there must have been a plentiful harvest and given the offer, he was able to sell at a price above the market price for the previous agreement made.
As you can see in this overview it is a question of assessing the value of time and the risk (probability of a loss). Generally and currently, the derivatives are used to hedge risks, using valuation methods.
Benefits of Organized Future Market:
Also as you can imagine the reader, if this market was not organized enough for a strong impassive to breach the contract in cases 2 and 3, first by the farmer, because there would be willing to sell the crop at a lower price market and in the third case because the buyer would not be willing to buy more expensive than the market price. This need for organization culminates in 1848 in Chicago, creating the Chicago Board of Trade (CBOT), which was a pioneer in the stock trading in futures contracts. At the time the contracts were settled by physical delivery, as expected.
The first futures contracts, as I said, were commodities (rice, corn, wheat, cotton …) and in the 80s, it began trading other products such as wood or some metals. And in the 90s they began to negotiate contracts on government bonds in the India, and later the first stock indices. Currently, the futures contracts include the widest range of traded products.
In short, performing of the contract at a later date is in itself a business method that is common and practiced by everyone. So the unique character of the futures markets is not the time period but the fact that the contracts are standardized.
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