A futures contract is a legal agreement to buy or sell a particular product or asset at a predetermined price at a specific time in the future. Futures contracts are standardized in terms of quality and quantity to facilitate trading on the futures exchange (within the derivatives market). The buyer of a futures contract is assuming the obligation to buy the underlying asset when the futures contract expires. The seller of the futures contract is assuming the obligation to provide the underlying asset on the expiration date.
What is a futures contract?
“Futures contract” and “futures” refer to the same. For example, we may hear someone say that they have bought oil futures, which means the same as an oil futures contract. When someone says “futures contracts”, they usually refer to a specific type of future, such as oil futures, gold, bonds or indices, like the S&P 500 . The term “futures” is more general and is often used to refer to the entire market.
Example futures contract
Futures contracts are used by two categories of market participants: hedge and speculators. The producers or buyers of an underlying asset hedge or guarantee the price at which they sell or buy the product, while portfolio managers and traders can also bet on price movements of an underlying asset using futures.
An oil producer needs to sell its oil. They can use futures contracts to do this. That way they can set a price at which they will sell and then deliver the oil to the buyer when the futures contract expires. Similarly, an industrial company may need oil to produce certain finished products. Since they like to plan ahead and always need oil every month, they can also use future contracts. This way, they know in advance the price they will pay for oil (the exercise price of the future contract) and know that they will receive the oil delivery when the contract expires.
Futures are available in many different types of assets. There are futures contracts on stock indices, commodities and currencies.
Mechanics of a futures contract
Imagine that an oil producer plans to produce one million barrels of oil during the next year and will be ready for delivery in 12 months. Suppose the current price is $ 75 per barrel. The producer could produce the oil and then sell it at current market prices in a year from today.
Given the volatility of oil prices, the market price at that time could be very different from the current price. If the oil producer believes that oil will be higher in a year, he may choose not to block the price now. But if they think $75 is a good price, they could guarantee a guaranteed selling price by entering into a futures contract.
A mathematical model is used to evaluate the futures, which takes into account the current spot price, the risk-free rate of return, the time to maturity, storage costs and dividends in the case of stocks. Suppose one year oil futures contracts have an exercise price, or agreed price, of $78 per barrel. By signing this contract, in one year the producer is obliged to deliver one million barrels of oil and is guaranteed to receive $ 78 million. The price of $ 78 per barrel is received, regardless of where the spot market (or spot market) prices are at that time.
The contracts are standardized. For example, an oil contract on the Chicago Mercantile Exchange (CME) is 1,000 barrels of oil . Therefore, if someone wanted to guarantee a price (sell or buy) of 100,000 barrels of oil, they would need to buy or sell 100 contracts. To set a price in a million barrels of oil, they would have to buy or sell 1,000 contracts.
Future contracts under negotiation
Traders and portfolio managers are not interested in give and take of the underlying asset. A trader has little need to receive 1,000 barrels of oil, but may be interested in profiting from movements in the price of oil (surplus value or disability).
Futures contracts can be traded on profit only, as long as the transaction is closed before maturity. Many futures contracts expire on the third Friday of the month, but contracts vary, so you should check the contract specifications before trading.
For example, from January to April, contracts are traded at $55. If a trader believes that the price of oil will rise before the contract expires in April, they could buy the contract at $55. This gives them control of 1,000 barrels of oil. However, they are not required to pay $55,000 ($55 x 1,000 barrels) for this privilege. Instead, to perform this management, they only need to pay $ 55,000 ($ 55 x 1,000 barrels) for that privilege.
The gain or loss of the position fluctuates in the account as the price of the future contract moves (daily). If the loss is too large, the broker will ask the trader to deposit more money to cover the loss. This is called maintenance margin.
The final gain or loss of the trade is made when the trade is closed. In this case, if the buyer sells the contract for $60, he earns $5,000 [($60 to $55) x 1,000)]. Alternatively, if the price drops to $50 and they close the position, $5,000 is lost.