A futures contract is an agreement between two parties – a buyer and a seller – wherein the former agrees to purchase from the latter, a fixed number of shares or an index at a specific time in the future for a pre-determined price. These details are agreed upon when the transaction takes place. As futures contracts are standardized in terms of expiry dates and contract sizes, they can be freely traded on exchanges. A buyer may not know the identity of the seller and vice versa. Further, every contract is guaranteed and honored by the stock exchange, or more precisely, the clearing house or the clearing corporation of the stock exchange, which is an agency designated to settle trades of investors on the stock exchanges. The terms “futures contract” and “futures” refer to essentially the same thing.
Mechanics of a Futures Contract
Imagine an oil producer plans to produce 1 million barrels of oil ready for delivery in exactly 365 days. Assume the current price is $50 per barrel. The producer could take a gamble, produce the oil, and then sell it at the current market prices one year from today. Given the volatility of oil prices, the market price at that time could be at any level. Instead of taking chances, the oil producer could lock-in a guaranteed sale price by entering into a futures contract. A mathematical model is used to price futures, which takes into account the current spot price, the risk-free rate of return, time to maturity, storage costs, dividends, dividend yields and convenience yields. Assume that the one-year oil futures contracts are priced at $53 per barrel. By entering into this contract, in one year, the producer is obligated to deliver 1 million barrels of oil and is guaranteed to receive $53 million. The $53 price per barrel is received regardless of where spot market prices are at the time.
Types of Futures Contracts
- Commodities – The most important is the oil futures contract. That’s because they set current and future oil prices. Those are the basis for all gasoline prices. Other energy-related futures contracts are written on natural gas, heating oil, and RBOB gasoline. Commodities contracts are also written on metals, agricultural products, and livestock. They are also written on financials such as currencies, interest rates, and stock indices. Investing in commodities futures is risky because prices are volatile and fraudulence is prevalent.
- Forward Contract – The forward contract is a more personalized form of a futures contract. That’s because the delivery time and amount are customized to address the particular needs of the buyer and seller. In some forward contracts, the two may agree to wait and settle the price when the good is delivered. A forward contract is a cash transaction. It is common in many industries, especially commodities.
- Futures Option – A futures option gives the purchaser the right, or option, to buy or sell a futures contract. It specifies both the date and the price. Contracts on optionsare commonly set for a month or more. Weekly contracts are becoming popular for those who like to wager on short-term events.
- Forward Rate Agreement – A forward rate agreement is an over-the-counter forward contract. It is written on a short-term interest rate.
Stock futures are derivative contracts that give you the power to buy or sell a set of stocks at a fixed price by a certain date. Once you buy the contract, you are obligated to uphold the terms of the agreement. Here are some more characteristics of futures contracts:
- Lot/Contract size: In the derivatives market, contracts cannot be traded for a single share. Instead, every stock futures contract consists of a fixed lot of the underlying share. The size of this lot is determined by the exchange on which it is traded on. It differs from stock to stock.
- Expiry: All three maturities are traded simultaneously on the exchange and expire on the last Thursday of their respective contract months. If the last Thursday of the month is a holiday, they expire on the previous business day. In this system, as near-month contracts expire, the middle-month (2 month) contracts become near-month (1 month) contracts and the far-month (3 month) contracts become middle-month contracts.
- Duration: Contract is an agreement for a transaction in the future. How far in the future is decided by the contract duration. Futures contracts are available in durations of 1 month, 2 months and 3 months. These are called near month, middle month and far month, respectively. Once the contracts expire, another contract is introduced for each of the three durations. The month in which it expires is called the contract month. New contracts are issued on the day after expiry.
Example: If you want to purchase a single July futures contract of ABC Ltd., you would have to do so at the price at which the July futures contracts are currently available in the derivatives market. Let’s say that ABC Ltd July futures are trading at Rs 1,000 per share. This means, you are agreeing to buy/sell at a fixed price of Rs 1,000 per share on the last Thursday in July. However, it is not necessary that the price of the stock in the cash market on Thursday has to be Rs 1,000. It could be Rs 992 or Rs 1,005 or anything else, depending on the prevailing market conditions. This difference in prices can be taken advantage of to make profits.
Index futures :
A stock index is used to measure changes in the prices of a group stocks over a period of time. It is constructed by selecting stocks of similar companies in terms of an industry or size. Some indices represent a certain segment or the overall market, thus helping track price movements. For instance, the BSE Sensex is comprised of 30 liquid and fundamentally strong companies. Since these stocks are market leaders, any change in the fundamentals of the economy or industries will be reflected in this index through movements in the prices of these stocks on the BSE. Similarly, there are other popular indices like the CNX Nifty 50, S&P 500, etc, which represent price movements on different exchanges or in different segments.
Futures contracts are also available on these indices. This helps traders make money on the performance of the index.