What Is a Futures Contract? Meaning, Types, Pros & Cons

Key Highlights

• A futures contract is a financial derivative that entails the buyer purchasing some underlying asset (or the seller selling that asset) at a predetermined future price.

• Investors can leverage futures contracts to speculate on the direction of securities, commodities, or financial instruments.

• To help prevent losses from unfavourable price movements, futures are often used to hedge the underlying asset's price movement.

• Almost every commodity can be traded as a futures contract, including grain, energy, currencies, and even securities.

Futures Contracts Meaning

A futures contract is a legal agreement to buy or sell a commodity asset, or security at a predetermined price at a future date. The quality and quantity of futures contracts are standardised in order to facilitate trading on futures exchanges.

When the futures contract expires, the buyer is responsible for buying and receiving the underlying asset. At the expiration date, the seller of the futures contract is responsible for providing and delivering the underlying asset.

These contracts are traded on regulated exchanges such as the National Stock Exchange (NSE). Standardisation of contract size, quality, and expiration dates ensures liquidity and makes it easier for participants to buy and sell. Futures exchanges also act as intermediaries to guarantee settlement and minimise counterparty risk.

Importance of Futures Contracts

Futures contracts play a crucial role in financial and commodity markets by serving two main purposes—hedging and speculation. For hedgers, such as farmers, exporters, or corporates, futures provide price protection against market volatility. By locking in prices in advance, they reduce uncertainty in revenue or costs, ensuring better financial planning and stability.

For speculators, futures offer an opportunity to profit from price movements without owning the underlying asset. Traders take positions based on market expectations, and leverage in futures allows them to amplify returns with relatively small capital. This dual function makes futures vital for both risk management and profit generation, contributing to liquidity, efficiency, and price discovery in the overall market system.

Attributes of Futures Contracts

The table below highlights the attributes of futures contracts:

Example of Futures Contracts

Suppose an oil producer wants to sell oil but is worried that oil prices will fall in the future. A futures contract could be used to ensure the oil producer gets a predetermined price and avoids incurring a loss. Using future contracts, the oil producer could also lock in the price at which the oil would sell, so that the oil could be delivered to the buyers once the contract expired.

In contrast, a manufacturing company would require oil to produce widgets. By planning ahead and ensuring that oil comes in every month, the company would also use a future contract.

By doing this, the company will know the price at which it will receive oil based on the price set in the futures contract.

Types of Futures

Types of futures trading refer to the different categories of futures contracts available in the market. Each type is linked to a specific underlying asset, such as commodities, currencies, or financial instruments. These contracts allow participants to lock in prices for future transactions and gain exposure to various markets without directly holding the physical asset. Settlement methods can vary, with some contracts requiring physical delivery of the asset and others settled in cash. Futures are widely used across industries and financial markets, providing flexibility for investors and businesses to manage market exposure effectively.

While there are many types of futures contracts, let’s have a look at some of them:

1. Stock Futures

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 characteristics of stock 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.

• 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.

• Expiry: All three monthly 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.

Example: If you want to purchase a single July futures contract of ABC Ltd, you will 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 trading is 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.

2. 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 like you make money on the performance of the index. Here are some features of index futures:

• Contract size: Just like stock futures, these contracts are also dealt in lots. But how is that possible when the index is simply a non-physical number. No, you do not purchase futures of the stocks belonging to the index. Instead, stock indices points – the value of the index – are converted into rupees.

For example, suppose the CNX Nifty value was 6500 points. The exchange stipulates that each point is equivalent to Re 1, then you have to pay 100 times the index value – Rs 6,50,000 i.e. 1x6500x100. This also means each contract has a lot size of 100.

• Expiry: Since indices are abstract market concepts, the transaction cannot be settled by actually buying or selling the underlying asset. Physical settlement is only possible in case of stock futures. Hence, an open position in index futures can be settled by conducting an opposing transaction on or before the day of expiry.

• Duration: As in the case of stock futures, index futures too have three contract series open for futures trading at any point in time – the near-month (1 month), middle-month (2 months) and far-month (3 months) index futures contracts.

Illustration of an index futures contract: If the index stands at 3550 points in the cash market today and you decide to purchase one Nifty 50 July future, you will have to purchase it at the price prevailing in the futures market.

This price of one July futures contract could be anywhere above, below or at Rs 3.55 lakh (i.e., 3550*100), depending on the prevailing market conditions. Investors and traders try to profit from the opportunity arising from this difference in prices.

3. Currency Futures

A currency futures contract is a standardised agreement between two parties to exchange a specified amount of one currency for another at a predetermined exchange rate and a specific date in the future. Currency futures contracts are used as a hedging tool by businesses and investors to manage their foreign exchange risk. For example, an importer can enter into a currency futures contract to buy a certain amount of foreign currency at a fixed price, thereby locking in the exchange rate and protecting against potential losses from currency fluctuations.

Key features of a currency futures contract include:

• Standardisation: The contract size, maturity date, and trading units are standardised by the exchange. For example, on the National Stock Exchange (NSE) in India, one USD-INR futures contract typically represents 1,000 U.S. dollars.

• Exchange traded: Unlike forwards, which are private agreements, currency futures are traded on recognised exchanges. This ensures greater liquidity, transparency, and reduced counterparty risk.

• Margin requirement: To enter into a futures position, you as a trader must deposit an initial margin and maintain a minimum margin level. This ensures that both parties honour their obligations.

• Mark-to-market settlement: Profits and losses are settled daily through a mark-to-market system. This prevents large accumulations of risk and ensures fairness between both parties.

• Cash or physical settlement: Most currency futures are cash settled, meaning no actual currency changes hands. Instead, gains or losses are adjusted in the trader’s margin account at expiry.

• Hedging and speculation use: While businesses use them to hedge foreign exchange risk, traders and investors also use currency futures to speculate on currency movements and profit from volatility.

Example: Suppose an Indian importer expects to pay USD 100,000 to a U.S. supplier three months from now. If the current USD-INR rate is ₹83, the payment obligation would amount to ₹83,00,000. The importer worries that the rupee might depreciate further to ₹85 per USD, which would increase the payment to ₹85,00,000, causing a loss of ₹2,00,000.

To protect against this risk, the importer buys 100 USD-INR futures contracts (each worth USD 1,000) at ₹83. At maturity, if the rupee actually depreciates to ₹85, the futures position generates a profit of ₹2,00,000, which offsets the higher payment in the spot market. This hedge stabilises the importer’s costs and shields the business from currency volatility.

4. Commodity Futures

Commodity futures are standardised financial agreements to buy or sell a specific quantity of a commodity at a fixed price on a future date. These contracts are traded on regulated exchanges, which ensures standardisation, price transparency, and reduced counterparty risk. Producers, consumers, and traders use commodity futures both to manage exposure to price fluctuations and to take positions for profit. By locking in prices, businesses gain certainty over their input costs or revenues, while traders gain opportunities to benefit from changing market conditions.

Some key features include:

• Standardisation: Each contract has a fixed size, quality grade, and delivery month as defined by the exchange. For example, a gold futures contract may represent 1 kg of gold with a set purity.

• Leverage and margin: Traders deposit only a margin, which is a fraction of the contract value. This increases exposure but also heightens potential losses.

• Price discovery: The futures market reflects global demand and supply expectations, making it an important tool for anticipating commodity price trends.

• Hedging function: Farmers, miners, and manufacturers use futures to protect against unfavourable price movements.

• Settlement: Depending on the contract, settlement may be through physical delivery of the commodity or via cash adjustment on expiry.

Commodity futures can be classified into various types. Some of these are –

• Energy Futures: An energy futures contract is a financial derivative that allows investors and businesses to buy or sell a certain amount of energy commodities, such as crude oil, natural gas, heating oil, or gasoline, at a predetermined price and on a specific date in the future.

• Metal Futures: A metal futures contract is a financial agreement between two parties to buy or sell a specific quantity of metal, such as gold, silver, copper, or platinum, at a predetermined price and on a specific date in the future.

• Grain Futures: A grain futures contract is a financial agreement between two parties to buy or sell a specific quantity of grains, such as wheat, corn, or soybeans, at a predetermined price and on a specific date in the future.

• Livestock Futures: A livestock futures contract is a financial agreement between two parties to buy or sell a specific quantity of livestock, such as cattle, hogs, or feeder cattle, at a predetermined price and on a specific date in the future.

• Food and Fibre Future Contracts: Food and fibre futures contracts are financial agreements between two parties to buy or sell a specific quantity of agricultural products, such as cotton, sugar, cocoa, coffee, and various types of grains, at a predetermined price and on a specific date in the future.

What Are the Advantages and Risks of Futures Contracts?

The existence and the utility of a futures market benefits a lot of market participants:

• It allows hedgers to shift risks to speculators.

• It gives traders an efficient idea of what the futures price of a stock or value of an index is likely to be.

• Based on the current future price, it helps in determining the future demand and supply of the shares.

• Since it is based on margin trading, it allows small speculators to participate and trade in the futures market by paying a small margin instead of the entire value of physical holdings.

However, you must be aware of the risks involved too. The main risk stems from the temptation to speculate excessively due to a high leverage factor, which could amplify losses in the same way as it multiplies profits. Further, as derivative products are slightly more complicated than stocks or tracking an index, lack of knowledge among market participants could lead to losses.

Conclusion

The futures market plays an important role in the smooth operation of the commodities market. In futures contracts, speculators can speculate on the price of some asset or security in the future. Whereas hedgers use futures to lock in a price between now and delivery/receipt of a good to reduce market uncertainty. A price lock in advance allows farmers, miners, manufacturers, and other market participants to work without worrying about daily market fluctuations.

Also Read:

https://www.kotakneo.com/stockshaala/derivatives-risk-management-and-option-trading-strategies/understanding-futures-contracts-basic/