Futures Contract

A futures contract requires a buyer and seller to trade an underlying asset at an agreed price on a specified future date. The contract is standardised and traded through an exchange.

• Futures may be based on commodities, currencies, stocks, financial instruments, or market indices.
• Traders deposit margin instead of paying the contract’s entire value upfront.
• Open positions are marked to market, which means profits and losses are calculated and settled regularly.
• Futures may be settled through physical delivery or cash settlement, depending on the contract.
• Leverage can increase both potential profits and potential losses.
• Futures are used for hedging price risk as well as speculating on future price movements.
   

A futures contract is a legally binding agreement to buy or sell a fixed quantity of an underlying asset at a predetermined price on a specified future date. Futures contracts are standardised and traded on recognised exchanges.
The underlying asset may be a commodity, currency, stock, financial instrument, or market index. SEBI describes a futures contract as a standardised, exchange-traded contract for buying or selling an underlying product at a predetermined price on a future date.
Futures contracts are commonly used for hedging or speculation. Hedging involves reducing the effect of an unfavourable price movement, while speculation involves taking a position based on an expected price change.
For example, a farmer may sell wheat futures to lock in a price for a future harvest. A trader who expects the price of an index to rise may buy an index futures contract. However, the trader can also suffer a loss if the index falls.
Futures trading involves margin. The required margin acts as collateral and may change according to the contract, market conditions, exchange rules, and clearing corporation requirements.
Depending on the contract, settlement may take place through physical delivery or by paying the cash difference between the contract price and the final settlement price.
 

The main features of a futures contract include the following.

NSE states that futures positions are marked to market using the daily settlement price at the end of each trading day. The resulting profits and losses are then passed between members through the clearing system.

Suppose you are a wheat farmer and are concerned that wheat prices may fall before your crop is ready for sale. You enter into a futures contract to sell a fixed quantity of wheat at an agreed price after six months.

Two possible situations may arise:

• The market price falls: You benefit from the hedge because you can sell at the higher price fixed in the futures contract.
• The market price rises: You may miss the opportunity to sell at the higher market price because the futures contract fixes the selling price.

The purpose of this hedge is not necessarily to earn an extra profit. It is to reduce uncertainty by fixing the selling price in advance.

Futures contracts can help market participants manage price risk and gain exposure to different markets. However, they also involve considerable risk because of leverage, changing prices, and margin requirements.

Hedging

Futures are widely used to reduce the effect of price volatility. For example, a farmer may sell crop futures to protect against a possible fall in prices.

Similarly, a company that needs a commodity in the future may buy futures to reduce the risk of its price increasing before the purchase date.

Liquidity

Actively traded futures contracts may allow participants to enter or exit positions more easily. However, liquidity is not equally high across every contract, asset, or expiry date.

A contract with limited trading activity may have fewer buyers and sellers. This can make it more difficult to execute a trade at the expected price.

Portfolio diversification

Futures provide exposure to different asset classes, including commodities, currencies, financial instruments, and stock market indices.

However, diversification does not remove the possibility of loss. The risk depends on the underlying asset, market movement, position size, and use of leverage.

Efficiency

Futures can provide price exposure without requiring you to immediately purchase, store, transport, or handle the physical asset.

For example, a trader seeking exposure to wheat prices can use wheat futures instead of buying and storing wheat. Transaction costs, margin requirements, taxes, and other charges may still apply.

Regulated trading environment

Exchange-traded futures operate under exchange rules, clearing arrangements, and regulatory oversight. These systems support price transparency, margin collection, settlement, and risk management.

Regulation reduces certain operational and counterparty risks, but it does not protect traders from market losses.

Additional Read: Futures and Options

Futures contracts involve substantial risk, mainly because leverage can magnify losses. A relatively small movement in the underlying asset may produce a much larger percentage gain or loss on the margin deposited.

Margin call risk

When the market moves against your position, additional funds may be required to maintain the applicable margin.

If you do not provide the required amount, your broker may reduce or close the position according to its policy and applicable rules. This may result in a realised loss.

Expiry risk

Every futures contract has a specified expiry date. Before expiry, you may close the position, roll it over by taking a position in a later contract, or allow it to proceed to final settlement.

If you hold the contract until expiry, you may face cash settlement or physical delivery obligations, depending on its terms.

Interest rate risk

Interest rate futures are affected by movements in interest rates. An unexpected change in rates may reduce the value of your position or result in a loss.

Interest rates may also influence the pricing of futures on other financial assets.

Systemic risk

Financial markets are interconnected. A major economic, financial, or geopolitical event may affect several markets at the same time.

As a result, an event outside the futures market may cause sudden price movements, reduced liquidity, or higher volatility in your contract.

Delivery risk

Physically settled futures may involve delivery-related requirements. These may include rules concerning quantity, quality, location, documentation, and delivery timelines.

Failing to understand these obligations may lead to additional costs or settlement issues.

Global event risk

Political events, economic crises, natural disasters, policy changes, and international conflicts may affect commodity, currency, and financial futures.

Such events can cause sudden price movements and may make it difficult to exit a position at the expected price.

Risk-management methods such as position limits, diversification, research, and stop-loss orders may help control risk. However, no method can guarantee that losses will be prevented, especially when prices change sharply.

Futures and forward contracts both involve an agreement to buy or sell an asset at a future date. However, they differ in how they are traded, structured, settled, and managed.

A forward contract is generally a privately negotiated over-the-counter agreement. Its terms can be customised according to the needs of the two parties.

A futures contract is standardised and traded on an exchange. The clearing corporation stands between buyers and sellers, helping reduce direct counterparty risk.

Forward contracts offer flexibility because the parties can customise the quantity, price, date, and settlement conditions. However, their private nature may result in greater counterparty and liquidity risk.

Futures provide standardisation, transparent exchange prices, and clearing support. However, they may not meet highly specific requirements because traders must use the contract specifications offered by the exchange.

The appropriate contract depends on the participant’s hedging needs, desired level of customisation, liquidity requirements, and ability to manage risk.

Futures contracts are standardised agreements that allow market participants to buy or sell an underlying asset at a fixed price on a future date. They support hedging, price discovery, and speculation across commodities, currencies, financial instruments, stocks, and indices.
However, futures involve leverage, margin requirements, daily settlement, expiry obligations, and the possibility of substantial losses. Before trading, you should understand the contract specifications, settlement method, margin requirements, and risks associated with the underlying asset.