Know everything about Futures Contract here.
A trader can succeed at a forward trade. As long as he has an opinion about the price movement of an underlying commodity or security, this is quite possible.
The trader needs to locate someone who may be willing to get into an agreement with them. This alone is no easy task for a trader to do.
However, due to its limitations, a forward contract does not appeal to many traders. Thus, they look forward to a futures contract.
By far, the latter easily overcomes the limitations and risk associated with a forward contract.
About Futures Contract
In all its practicality, a futures contract is only a developed form of the forward contract.
The unique construction of a futures contract retains the fundamental transactional features of a forward contract. However, it eliminates the risks which come with it.
Thus, traders have come to prefer futures trade in a greater proportion in comparison to forwards trade.
Once again, as long as an investor has a clear outlook towards the directional movement of the price of an underlying security, there is a huge scope to make a financial gain under one such contract.
In the absence of a clear view such as this one, it will only be a gamble to take part in a futures contract. Think of it as this way.
Consider any item of utility which you use on a daily basis, let us say, an umbrella. No matter what the color of that umbrella may be or no matter how many changes in its structure take place.
The core purpose of the umbrella will remain the same. It will continue to shield you from the rain and that is what the concept of core transactional structure refers to.
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Learn about Futures Agreements
As we have already seen, the core essence of a futures and forward trade is the same. So, why is it that we have given them two different names?
At this point, it makes sense to understand the features which make the two types of contracts different from each other.
In the previous example, we had talked about A and B, two parties to a futures contract. Here, A was willing to purchase copper while B was willing to sell it.
We assumed that when A wanted to enter into a forward contract to buy copper, B was willing to enter into a forward contract to sell it.
However, what would have happened if A and B had not found each other? In this case, even though A and B were individually willing to enter into a forward agreement and they had a positive view on the direction of the price movement of copper, they would be helpless in the absence of a party to match the contract.
To overcome this problem
A and B have the option to approach a financial market. Here, they are likely to find each other far more easily.
Otherwise, it would be difficult to search for an opposite party on their own. These financial markets are a place where A and B can simply present their willingness to enter into a contract.
In return, they are highly likely to come across many counter parties to their offer. Interestingly, a well developed financial market is also likely to have people who are not only willing to trade in copper.
Instead, they may be ready to deal in all other sorts of financial and non financial securities as well.
This is exactly how the inception of a futures contract takes place. So, in a way, it is not just A and B who have access to a market of opportunities.
A financial market such as this one invites and offers a chance to many such traders.
Here, they can come together and access the trades which other parties are willing to offer. A market such as this one has come to manifest itself as an exchange.
This could be for financial instruments or for commodities as well.
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What makes a Future Contract different from a Forward Contract?
The major difference between a future and forward contract lies in their structure. Let us take a closer look at the differences which highlight how they are different.
- A futures contract is based on an underlying security. For every security in which traders wish to trade, there can be a futures contract. Incidentally, a future contract for given security behaves the same way as the security itself. Thus, if you expect the price of gold or copper to go up, the futures contract for gold or copper will also go up.
- As against forward contracts, the terms of the contract are strictly standard in case of future contracts. Thus, the traders could enter into an agreement to exchange 14.5 kg of copper in our example. But the same is not possible in case of a futures trade. They will have to adhere to the standard set by the exchange if they wish to enter into a trade for copper.
- In a forward contract, the parties were under the obligation to honour the terms of the contract until the very end. However, such is not the case in a futures contract. If at any point in time the parties desire, they can simply trade the futures contract. By doing this, they will escape the liability to honour the agreement on the date of its expiry.
Added Differences between Futures and Forwards
- There is strict regulation of the futures market in India. A regulatory body by the name of SEBI is in charge of overseeing that the markets perform optimally. Thus, they avoid any instance which could spell damages or trouble for any party to a contract in futures. Incidentally, this also implies that there are very few chances of a default by either party on their promise to honour the contract.
- There is a time boundary on every futures contract. In our example, A and B had entered into a forward trade for 3 months. In the futures market, contracts are available not only for 3 months but also for 1 and 2 months as well. The time frame at which the contract ends is the expiry date of the contract.
- In a futures contract, most parties to the trade opt for a cash settlement. Thus, only the amount of difference between the trade is given by one party to another. As such, no physical settlement of securities takes place in such contracts. A regulatory authority overlooks the procedure of settlement. This ensures that no party has to suffer due to the misconduct of the other party.
Elements of a Futures Contract
Before understanding anything about the working of a futures contract, it is vital to understand about its aspects.
Here are some of the vital elements of a futures contract, which an investor must know about.
Every aspect of a futures contract is pre determined. This is why it is a standard contract. Accordingly, for every futures contract, a trader can take up specific lot sizes of the underlying security.
Usually, these lot sizes are even numbers and traders are not at discretion to change the size of a lot. However, the size of a lot may vary from one asset to another.
Every futures contract has a contract value. For an example, A had agreed to purchase 15 kg copper from B at a price of INR 1550 per kg.
This means that the total value of the contract was INR 23250 (1550*15). Thus, it will be right to say that the value of a contract is expressed in quantity times of the price of an asset.
Taking clues from our first point, it can be said that the value of futures contract is equal to the lot size, multiplied by the price.
Further explanation along with an example
Again, in our previous example, A and B had agreed to enter into a forward contract on 9th. They did this through word of mouth, without the involvement of any exchange in between.
No cash or security was transferred between either one of them. However, in the case of a futures contract, A and B will have to pay a certain sum of money to enter into a contract.
Consider this as token money which is given out in advance by the parties to the contract. In a futures contract, this token money comes out to be a certain percentage of the value of the contract, which we discussed in the previous point. The name of this token money is the margin amount.
Every futures contract is bound by time at the date of expiry. This date of expiry is the time frame up to which a futures contract is valid.
In an exchange, futures contract expires at fixed dates and at their expiry, new ones are introduced in their place.
To Conclude Futures Contract
By now, it is amply clear that as long as an investor has a clear directional view on the price movement of a security, they can enter into a forward, as well as a futures contract.
It is clear how the futures contract is an expansion and extension of the forward’s contract.
The price of the underlying security in the case of a futures contract emerges from the price of the security in the spot market.
If the traders decide that they do not wish to continue being a party to the futures contract, they are at liberty to trade the contract and extinguish their liability.
Also, it is clear from the explanations above that there is strict standardization of terms in a futures contract.
It helps that they are under the scrutiny of a regulatory body such as SEBI. Thus, traders who wish to enter into a forward contract can certainly consider a futures contract for their benefit.
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