In finance, a futures contract (commonly referred to simply as futures) is a contract between to parties to carry out a specified transaction on a future date (the delivery date). The transaction will consist of one of the counterparts purchasing* a specific asset from the other counterpart, for a predetermined price. This predetermined price is called the futures price.
Futures have traditionally been used to mitigate risk, by allowing the counterparts to fix prices or rates right now for a transaction that will take place in the future.
A futures contract is a type of derivative. Examples of assets that are used to underlay futures are stocks, bonds, equity, currency and commodity.
*Some modern futures contracts do not have any physical underlying assets that can be bought and sold. There is for instance futures contracts available where the future position of a specific index till determine which one (if any) of the counterparts that will profit from the futures contract.
Unlike forward contracts, futures contracts are typically traded on exchanges and tend to be highly standardized.
Futures trading is usually done in order to mitigate risk or for speculative purposes. Mitigating risk (hedging) is the original use of this derivative; speculation began to occur later. Since the original use of futures contracts was to mitigate risk, exchanges still require both parties to deposit collateral (cash or performance bond) when they enter into the futures contracts. This collateral is known as the margin, and it is there to palliate the consequences of one participant not honoring their obligation.
The margin must be maintained for the duration of the futures contract. Once a day, the difference between the futures price and today’s market price of the underlying asset is checked and the exchange moves money from one counterparts margin account to the margin account of the other counterpart accordingly.
If the difference between the futures prices and today’s market price becomes so big that the deposited collateral is not longer large enough (it must be a certain percentage of the difference) the exchange will make a margin call and ask the owner of the margin account to add more collateral.
Physical settlement and cash settlement
Futures can be settled by physical delivery of the underlying asset or by making a cash payment.
In cases where physical delivery is required, the asset will be delivered to the exchange who then hands it over to the new owner. Physical asset delivery is common for commodity futures and bond futures.
Cash settlement entails making a cash payment. Some futures must be settled in cash, since there is no physical underlying asset. This is for instance the case with futures contracts based on an index.
As mentioned above, most futures are highly standardized exchange-traded contracts. This also means that there is a standardized code system that most futures adhere to.
A typical futures contract will have a five characters long code on it. The firs two characters will tell you what type of contract it is, the third character will tell you the month and the last two characters will tell you the year.
Example: CLQ16 is a Cruide Oil (CL) August (Q) 2016 (16) futures contract.
|F = January||J = April||N = July||V = October|
|G = February||K = May||Q = August||X = November|
|H = March||M = June||U = September||Z = December|
Options on futures
Options traded on futures are called futures options.
- A put is the option to sell a futures contract.
- A call is the option to buy a futures contract.