Futures Contracts - Definition
Futures Contracts are derivative instruments that bind a buyer and a seller for the sale and purchase of an asset sometime in the future at a predetermined price.
Futures Contracts - Content
What are Futures Contracts?
Terms of Futures Contracts
What Are Futures Contracts?
Futures Contracts are simply agreements between buyers and sellers for the sale and purchase of a product in the future at a price agreed today (hence the name "Futures"). What sets futures contracts apart from mere mutual agreements between two persons is that a futures contract is a regulated, standardized contract that is enforced by a middle-man called the clearing house. The clearing house acts as middle-man in a futures transaction in order to make sure the buyer ultimately buys as agreed and the seller sells as agreed. On top of that, what makes futures contracts so powerful is the fact that performance on the contract is GUARANTEED by the clearing house who will be responsible for making sure both parties fulfill their obligations. Another thing that makes futures contracts more powerful than just a mutual agreement is the fact that futures contracts can be traded over an exchange. This allows the buyer or seller to take on an opposite contract in the market in order to offset his/her obligations under the current contract. Of course, this can only happen when the futures contracts of that particular product is widely traded or what we call having a high level of "liquidity".
Terms of Futures Contracts
Futures contracts are standardized by the exchange. This means that the exchange fixes all the terms with price being the only variable to be determined by the buyer and seller. It is this standardization of terms that creates the liquid futures market that is in operation all over the world today. Having standardized terms allows each futures contracts to be freely traded over an exchange as every participant knows that terms are homogeneous.
Terms of futures contracts that are standardized by futures exchanges include:
1. The underlying. The product or asset that is to be traded as agreed by the futures contract.
2. Type of Settlement. How the product or asset is to be delivered by cash difference (Cash Settlement) or by actual physical product (Physical Settlement).
3. Contract Size. Amount of the underlying covered by the futures contract.
4. Currency. Specifies the currency that the futures contract is quoted in.
5. Grade of the underlying to be delivered (the deliverable). Every product comes with different grades and consequently, different prices.
6. Delivery month. When the futures contract expire and products exchanged hands.
7. Last trading day. The final day of trading before the futures contract expires.
8. Ticks. The minimum price movement of the underlying covered under the futures contract.
9. Price Unit. The price per unit quoted.
10. Trading Hours. The hours of a day where trading of the contract may take place in the exchange.
11. Daily Price Limit. The maximum price fluctuation allowed for a futures contract in a single day.
12. Margin Requirement. Initial and maintenance margin established by the exchange.
Futures Contracts - The Underlying
Almost anything can become the underlying asset for futures contracts. Everything from real physical commodities to indexes that are nothing more than just numbers, can be the underlying asset for futures contracts to be written on. In recent years, with the start of Single Stock Futures trading, shares of companies also became the underlying asset for futures contracts and futures trading.
Learn about the different Kinds of Futures Contracts.
Futures Contracts - Type of Settlement
Settlement refers to how the underlying asset is delivered. There are two main settlement types; Cash Delivery and Physical Delivery.
Physical delivery refers to the actual delivery of an asset to the long from the short. Bushels of grains covered by futures contracts will transfer from the short to the long. Shares covered under a Single Stock Futures contract transfers from the short's account to the long's account.
Cash delivery is when no actual assets are transferred from the short to the long but rather a cash difference between the initial value of the asset and the value of the asset upon expiration of the futures contract. An example of a cash delivered asset would be
index futures where the cash difference between the initial value of the index and the closing value are settled by cash between the long and the short.
Read the full tutorial on Futures Settlement.
Futures Contracts - Contract Size
Contract size refers to the quantity of the underlying covered under a futures contract and is fixed by the exchange. For instance, Single Stock Futures comes in contract sizes of 100 or 1000 shares and grains futures might come in contract sizes of 5000 bushels. These quantities are fixed and cannot be changed. It is these fixed quantities that makes futures contracts easily tradable between traders. If quantities covered aren't fixed and contracts of all kinds of sizes are floating around the market, you might not be able to find a corresponding offset contract of the exact size of your contract if you want to close out.
Read the full tutorial on Contract Size.
Futures Contracts - Currency
This is straightforward and usually applies only to trading of international commodities.
Futures Contracts - Grade of Underlying
This applies specifically to commodities futures as there are many different grades of commodities. For instance, grains are grade from No.1 to No.4 and crude oil are graded based on density and sulphur content. Obviously, different grades of commodities are valued differently and that is why specifying the grade being traded is so important. Without grades, there can be no basis of pricing for commodities.
Futures Contracts - Delivery Month
The delivery month is the month settlement must take place. This means that this is the month the short delivers the physical asset to the long for a physically settled futures contract and profit / loss are settled between the short and long in a cash settled futures contract. There is usually a range of delivery months to choose from and is different for different underlying. For instance, financial futures usually have March, June, September and December as delivery months.
Futures Contracts - Last Trading Day
The Last Trading Day of a futures contract is the final day that a futures contract can be traded or offset. By the end of the last trading day, parties involved must be prepared for fulfilling their obligations under the futures contract. Last trading day varies according to the specific exchange or market being traded in. For most commodities futures, the last trading day is the final business day of the delivery month and for most financial equities futures, the last trading day is the third Friday of the delivery month.
Futures Contracts - Ticks
Also known as "Minimum Price Change", is the minimum price movement that the underlying makes. For instance, the Australian Dollar has a tick size of 0.01cent. This means that on its standard contract size of 100,000AD, the futures contract would move $10 per tick. On a bushel of grain with a 0.25cent tick size and a contract size of 5000 bushels, its futures contracts will move $12.50 per tick. Tick size basically allows you to calculate how much value your futures contracts will change in accordance to changes in price of the underlying asset.
Read the full tutorial on Minimum Tick.
Futures Contracts - Price Unit
This specifies the price per unit of the underlying asset covered by a futures contract. For instance, the price unit for Australian Dollar is $/ASD while the price unit for cocoa is $/metric ton. Other more exotic price units are like index futures where 100th/pt are used.
Futures Contracts - Trading Hours
Trading Hours is basically the hours of a day where trading of a futures contract can take place in an exchange. Again, this varies widely according to the asset being covered. Some commodities futures are traded only a couple of hours a day and some index futures are traded 24 hours a day non-stop.
Futures Contracts - Daily Limit
Daily price limit is a safety mechanism which stops the trading of a futures contract until the next business day if the daily price limit is hit. Again, daily price limit varies widely across the different markets. There are futures contracts with no daily price limits like most forex futures and there are futures contracts with fixed daily limits such as Orange Juice, which has a daily price limit of $5.00.
Futures Contracts - Margin Requirement
The initial margin required and maintenance margin limit are established by each exchange. For instance, the initial margin needed for single stock futures is 25% of the contract value. Read the full tutorial on Futures Margin.