What is a Futures Contract?

A futures contract is a legal agreement signed between two parties to buy or sell a particular commodity, asset, or security at a predetermined price and an agreed date in future. The payment and delivery of the commodity are made on the agreed future date. In a futures contract, the buyer is said to hold a long position or just long, while the seller is known to have a short position or just short.

Futures Contract Explained

In a futures contract, the underlying assets could be commodities, stocks, bonds, currencies, crude oil, etc. When a buyer and seller enter into an agreement through a futures contract, it must be held at a recognized stock exchange. The purpose of the stock exchange is to serve as a mediator between both parties. When the futures process begins, both parties will be required by the exchange to create a nominal account known as the margin.

The margin serves as a basis for settling price differences since the futures prices are sure to change every day. In a case where the margin is used up, the parties involved have to replenish the account. On the day of delivery, it is the spot price that will be used to decide the difference.

Futures can also be used as a strategy to speculate the price movements of a commodity, security, or financial instrument, using leverage. It can also be used to hedge against risks by hedging the price movement of an underlying commodity/asset to prevent losses that could spring from an unfavorable price change.  

Closely related to futures contracts are ‘forward contracts’. Forwards are also a type of agreement that involves buyers and sellers, however, forwards are traded over-the-counter (OTC). They also have customizable terms that favor the parties involved. Whereas, futures have general terms that are applicable to both parties regardless of the status of any party.

Futures contracts can be categorized into two parts, namely; hedging and speculating. Futures traders can either use futures to hedge risk or speculate price movements. For example, producers or purchasers of an underlying commodity or asset can hedge the price at which a commodity should be bought or sold. While portfolio managers and traders can speculate price movements of underlying commodities or assets using futures.

Note: The terms ‘futures’ and ‘futures contract’ both mean the same thing. However, ‘futures’ is more general and is used to refer to a whole market such as futures trader, stock futures, oil futures contract, etc.

Futures Vs Stocks

Trading futures and stocks are quite similar but differ in more ways than their similarities. Individual investors interested in owning stocks of a particular company can do so by registering with an online broker. They’d simply go online or call their broker to buy or sell. Their order is facilitated through a recognized exchange like the New York Stock Exchange. In the same way, futures can also be traded. You can either go online or call a broker over the phone to buy or sell futures. Once that is done, the order will be facilitated through a recognized exchange like the New York Merchantile Exchange (NYMEX) or the Chicago Merchantile Exchange (CME).

While buying or owning stock gives you part ownership in a company or portfolio of companies, simply buying a futures does not give you ownership of a commodity or asset. You are simply entering an agreement with a seller to purchase a commodity or securities for a predetermined price to be paid at a later date in the future.

Assuming you own a fabric manufacturing company and you need cotton to produce some of your fabrics. The way financial markets work, the price of a commodity changes every business day. As a business person, you can’t possibly keep changing your prices every day and you would want to buy cotton at the least lowest price so you can run your business at a gain and make profit. The changing price of the market may hinder you from achieving this goal, therefore, the best way to go about it is to enter a futures contract with your seller by agreeing on a futures date and a certain price.

Both stock exchanges and commodity exchanges are membership organizations that have been set up to function as mediators and facilitators between buyers and sellers of all types of commodities and securities. They facilitate the transfer of ownership rights between a buyer and seller on legal grounds that protect the interests of the parties involved.

Buying stocks requires that you have enough money in your account to buy the stocks and to cover commission costs. Once you make a purchase, the money is immediately deducted from your broker account. While trading futures does not require that you make any immediate payment since you are only entering a contract to make purchases at a future date. However, the broker will still require a certain amount in your margin account. Margin minimums differ by commodity. If you are on the ‘buy’ side of the contract and the value of a commodity reduces, your contract will also lose value. When that happens, you will receive a call from your broker notifying you about the unrealized losses that may have exceeded your margin requirement. This is known as a ‘margin call’.

Futures traders also have a major advantage with leverage. Leverage allows a trader to control a large amount of money or commodity worth a large amount of money with little money. On the contrary, leverage is said to be a ‘two-edged sword’ that can either benefit the trader or work against the trader. Stock traders can also take advantage of leverage if they trade with a margin account. This would allow the stock trader purchase stocks on margin at the normal rate of 50%.