In finance, futures contracts have traditionally been used for risk management, since they can be used by two counterparts that wish to fix a price or a rate today for a transaction that will take place at a future date.
Nowadays, standardized futures contracts are traded by investors. Unlike forward contracts, futures contracts tend to be traded on exchanges rather than over-the-counter (OTC).
What is a futures contract?
It is a contract between two parties that agree to carry out a specific transaction at the delivery date for the futures price. A futures contract is binding for both parties.
The transaction can for instance consist of one party selling a commodity to the other party. Other examples of common underlyings for futures contracts are stocks, bonds and commodities.
There are modern futures contracts where the underlying isn’t an asset that can be bought and sold. Instead, the futures contract is based on an index or similar. It is not possible to settle these contracts with any physical delivery of under underlying.
Physical settlement or cash settlement
Futures contracts can be settled in two ways:
- One party actually delivers the underlying and the other party pays accordingly.
- The two parties settles the contract with a cash payment.
Physical delivery is still fairly common for commodity futures and bond futures.
Historically, futures contracts were only utilized to mitigate risk. Today, many futures contracts are bought simply for speculative purposes.
For historical reasons, exchanges require both parties to deposit collateral (margin) before they enter into a futures contracts. The collateral is often required to be cash or a performance bond, not stocks or derivatives. The collateral must remain with the exchange throughout the lifetime of the futures contract and must be (at least) a certain percentage of the difference between the futures prices and the current market price of the underlying.
Each day, the exchange will check the difference between the futures prices and today’s market price of the underlying. If the difference becomes too large for the deposited collateral to be sufficient, the exchange will make a margin call and ask the owner of the insufficient margin account to add more collateral.
Exchange-traded futures contracts are highly standardized. To facilitate efficient trading, a code system has been created for labelling futures contracts. This code will provide you with a lot of important information about the futures contract.
- The first two characters of code signals the type of contract.
- The third character marks the month.
- The fourth and fifth characters marks the year.
CL = Crude oil
K = The month of May
17 = The year 2017
|F = January||J = April||N = July||V = October|
|G = February||K = May||Q = August||X = November|
|H = March||M = June||U = September||Z = December|