Understanding a Futures Contract
07/07/2012 16:38
A futures contract refers to a standard contract to buy or sell a particular commodity of standard quality at a particular date in the future. It is also set at a price that is determined by the market. These contracts are traded on the futures exchange. They are not securities that are considered “direct” such as stocks, bonds, rights or warrants. They are still considered securities that are a type of derivative contract.
When purchasing a futures contract, an agreement occurs to buy something at a set price that the seller has not yet produced. By participating in the futures market, one is not responsible for receiving or delivering large amounts of physical commodities. Typically, buyers and sellers enter into this market to avoid risk or to speculate rather than exchange physical goods. That’s why futures are also used by speculators as financial instruments. The exact market and contract to be traded are determined by the symbol, expiration date, and exchange. The tick size and value are used to come up with the price movement and profit and loss potential. They can also be used to organize trading and charting software. This ensures that they trade in the correct market and that the correct prices are displayed.
In the investment world, the futures market is considered a significant financial hub as it provides an outlet for the often intense competition between buyers and sellers. Even more importantly, it provides a place to manage price risks. The futures market is liquid, risky, and complex. For example, a futures contract for wheat goes up to $5 a bushel the day after the farmer enters into a contract at $4 per bushel. The farmer, who is the short position holder, essentially loses $1 per bushel because the selling price went up from the agreed price. A bread maker entered into the contract,as well. He has the long position and profits by $1 per bushel because the price he agreed to pay is less than what the rest of the market agreed to pay.
The prices are figured based on the immediate equilibrium between supply and demand that occurs with buy and sell orders on the exchange at the time the contract is made. In some cases, the fundamental asset to a contract in the futures market may not be commodities. It could be currencies, securities, or financial instruments and physical assets. They could also be stock indexes or interest rates. The future date is referred to as the delivery date or final settlement date. The settlement price refers to the official price of the contract at the end of the trading day. The price is specified that day.
A contract in the futures market obligates the holder to make or take delivery under the agreement in the contract. An option, on the other hand,gives the buyer the right—but not an obligation—to establish a position that was once held by the option’s seller. So, the owner of an options contract may or may not go through with the contract, but both parties in a futures contract must fulfill their end of the contract on the settlement date. The seller must deliver the fundamental asset to the buyer or if it’s settled in cash, then cash is transferred from the futures trader who has the loss to the one who has the profit. To exit the contract before the date of settlement, the holder of the futures position must either sell a long position or buy back a short position. This will offset the closing of the position and the obligations of the contract.