What Is A Futures Contract?
A futures contract is an agreement between two parties to buy or sell an asset at a future date at a specific price. Breaking it down, one party agrees to buy a particular commodity at a specific price at a later date, while a second party “counterparty” agrees to sell the exact commodity purchased at the agreed price and at the agreed date.
The future date is the delivery date or final settlement date. The price of the futures contract at the end of a trading session on the exchange is the settlement price for that day of business on the exchange. These can’t be referred as ‘direct’ securities as in the case of stocks or bonds.
In a futures contract, price is the only variable. They are standardized for quantity, quality, and delivery specifications. Because of this, futures contracts can be traded on an exchange.
This open auction market, often consisting of hundreds or thousands of participants, brings a large amount of liquidity to futures trading. In essence, the open auction process means that you can buy from any market participant, or sell to anyone looking to buy.
It’s important to note that some commodities–such as Crude Oil, Wheat, gold, among others–are physically deliverable while other contracts (such as index futures) can only be converted into cash equivalents.
Specifications of Futures Contract
Contract size, or lot size, is the minimum tradable size of a contract. It is often one unit of the defined contract. For example, the current contract size of the PMEX sugar contract is 10 Tons. This implies that trading one contract creates a position of 10 tons of sugar. PMEX rice contract has a contract size of 25 tons.
Daily settlement refers to the process whereby the exchange debits and credits all accounts with daily profits and losses as calculated by the mark-to-market process. Daily settlement is necessary in order to recover losses and pay profits to respective accounts.
Delivery date or delivery period refers to the time specified by the exchange during or by which the seller has to make delivery according to contract specifications and regulations. The delivery date is often later than the expiry date of a contract, especially in the case of physically delivered commodities.
Expiration (also known as maturity or expiry date) refers to the last trading day of the futures contract. After the expiry of a futures contract, final settlement and delivery is made according to the rules laid down by the exchange in the contract specifications document.
The initial margin is the minimum collateral required by the exchange before a trader is allowed to take a position. Initial margins can be paid in various forms as laid down by the exchange and vary from commodity to commodity as well as from time to time. The level of initial margin is dependent on the price volatility of the contract. More volatile commodities generally have higher margin requirements.
Mark to Market
Mark to market refers to the process by which the exchange calculates and values all open positions according to pre-defined rules and regulations. Mark-to-market is an essential feature of exchange-traded futures contracts whereby the exchange ensures that all profits and losses are recognized by pricing them according to accurate market conditions. It is also an important feature for the risk management of positions of participants.
Price Quotation is the units in which the traded price of a contract is displayed. It can be different from the trading size of a contract and is often based on industry practices and conventions. While the contract size of the PMEX sugar contract is 10 tons, its price is quoted in Rupees per 100 kgs. PMEX Palm Oil contract has a size of 25 tons but its price quotation follows local trade practices and is displayed as Rupees per maund.
Tick Size is the minimum movement allowed by the exchange in Price Quotation. For example, the tick size of the PMEX 100gms gold futures contract is Re. 1, whereas it is $0.01 or 1cent for the PMEX 10oz gold futures contract.
Tick Value = Contract Size x Tick Size
Tick Value refers to the minimum profit or loss that can arise from holding a position of one contract. Tick value depends on the size of the contract and its tick size. While it is often explicitly mentioned in contract specifications, it can be calculated by the formula:
Advantage Over Stocks
Whereas the price of a stock may be driven by the estimation of future earnings, the talent of corporate management, or the quality of products produced, futures prices are driven strictly by supply and demand. The aggregate belief of the market participants determines the supply/demand balance for each commodity.
This has an advantage over stocks in that there can be no manipulation of earnings or cover-ups of the material facts. The value of a gold contract, for example, depends on what market participants believe the price of gold will be when the contract expires.
If you believe the price of gold will be higher, you would buy the contract. If you believe it will be lower, you would sell it short. Being able to short sell is an opportunity to make money when a market declines, and sometimes markets fall faster than they rise!