A futures contract is a very powerful financial instrument that plays a pivotal role in the modern financial market. Whether in commodities, currencies, or stocks, these contracts allow traders and investors to hedge against risks, speculate on market movements, and secure future prices. Futures contracts are traded on regulated exchanges and offer transparency, liquidity, and risk management opportunities. To succeed in these complexities of world markets, a business needs to know what futures are, the types of futures contracts, and their legal settings. Understanding futures contracts is essential for grasping the complexities of financial derivatives and their impact on the global economy.

Meaning of Futures Contract

A futures contract is a standardized legal contract between two parties agreeing on buying or selling an asset at a predetermined price upon a specific date in the future. Unlike the spot markets, where goods or assets are exchanged immediately, futures are commitments for future delivery, and these contracts are exchanged on organized exchanges, enforce rules, and obtain counterparty performance through a clearinghouse.

Underlying assets are commodities such as gold and oil, as well as agricultural products to financial instruments such as bond indices and currencies. The utility of futures contracts in price risk management makes them integral to business's and investors' operations.

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Features of Futures Contract

Futures contracts are integral to financial and commodity markets, characterized by specific features that distinguish them from other financial instruments. Features of the futures contract include:

• Standardisation: The quantity; quality and time of deliveries, the place of delivering

• Exchange-Traded: Futures contracts are traded on regulated exchanges. This helps ensure transparency and standardized trading practices.

• Margin Requirements: Traders must deposit an initial margin to open a position and must maintain a maintenance margin during the entire duration of the contract.

• Settlement Options: Settlement options include either physical delivery of the asset or cash settlement, depending on the terms of the contract.

• High Liquidity: Futures markets are highly liquid, providing ease of entry and exit for traders.

• Hedging and Speculation: Futures contracts serve dual purposes, allowing market participants to hedge against price volatility or speculate on price movements.

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Types of Futures Contracts

A futures contract is a standardized agreement to buy or sell an asset at a predetermined price on a specific future date. These contracts are traded on regulated exchanges, ensuring transparency and reducing counterparty risk. They can be divided broadly into several categories according to the underlying asset:

1. Commodity Futures

• These comprise the contracts for physical commodities like crude oil, natural gas, gold, silver, and other agricultural products such as wheat, corn, and coffee.

• Used by producers, exporters, and traders in order to hedge against fluctuations in price.

2. Financial Futures

• These comprise contracts for financial instruments like stock indices, treasury bonds, and currencies.

• Among institutional investors, widely used in hedging and speculative trades.

3. Index Futures

• Derive their value from stock market indices like the S&P 500, Nifty 50, or FTSE 100.

• Ideal for Portfolio hedging and Speculative uses

4. Currency Futures

• Majorly used for major currency pairs such as USD/EUR, USD/JPY, or GBP/USD

• Exporters, importers, and forex traders for currency risk hedging purposes

5. Interest Rate Futures

• Securities such as government bonds.

• Widely used to manage interest rate exposure

Meaning of Futures Trading

Futures trading is the buying or selling of futures contracts on an exchange. The purpose of this can either be hedging against price risks or gaining from price movements. While investing in the underlying asset does not expose market participants to its price, futures trading exposes them to the price without directly owning the asset.

For instance, a wheat farmer might sell wheat futures to hedge the price at a favourable price. A bakery might buy wheat futures to hedge a stable supply cost. Speculators, however, trade futures solely to profit from price fluctuations without any intention of physical delivery.

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Types of Future Traders in Futures Contracts

Futures traders are hedgers, speculators, arbitrageurs, and day traders who work with different strategies to face risks or make profits from price variations. The futures market traders can be broadly classified into two types:

1. Hedgers

Hedgers use futures to reduce the risk of price fluctuation in assets like commodities, currencies, or stocks. They look for stabilization of costs or revenues. Therefore, hedging becomes a vital tool for managing risks, and businesses and investors often hedge against market volatility.

2. Speculators

Speculators trade futures to make money from the price change without owning the underlying asset. They take calculated risks, predicting market movements for short-term gains. They are not hedgers and their primary objective is generating profit rather than risk mitigation, which makes them crucial for market liquidity.

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Advantages of Futures Contracts

Futures contracts are essential financial instruments in modern markets. They allow traders to hedge risks, secure prices, or speculate on market movements. Futures contracts provide benefits such as:

• Hedging: Reduces adverse movements on the price of commodities, currencies or underlying assets.

• Leverage: Manage large positions with limited money; hence increasing possible revenues.

• Liquidity: liquid markets enable easy access.

• Standardization: Highly liquid and standardized contracts minimize risks because of counterparty risk

• Cost-Effectiveness: Lower transaction costs in terms of spot markets

• Market Diversity: The above helps trade in commodities, indices, currencies, and interest.

Disadvantages of Futures Contracts

Understanding futures contracts is crucial for navigating financial derivatives. There are several disadvantages of future contracts. This  includes:  

• High Risk: Leverage can magnify gains and losses to a large extent.

• Complexity: It requires advanced knowledge and experience, which is a bit challenging for beginners.

• Over-Leverage: Minor price fluctuations can result in huge losses due to the margin system.

• No Ownership: It does not provide physical ownership of the underlying assets.

• Fixed Expiry: The contract may expire without aligning with the trading strategy.

• Volatility: Prices can be extremely volatile, which increases unpredictability.

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Legal Provisions Related to Futures Contracts

Futures contracts in India are primarily governed by the Securities Contracts (Regulation) Act, 1956 (SCRA) and regulations issued by the Securities and Exchange Board of India (SEBI). Under the SCRA, futures are classified as derivative instruments, which are financial contracts deriving their value from an underlying asset like commodities, currencies, or stocks. SEBI regulates futures trading to ensure transparency, reduce systemic risk, and protect investors.

The Forward Contracts (Regulation) Act, 1952 (now repealed) initially governed commodity futures; however, these are now under the jurisdiction of SEBI. Commodity derivatives are traded on exchanges like the Multi Commodity Exchange (MCX) and National Commodity and Derivatives Exchange (NCDEX).

The Indian Contract Act, 1872 also applies, ensuring contracts meet enforceability criteria, such as legality, mutual consent, and absence of fraud. Additionally, taxation laws, including GST and capital gains provisions, influence future transactions.

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Summing Up

Futures contracts are versatile financial instruments serving diverse purposes, from hedging risks to speculative trading. Their standardized nature and regulatory framework make them part of the global financial system. However, the inherent risks of leverage and market volatility demand caution and expertise. An understanding of the basics of futures contracts empowers traders and businesses to harness the potential of futures contracts while managing associated risks.

What is a Futures Contract? FAQs

Q1. Which type of asset can be traded in the futures trade? 

Commodities, Financial Instruments, Stock Indexes, Currencies, and Interest rates

Q2. Who trades in the futures contracts? 

Hedgers, Speculators, Arbitrageurs, and Day traders

Q3. How do futures contracts operate in India?

By SEBI under the Securities Contracts (Regulation) Act, 1956.

Q4. What is a margin in futures trading?

An amount deposited to secure the position against losses.

Q5. What is the distinction between futures and spot trading?

Futures are traded for delivery in the future. Whereas, spot trading is used for immediate exchange.