What is a Futures Contract?

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Now that we have learned what a commodity is, let's define what a futures contract is.  As explained in the lesson about the history of futures markets, the futures contract evolved from the forward contract.

A futures contract is an exchange-traded contract entered into by two parties in order to exchange a specific grade and amount of a commodity at a predetermined price and date in the future. (That's quite a mouthful, but don't worry, we'll go over each specific point below.)

As such, it is a legally binding contract.  When someone buys or sells a futures contract they are not buying or selling an actual commodity, instead they are buying or selling an obligation to receive or deliver the underlying commodity in the future. 

Thus, futures contracts are derivatives, which are financial instruments that represent an underlying asset.  The contract's value is "derived" from the underlying asset.

Differences Between Futures and Stocks

It's important to understand the concept of derivatives and a comparison between stocks and futures may help.  When you purchase a stock, you are buying ownership of a company.  That share of ownership is a real asset, therefore buying shares of stock should be considered the purchase of an asset.  However, when you trade a futures contract you are trading just that - a contract or a legal obligation, not the underlying asset itself. 

However, there is a price attached to each futures contract, which is derived from the price of the underlying commodity.  The price of futures contracts changes all the time, just as stock prices do.  So, as far as prices work, the trading of futures contracts and the associated gains and losses is very similar to stock trading.  In other words, the mechanism for making and losing money with futures is very similar to that of stocks, but the instrument being traded is very different.

Anatomy of a Futures Contract

There are two very important features that make futures contracts easily interchangeable and very liquid.
  • Standardization means that every contract for a specific commodity is the same.  Futures contracts are specific about the quantity and quality of the underlying commodity.  For instance, a single corn contract traded on the CBOT specifies 5,000 bushels of #2 Yellow corn.
  • Exchange traded means that these contracts are only traded on an exchange and they are guaranteed by the exchange and its associated clearinghouse.  This exchange guarantee eliminates the risk of default that would exist if two parties entered into a private forward contract.

Also, all specifications for a futures contract are set by the exchange on which it is traded.  The most important of these specifications include: the delivery month, the minimum tick size, the trading hours, the settlement procedure, and daily price limits.  All of these specifics are designed to provide an even playing field for all trading participants.

 

1Futures contracts have specific delivery months that can be traded. For instance, the delivery months for the CBOT corn contract are March, May, July, September, and December.

 

2The tick size is the minimum amount that the price of a contract can advance or decline.

 

3The daily price limit is the maximum amount a contract's price can move above or below the day's opening price.

 

4Lastly, settlement procedures and delivery dates are specified for each contract.  For example, the settlement procedure for a real commodity usually calls for physical delivery, while a currency futures contract ends with a cash settlement.

 

Of course, the one element of a futures contract that is not specified by the exchange is the price.   This price is always changing and ultimately determined by the collective action of all traders in the market.  Once a futures trader buys or sells a contract in the marketplace the price is locked in.  Now he holds a contract that obligates him to receive/deliver the commodity at that price on the specified date in the future.