What is a Futures Contract? Definition, Examples, and Risks

A futures contract is a standardized agreement to buy or sell a specific asset, such as a stock, commodity, currency, or index, at a predetermined price at a specified time in the future. These contracts are legally binding and traded on futures exchanges, like the Multi Commodity Exchange (MCX) or the National Stock Exchange (NSE) in India, which also provide the framework for these transactions, including the terms, quality, and quantity of the asset.

Key Components of a Futures Contract

• Asset: The underlying commodity, stock, currency, or index that is the subject of the contract.
• Quantity: The amount of the asset specified in the contract.
• Price: The agreed-upon price at which the asset will be bought or sold in the future.
• Expiration Date: The specified future date when the contract matures and the transaction must be settled.

How Futures Contracts Work

Opening a Position

To engage in futures trading, an investor decides whether they believe the price of the underlying asset will go up or down before the contract expires. They then enter a contract accordingly:

• Going Long: Buying a futures contract with the expectation that the asset's price will increase.
• Going Short: Selling a futures contract, expecting the asset's price to decline.

Settlement

Futures contracts can be settled in two ways:

• Physical Delivery: The actual asset is delivered from the seller to the buyer on the expiration date.
• Cash Settlement: The difference between the initial contract price and the final settlement price is exchanged, without any physical delivery of the asset.

Purpose and Use of Futures Contracts

Hedging

Futures contracts are used by investors and companies to hedge against price fluctuations in the market. For example, a farmer might use futures to lock in a price for their crops, protecting against the risk of price drops before harvest.

Speculation

Traders use futures to speculate on the direction in which they believe the market will move. Because futures can be purchased with a margin (a fraction of the contract's total value), they allow for significant leverage, magnifying both potential gains and losses.

Diversification

Futures contracts offer investors an additional method to diversify their investment portfolios beyond traditional stocks and bonds.

Risks Associated with Futures Contracts

While futures trading can offer high rewards, it also comes with high risks:

• Leverage: While leverage can amplify gains, it can also lead to substantial losses, possibly exceeding the initial investment.
• Market Volatility: Prices of futures can be highly volatile, influenced by various unpredictable factors.

Example in the Stock Market Context

Imagine a scenario where an investor believes that Infosys stock will rise in the next three months. If Infosys is currently trading at ₹1,000 per share, the investor might enter a futures contract to buy 100 shares at ₹1,050 in three months. If the share price rises to ₹1,200 by the contract's expiration, the investor profits by the difference (minus any fees or commissions). However, if the price falls below ₹1,050, the investor faces a loss.

Conclusion

Futures contracts are a powerful tool in the financial markets, offering opportunities for hedging, speculation, and portfolio diversification. However, due to their complexity and risk, they are best suited for experienced investors who understand the markets and the nature of leveraged instruments.