A future contract, unlike the privately-traded forward contract, is publicly traded. Futures markets were designed to solve the problems that exist in forward markets. A future contract is a standardized contract to buy or sell an underlying on a specified date for a pre-determined price and is traded on an exchange. The basic utility of the product is that it helps in managing the price risk of the underlying.
As we explained earlier, the futures contract is a standardized forward contract, which is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time specified in the futures contract.
A futures contract is highly standardized contract with the following details specified:
- The underlying asset or instrument. This could be anything from a barrel of crude oil, a kilo of Gold or a specific share or stock market index.
- The type of settlement, either cash settlement or physical settlement. Currently in India most stock futures are settled in cash.
- The amount and units of the underlying asset per contract. This can be the weight of a commodity like a kilo of Gold, a fixed number of barrels of oil, units of foreign currency, quantity of shares, etc.
- The currency in which the futures contract is quoted.
- The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery.
- The delivery month.
- The last trading date.
Presently, stock futures are settled in cash. The final settlement price is the closing price of the underlying stock. The investor can square up his position at any time till the expiry. The investor can first buy and then sell stock futures to square up or can first sell and then buy stock futures to square up his position. E.g. a long (buy) position in December ACC futures, can be squared up by selling December ACC futures.
Also note that investors can take long term view on the underlying stock using stock futures. Stock futures offer high leverage. This means that one can take large position with less capital. For example, paying 20% initial margin one can take position for 100 i.e. 5 times the cash outflow. Trading in futures is regulated by the Securities & Exchange Board of India (SEBI). SEBI exists to guard against traders controlling the market in an illegal or unethical manner, and to prevent fraud in the futures market.
Let us now understand the pay-off of future contracts.
Let us take an example of Reliance Industries; whose lot size is say 75 and the current market price is Rs 1200. Suppose Mr Mahesh is LONG 1 lot of Reliance Industries February Future at Rs 1220 (meaning that he has agreed to buy 75 shares of Reliance Industries on 26th Feb 2009 at a price of Rs 1220). On the other hand, Mr. Ramesh is SHORT 1 lot of Reliance Industries February Future at Rs 1220 (meaning that he has agreed to sell 75 shares of Reliance Industries on the expiry date of 26th Feb 2010 at a price of Rs 1220).