What is Futures Contract?
A futures contract is a legal agreement between two parties to buy or sell a specific quantity of a commodity or financial instrument at a predetermined price on a specified future date. Unlike spot contracts, which involve immediate exchange of goods or assets, futures contracts standardize the terms such as the amount, quality, delivery date, and location so that they can be traded on organized exchanges. These contracts offer a way for producers, consumers, and investors to manage price risk by locking in prices ahead of time.
In India, futures contracts on commodities such as gold, silver, crude oil, and agricultural products trade on exchanges like the Multi Commodity Exchange (MCX) and the National Commodity & Derivatives Exchange (NCDEX). By offering a transparent marketplace with guaranteed settlement, these exchanges enable market participants to hedge against adverse price movements or speculate on future price trends.
Definition of Futures Contract
A futures contract can be defined as a standardised derivative instrument that obligates the contract holder to transact an asset at a set price on a specified future date. The key characteristics that define it include the contract size, quality specifications, delivery date, and the grade of the underlying asset. Futures are legally binding, meaning both the buyer and the seller must honor the contract terms or face penalties.
In simple terms, if you purchase a futures contract for 100 barrels of crude oil at ₹5,000 per barrel for settlement on January 1, 2026, you are committing to pay ₹500,000 on that date and to take delivery of the oil, unless you offset or close the position before then. This standardized format ensures liquidity and efficient price discovery on regulated exchanges.
How does Futures Contract Work?
When you enter into a futures contract, the exchange requires both parties to deposit a margin a small percentage of the contract’s total value as security against default. Margins in India are managed by clearing corporations affiliated with MCX or NCDEX. Once the contract is active, its price fluctuates daily based on supply, demand, and market sentiment. Each trading day, gains and losses are calculated through a process called “marking to market,” where profits are credited and losses debited to traders’ margin accounts according to the day’s price change.
If losses exceed the margin deposit, the trader receives a margin call and must add funds to maintain the position. Conversely, profitable positions increase usable margin. This daily settlement ensures that credit risk is minimized. As the contract approaches its expiry date, traders can either close their positions by taking an opposite trade or settle them through physical delivery or cash settlement, depending on contract terms.
Types of Futures Contract
Futures contracts cover a wide array of underlying assets. In the commodities section of the capital markets, common types include:
- Agricultural Futures: Contracts on crops such as wheat, soybean, coffee, sugar, and spices. Farmers and processors use these to manage harvest-time price risks.
- Metal Futures: Contracts on precious metals like gold and silver, as well as base metals like copper and aluminium. These serve as a hedge against inflation and currency devaluation.
- Energy Futures: Covers crude oil, natural gas, and refined products such as gasoline and diesel. Energy producers and consumers rely on these contracts to stabilize their price exposures.
- Financial Futures: While technically outside commodities, financial futures on interest rates, equity indices, or currencies are similar in structure and may also trade alongside commodity contracts.
- Soft Commodity Futures: Includes contracts on items like cotton, rubber, and palm oil. These are especially relevant in tropical and sub-tropical regions, and play a vital role in price risk management for agribusinesses.
Different exchanges may offer tailored contracts to suit domestic market needs while adhering to global standards.
Benefits of Futures Contract
Futures contracts provide several benefits for participants in the commodities and financial markets:
Price Risk Management:
Producers and consumers can lock in prices for commodities, thereby insulating their businesses from sudden market volatility. For example, a soybean farmer can secure a selling price months before harvest, avoiding the risk of price crashes.
Leverage:
By posting only a fraction of the contract’s value as margin, parties can gain exposure to large positions with limited capital. This amplifies both potential gains and potential losses.
Liquidity and Standardization:
Standardized contract terms and centralized trading platforms foster high liquidity. This ensures smooth entry and exit from positions without significant price concessions.
Transparent Pricing:
Exchanges publish real-time price data, fostering price discovery that reflects global supply and demand factors. This helps businesses make informed decisions.
Hedging and Speculation:
While hedgers manage risk by taking positions opposite to their commercial exposure, speculators provide liquidity and try to profit from price movements. Their activity ensures active markets.
Regulatory Oversight:
In India, futures trading is overseen by the Securities and Exchange Board of India (SEBI), which sets margin requirements and monitors trading to prevent market abuse.
Features of Futures Contract
A well-structured futures contract typically includes:
- Standardized Terms: Contract size (like 100 troy ounces of gold), delivery months, quality grade, and delivery location are pre-defined by the exchange.
- Margin Requirements: Initial and variation margins set by clearing houses ensure financial integrity.
- Mark-to-Market Mechanism: Daily settlement of gains and losses maintains credit discipline.
- Expiration and Settlement: Contracts specify an expiry date, after which they are either cash-settled (no physical delivery) or physically settled.
- Clearing House Guarantee: The exchange’s clearing corporation acts as a counterparty to both sides, reducing default risk.
- Open Interest: The total number of outstanding contracts indicates market activity and liquidity.
- Price Limits and Circuit Breakers: Exchanges may impose daily price movement limits to curb excessive volatility.
- Standard Contract Months: Only specific months are available for trading (for instance, January, March, May, July, September, and December for many commodities), streamlining market activity.
Examples of Futures Contract
To illustrate, consider a few real-world scenarios in the Indian context:
Gold Futures on MCX: A jeweller who expects to purchase 10 kg of gold in three months enters a gold futures contract at ₹52,000 per 10 grams. This locks in the price, protecting against global gold price fluctuations.
Soybean Futures on NCDEX: A vegetable oil miller looking to buy 1,000 kg of soybean enters into a futures contract at ₹4,500 per 100 kg. This guarantees input costs, assisting in budgeting and pricing for refined oil.
Crude Oil Futures on MCX: An oil refinery hedges its exposure by selling crude oil futures at $70 per barrel for delivery next month. Such a position helps the refinery manage the risk of rising crude oil prices.
Cotton Futures on NCDEX: A textile manufacturer secures its raw cotton requirements by buying futures contracts for December delivery at ₹20,000 per bale, ensuring predictable production costs.
Application of Futures Contract
Futures contracts find application across multiple domains:
Hedging by Producers and Consumers: Farmers hedge crop prices, while airlines lock in jet fuel costs. Industrialists use metal futures to fix input prices for manufacturing.
Speculative Trading: Individual and institutional traders attempt to profit from price swings without ever handling the physical asset. Their active participation adds liquidity to the market.
Portfolio Diversification: Financial investors incorporate commodity futures to diversify portfolios, given commodities often have low correlation with equities and bonds.
Price Discovery and Forecasting: Futures prices reflect market expectations. Policy makers and businesses analyze them for planning and strategy.
Arbitrage Opportunities: Traders exploit price differences between spot and futures markets or between different exchanges, helping align prices and reduce inefficiencies.
Risk Management by Financial Institutions: Banks and non-banking financial companies offer customized hedging solutions using futures to corporate clients, charging fees or spreads for their services.
Components of Futures Contract
Every futures contract comprises several key components:
- Underlying Asset: The specific commodity or financial instrument such as crude oil, wheat, or gold against which the contract is written.
- Contract Size: The standardized quantity of the underlying asset (e.g., 1 metric tonne of copper or 100 barrels of crude oil).
- Delivery Month: The calendar month in which the contract expires and settlement occurs. Exchanges define permissible delivery months.
- Price Quotation: The unit price expressed in domestic currency (e.g., ₹ per 100 kg) or international benchmarks (e.g., USD per barrel).
- Quality Specifications: Grade standards, purity levels, and other quality parameters ensure uniformity in delivery.
- Delivery Terms: Whether the contract allows physical delivery with specified delivery centers or is cash-settled based on a reference price index.
- Margin Requirements: The initial deposit and variation margin amounts are calculated as a percentage of contract value.
- Daily Settlement Procedures: Rules for marking to market, margin calls, and default protocols.
- Position Limits: Maximum allowable open positions for single entities to prevent market dominance and manipulation.
- Trading Hours: Specific hours during which the contracts can be traded, often aligned with global markets for round-the-clock coverage.
Mechanics of Futures Contract
The life cycle of a futures contract follows a clear sequence:
- Order Placement: Traders place buy or sell orders through brokers on the exchange’s electronic platform.
- Matching and Execution: The exchange’s order book matches buyers and sellers based on price and time priority.
- Initial Margin Collection: Once the trade executes, both parties deposit the initial margin with the clearing house.
- Daily Mark-to-Market: At market close, contract values are adjusted to current settlement prices. Profits and losses are credited or debited from margin accounts.
- Margin Calls and Maintenance: If account balances dip below maintenance margin thresholds, traders must top up funds within a specified window.
- Rolling Over Positions: Traders looking to maintain exposure beyond contract expiry close their current position and open an equivalent one in a later delivery month.
- Expiration and Settlement: As expiry approaches, most traders close positions to avoid delivery obligations. Remaining contracts undergo physical or cash settlement.
- Clearing and Delivery: The clearing corporation facilitates the transfer of assets or cash settlements and ensures obligations are met.
- Record-Keeping and Reporting: Exchanges and regulators maintain detailed records of all trades, positions, and margin movements for audit and compliance.
Who Uses Futures Contracts?
Futures markets attract a diverse group of participants:
- Hedgers: Producers (like farmers, miners, and oil drillers) and consumers (such as manufacturers, airlines, and jewellers) use futures to lock in prices and manage budgetary certainty.
- Speculators: Individual traders, hedge funds, and proprietary trading desks aim to profit from price movements by taking positions without any underlying commercial exposure.
- Arbitrageurs: Professionals scan for price discrepancies between related markets or different contract months and execute trades to capture risk-free profits, thereby contributing to market efficiency.
- Portfolio Managers: Investment managers incorporate commodity futures as an asset class to diversify holdings and hedge against inflation.
- Retail Investors: Through derivative segments of mutual funds and exchange-traded funds (ETFs), smaller investors gain exposure to commodities without directly trading futures.
- Regulators and Analysts: While not trading, they use futures data to monitor market health, forecast economic trends, and guide policy decisions.
The mix of these participants determines market liquidity, depth, and price stability.
Futures Contract vs. Forward Contract
Although both futures and forward contracts allow parties to fix prices for future transactions, they differ in several ways:
- Trading Venue: Futures trade on regulated exchanges with standardised terms, while forwards are private over-the-counter (OTC) agreements customised to specific needs.
- Counterparty Risk: Clearing houses guarantee futures contracts, virtually eliminating counterparty risk. Forward contracts carry higher default risk, as they rely solely on the creditworthiness of the counterparty.
- Standardisation: Futures have fixed contract sizes, quality specifications, and delivery dates. Forward contracts can be tailored in size, delivery location, and settlement method.
- Liquidity: Futures enjoy higher liquidity due to exchange trading and active participation. Forwards are less liquid, as they are bespoke and privately negotiated.
- Margining and Settlement: Futures require daily margining through mark-to-market. Forward contracts settle only at maturity, with no interim cash flows.
- Regulation and Transparency: Futures markets are subject to strict regulatory oversight, with transparent price reporting. Forward markets offer less transparency and are subject to fewer regulations.
Risks Associated with Futures Contracts
While futures contracts offer valuable risk-management tools, they also carry inherent risks:
- Leverage Risk: Small price movements can lead to large gains or losses due to the leveraged nature of margin trading. Traders may lose more than their initial margin deposit.
- Margin Calls: Adverse price changes can trigger margin calls, requiring additional funds. Failure to meet calls can lead to forced liquidation of positions at unfavorable prices.
- Basis Risk: When the futures price and the spot price of the underlying do not move in perfect correlation, hedgers may face residual risk at contract expiry.
- Liquidity Risk: While major contracts are liquid, less popular delivery months or niche commodities may have low trading volume, leading to wider bid-ask spreads.
- Counterparty Risk in OTC Extensions: Although futures carry minimal counterparty risk, related OTC instruments or spread trades may reintroduce credit exposure.
- Operational and Technical Risk: System outages, trading halts, or miscommunication of orders can cause unexpected losses.
- Regulatory and Exchange Risk: Changes in margin requirements, position limits, or contract specifications by exchanges or regulators can impact trading strategies and costs.
- Delivery and Rollover Risk: Traders who fail to roll over or close positions before expiry may face logistical challenges and costs associated with physical delivery.
- Psychological Risk: Rapid market movements can trigger emotional decision-making, potentially leading to poor trading choices.