Understanding Futures Contracts

A Futures Contract is an agreement that is universally regulated to either buy or sell a product at a fixed and specified date in the future, and most importantly at a pre-determined price. The pre-fixed date is termed as the final settlement date. The price is termed as the futures price.

The final settlement date is the date by which both the buyer and seller are bound to fulfill the contract. Future contracts could be fulfilled through cash settlements, or at times the physical delivery of the product.

Some examples of Futures contract are:

* corn futures (CBOT)

* gold futures (COMEX)

* crude oil futures (NYMEX)

* stock index futures (CME)

* Eurodollar futures (IMM)

* bond futures (CBOT)

These contracts are termed according to the product and are therefore understood.

In case of a Stock Index Futures Contract, different stocks are combined to form an index. The big advantage is that investors have a choice of equities. The price risk factor is significantly reduced, leaving investors with a secure portfolio.

There are some guidelines and specifications to a Futures Contract. Since futures contracts are flexible, and are privately negotiated, specifications and guidelines are therefore necessary. They are also required to detail the nature of these agreements. The first responsibility of the parties involved in this type of a contract is to lay down the Futures Contract specifications and guidelines.

The factors that need to be considered are:

* The asset - The quality or grade of the product.

* Contract size - The amount of the asset to be delivered in the relevant contract.

* Delivery arrangements - The seller will choose the exact date for delivery.

* Price quotes - futures prices need to be specified.

* Limit up/down - the upper and lower limit of the price on the futures contract has to be specified, which is when trading would be stopped.

* Position limits - The maximum number of contracts that the agent holds has to be regulated.

Although a Futures Contract is similar to a Forward Contract, both are agreements to trade on a set future date. However, there are still some significant differences to note, which are listed below. This would help you understand Futures contracts further.

* Futures contracts are highly standardized globally, while each Forward contract is personalized, customized, and unique.

* Futures are settled at the end on the last trading date with the settlement price; whereas, the Forwards contracts on the other hand are settled at the start with a forward price.

* The profit or loss on a Futures position is exchanged in cash on a daily basis. With the Forwards contract, only at the time of settlement is the profit or loss realized.

* The Futures contract does not specify clearly the recipient to whom the delivery of a physical asset must be made; but in a Forwards contract it is clearly specified who would be the recipient of the delivery.

* Futures are traded at any exchange, while Forwards are traded OTC (over-the-counter).

Futures contracts are a great way to make money as long as you are cautious about certain issues. A highly volatile market is likely to remain unpredictable since it is influenced by factors such as demand and supply, geopolitical issues, growth, and inflation.