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What is a futures contract?

A futures contract is a standardized financial agreement to buy or sell a specific quantity of an underlying asset such as commodities, currencies, or financial instruments at a predetermined price on a specified future date. These contracts are traded on exchanges like NSE and BSE and are different from forward contracts because they have standardized terms and are highly regulated. Key features of futures contracts include:

  • Standardization: Futures contracts have standardized terms, including contract size, expiration date, and other specifications. This standardization facilitates trading on organized exchanges like NSE and BSE and enhances market liquidity.
  • Exchange-Traded: Futures contracts are traded on organized futures exchanges, providing a centralized marketplace for buyers and sellers. This centralized exchange facilitates transparent price discovery and reduces counterparty risk.
  • Clearinghouse: A central clearinghouse acts as an intermediary between the buyer and the seller in a futures contract. It guarantees the fulfillment of the contract, reducing the risk of default by either party.
  • Marking-to-Market: At the end of each trading day, the gains or losses on a futures contract are settled by marking the contract’s value to the market price. This process ensures that both parties maintain sufficient margin in their accounts to cover potential losses.
  • Leverage: Futures contracts allow traders to control a large position with a relatively small initial investment. This is achieved through the use of margin, which is a performance bond that traders must deposit with the clearinghouse.
  • Offsetting Positions: Traders can close out their positions before the contract’s expiration by taking an opposite position, known as offsetting. This allows participants to realize gains or losses without physical delivery of the underlying asset.

Futures contracts serve various purposes, including risk management, speculation, and price discovery. They are widely used by hedgers to protect against price fluctuations, by speculators seeking profit from price movements, and by arbitrageurs to exploit price differentials between related assets. The existence of a standardized, regulated marketplace enhances liquidity and transparency in futures trading.