Definition of future contracts

Future contracts is an agreement made and traded on the exchange between two parties to buy or sell a commodity at a particular time in the future for a pre-defined price. Since both the parties are unaware of each other, the exchange provides a mechanism to give the party assurance of honoured contract. The exchange specifies standardized features of the contract. The risk to the holder is unlimited, and because the pay off pattern is symmetrical, the risk to the seller is unlimted as well.

Money lost and gained by each party on a futures contract are equal and opposite. In other words, futures trading is a zero-sum game. These are basically forward contracts, meaning they represent a pledge to make a certain transaction at a future date. The exchange of assets occurs on the date specified in the contract. These are regulated by overseeing agencies, and are guaranteed by clearinghouses. Hedgers often trade futures for the purpose of keeping price risk in check.

Future contracts are often used by commercial enterprises as ‘hedging tools’ to reduce the risk of expected future purchases or sales of the underlying asset. If used to speculate, risk increases. So risk depends on the underlying instrument and the use of the future.

Advantages of Futures Contracts

• If price moves are favourable, the producer realizes the greatest return with this marketing alternative.
• No premium charge is associated with futures market contracts.

Disadvantages of Future Contracts

• Subject to margin calls
• Unable to take advantage of favourable price moves
• Net price is subject to Basis change

Futures contracts are similar to Options. Both represent actions that occur in future. But Options are contract on the underlying futures contract where as futures are either to accept or deliver the actual physical commodity. To make a decision between using a futures contract or an options contract, producers need to evaluate both alternatives.