The stock markets are very diverse when it comes to the listing products as well as the investors that trade on them. From large-scale institutional investors to small traders and the general public as well as government entities. The financial markets are a common ground for all the players looking to make the most of their investments. The share trading on the stock exchange lists publicly traded companies and derivative products like options, bonds and mutual funds. However, something that often confuses novice investors and enthusiasts is the future contracts. These long-term financial derivatives are complex financial products that are difficult to model and attract curious parties.
But, before answering why they belong on the share trading platforms, it is crucial to understand what are future contracts.
Future contracts are long-term financial derivative products that use other assets like equity and commodity as the underlying entity. When two parties enter/ trade a future contract, they are in agreement to buy/sell the specified product as per the contract terms. A future contract lists out the details of the price, quantity and settlement terms of the underlying asset as per standardised terms on the exchange.
Let’s understand the future contracts a little bit in detail
- Why are they popular among investors?
Contrary to other financial assets in the market, future contracts allow investors to invest in large positions by paying a fraction of the total contract size. This means that the traders only pay the initial margin to control a larger underlying contract, thus allowing them to amplify their profits on settlement.
- Standard products and exchange managed
Future contracts are highly standardised products that specify the trade quantity, settlement dates, quality and price for future settlement dates. These contract terms are defined by the exchange and provide transparency and liquidity in the market. Also, since they are regulated by the exchange, the trading parties are secure and bound to the regulations and legal terms. Thus offering them counterparty risk mitigation and stability, which is all visible and managed through the trading account.
- Settlement dates, methods and pricing
Future contracts usually are defined with equity or physical commodities like metals, oil, agricultural products etc. as the underlying asset. Therefore at maturity, the parties are expected to exchange the specified underlying asset as per contract terms. Now, a future contract can be either physically settled (by exchange of underlying assets) or financially settled (by paying the difference in the contract and market price) on the maturity date.
The contract price is the price at which the parties entered the future contract (as per the terms) while the market price is the current market price of the commodity as per the contract.
More often than not, future contracts are financially settled by the involved parties in the stock market. Therefore, futures have become an attractive risk management product for investors. And they use these contracts to hedge the risk of their portfolios by taking opposing positions. By using short-term futures, investors can reduce their overall risk and take appropriate actions to realise their positions and achieve their returns.