Futures Contract

Definition

The financial investing term futures contract refers to a standardized agreement between two parties to buy and sell a commodity or security at a pre-determined price on a future date.  Futures contracts are traded on an exchange, and can be settled in either cash or physical delivery of the commodity or financial instrument.

Explanation

Futures contracts are standardized agreements between two parties, which are traded on an exchange.  Also known as futures, these contracts involve margin true-ups, and are marked-to-market over time.  Futures contracts are oftentimes sold before the expiration date, and the agreement will outline:

  • Quantity: the units of the commodity bought or sold (bushel, pound, metric ton)
  • Delivery Location:  the physical location of the commodity on the expiration date (oftentimes shipping ports).
  • Quality:  an indicator of the specific commodity (type of corn) or an indication of its quality (moisture content, impurities)
  • * Pricing Unit:  dollars or cents per unit of commodity

The party purchasing the commodity is said to be taking a long position, while the seller is assuming a short position.  As the price of the underlying asset changes over time, futures contracts are marked-to-market on a daily basis.  Traders will need to open a margin account, which is used during the daily settlement process.

Most futures contracts are settled in cash, and traders close out their positions before they expire.  Unlike forward contracts, which are primarily used as a hedge against future price movements of the underlying asset, futures contracts are valued by speculators as well as hedgers.

Example

A trader enters into a futures contract to buy 5,000 bushels of corn at $2.65 per bushel for delivery in September.  The following day, that futures price for corn delivered in September is now $2.62 per bushel.  Since the trader has agreed to buy the corn at $2.65 and its price is now $2.62, the difference ($2.65 - $2.62) x 5,000 bushels, or $150, would be deducted from their margin account.

Related Terms

equipment trust certificate, forward contract, margin account, stock exchange specialist