What is a Futures Contract? Meaning, Examples & How It Works

Table of Contents:

1. What Is a Futures Contract?
2. Real-Life Hedging Example
3. Key Features of a Futures Contract
4. Futures vs. Forward Contracts: What’s the Difference?
5. Advantages and Risks Associated with Futures Contracts
6. Conclusion

What is a Futures Contract?

A futures contract is a legally binding agreement between two parties to buy or sell a specific asset, such as gold, crude oil, currency, or stocks, at a fixed price on a predetermined future date. Unlike informal buying or selling, these contracts are traded on regulated exchanges like the NSE, BSE, or MCX. The exchange standardizes all terms, such as the quantity of the asset, quality (where applicable), and expiry date. This standardization makes the process transparent and safe for everyone involved.

Both the buyer and seller are obligated to fulfill the contract at expiry unless they close (square off) their positions before that date. Futures contracts serve two main purposes:

• Hedging (reducing price risk)
• Speculation (profiting from price movements)

They allow buyers and sellers to lock in a price today for a transaction that will occur in the future, providing price certainty.

Real-Life Hedging Example: Currency Futures for Business Protection

XYZ Electronics, an Indian company, has imported machines from a U.S. supplier. The payment of $100,000 is due in 2 months.

Today, the exchange rate is 1 USD = ₹80. XYZ is worried that if the rupee weakens and the rate moves to ₹82, they will have to pay more in rupees (an extra ₹2 lakh).

To hedge this risk, XYZ buys a USD-INR futures contract on the NSE. The contract locks the rate at ₹80 per dollar for settlement after 2 months.

• If the rate rises to ₹82, XYZ pays more on actual conversion but gains from the futures contract, offsetting the loss.
• If the rate falls to ₹78, they lose on the futures but save money on the actual payment.

In both cases, the company benefits from price certainty, which helps in budgeting and financial planning. Like other futures, in India, currency futures are usually cash-settled, meaning the net profit or loss is credited or debited in rupees, and there is no physical exchange of currency.

Key Features of a Futures Contract (Explained Simply)

Important: What is Derivatives?: Simple Guide for Beginners

Difference between Forward and Future contract

Advantages and Risks Associated with Futures Contracts

Advantages:

• Hedging Against Price Volatility: Futures are commonly used to lock in prices and protect against sudden fluctuations.
• High Liquidity: Futures markets have many active buyers and and sellers. This means you can easily enter or exit positions without waiting long, making trading faster and smoother.
• Diversification of Investments: With futures, investors can access markets they usually wouldn’t—like oil, gold, stocks, or foreign currencies—without physically owning them. This adds variety to portfolios and spreads out risk.
• Cost-Efficiency: You don’t have to worry about physical delivery, storage, or transport. Transaction costs in futures trading are generally lower than dealing in actual goods.
• Regulated Environment: Indian futures markets are monitored by SEBI. This ensures transparent pricing, reduced fraud, and a level playing field for all traders.

Risks:

• Margin Call Risk: When the market moves against your trade, you may start incurring losses. In such cases, your broker might ask you to add more funds to your account, known as a margin top-up. If you fail to do so on time, your position could be squared off by the broker, locking in the loss.
• Expiration Risk: Futures have a fixed expiry date. If you don’t close or roll over your trade-in time, you may have to settle it at an unfavorable price or face physical delivery obligations.
• Interest Rate Risk: For futures based on interest rates (like government bonds), even a small change in rates can affect the value of your contract, causing profits or losses.
• Leverage Risk: Futures are highly leveraged instruments, which can amplify both profits and losses.

Conclusion:

Futures contracts allow you to lock in a price today for buying or selling an asset—be it gold, oil, currencies, or stocks—at a specified date in the future. Traded on regulated exchanges such as the NSE, BSE, or MCX, they serve two main purposes: hedgers use them to protect against sudden price swings (for example, a manufacturer locking in the cost of raw materials), while speculators seek to profit from anticipated market moves. Although only a small margin deposit is required to open a position, leverage can magnify both your gains and your losses, so disciplined risk management is essential.

Frequently Asked Questions (FAQs)