Futures Contracts

A futures contract is a standardized agreement between two parties that a) commits one to sell and the other to buy a stipulated quantity and grade of a commodity, currency, security, index or other specified item at a set price on or before a given date in the future; b) requires the daily settlement of all gains and losses as long as the contract remains open; and c) for contracts remaining open until trading terminates, provides either for delivery or a final cash payment (cash settlement).

These contracts have several key features:

• The buyer of a futures contract, the "long," agrees to receive delivery;

• The seller of a futures contract, the "short," agrees to make delivery;

• The contracts are traded on exchanges either by open outcry in specified trading areas (called pits or rings) or electronically via a computerized network;

• Futures contracts are marked to market each day at their end-of-day settlement prices, and the resulting daily gains and losses are passed through to the gaining or losing accounts;

• Futures contracts can be terminated by an offsetting transaction (i.e., an equal and opposite transaction to the one that opened the position) executed at any time prior to the contract's expiration. The vast majority of futures contracts are terminated by offset or a final cash payment rather than by delivery; and

• The same or similar futures contracts can be traded on more than one exchange in the United States or elsewhere, although normally one contract tends to dominate its competitors on other exchanges in terms of trading activity and liquidity.

• Underlying instrument--the commodity, currency, financial instrument or index upon which the contract is based;

• Size--the amount of the underlying item covered by the contract;

• Delivery cycle--the specified months for which contracts can be traded;

• Expiration date--the date by which a particular futures trading month ceases to exist and therefore all obligations under it terminate;

• Grade or quality specification and delivery location--a detailed description of the "par" commodity, security or other item that is being traded and, as permitted by the contract, a specification of items of higher or lower quality or of alternate delivery locations available at a premium or discount; and

• Settlement mechanism--the terms of the physical delivery of the underlying item or of a terminal cash payment. The only non-standard item of a futures contract is the price of an underlying unit, which is determined in the trading arena.

Figure 2: Payoff Diagram of a Long Futures Position

Figure 3: Payoff Diagram of a Short Futures Position

As indicated in Figure 2, if you buy (go long) a futures contract and the price goes up, you profit by the amount of the price increase times the contract size; if you buy and the price goes down, you lose an amount equal to the price decrease times the contract size. Figure 3 reflects the profit and loss potential of a short futures position. If you sell (go short) a futures contract and the price goes down, you profit by the amount of the price decrease times the contract size; if you sell and the price goes up, you lose an amount equal to the price increase times the contract size. These profits and losses are paid daily via the futures margining system, as illustrated later in this program.