A standardised contract between two parties to buy or sell a specific asset (the underlying), at a specific date in the future (delivery date) at a price agreed upon today (futures/strike price). These contracts trade on a futures exchange.
Every transaction has a buyer and a seller. The buyer is said to be ‘long’ the contract whereas the seller is ‘short’ the contract.
For example, a 1700 future on gold with expiry in September gives the buyer the obligation to buy gold at USD 1700 on the last trading day of the futures contract in September.
The seller of the contract will have the obligation to sell gold at USD 1700 on the last trading day of the futures contract in September.
The pay-off to the buyer will be the difference between the spot price at maturity (S) and the strike price (K) set out in the contract, thus (S – K). The pay-off to the seller will be the reverse (K – S).
If at expiration the price of gold is USD 1,500, the buyer of the futures contract will lose USD 200 whereas the seller of the contract will gain USD 200.
If at expiration the price of gold is USD 1,900, the buyer of the futures contract will gain USD 200 whereas the seller of the contract will lose USD 200.
If at expiration the price of gold is USD 1,700, neither the buyer nor the seller makes a profit or loss.
The terms to be specified in the contract are the underlying asset, the type of settlement (cash or physical), the amount and units of the underlying asset per contract, the currency in which the futures contract is quoted, the quality of the asset, the delivery month, and the last trading date.
To minimise the probability of default by either party, the futures exchange requires both parties to put up an initial amount of cash or collateral known as margin. As the futures price changes daily, the profit is settled.
As demonstrated in the diagram above, as one party gains, the other loses. Thus the exchange will draw money out of the losing counterparty’s margin account and place it in the winning counterparty’s margin account so that daily profit and loss is taken appropriately.
Futures are traded by two groups: hedgers, who wish to protect themselves against the risk of price changes, and speculators, who seek to make a profit by predicting market moves.