Buy or sell futures contracts

Question

I cannot find a clear and unambiguous definition of the terms "selling futures contract" or "buying futures contract". From Hull's book:

[...] a futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price.

The price in question is, if I am not mistaken, the price when the futures contract comes to maturity.

So, what does it mean to buy or sell a futures contract?

Let us suppose that I buy on June 1 a futures contract at the futures price of $100, with a maturity date on August 1. What does it mean exactly ? Does it mean that I will have to buy on August 1 the underlying asset at the spot price (let us say $110 on August 1) to the person that sold me the futures contract ? But what about the $100 I paid already to the person who sold me the futures contract?

I understand the definition of a futures contract, but I do not know what it means concretely to "buy" or "sell" a futures contract.

Answer 1

Buying (or selling) a futures contract means that you are entering into a contractual agreement to buy (or sell) the contracted commodity or financial instrument in the contracted amount (the contract size) at the price you have bought (or sold) the contract on the contract expire date (maturity date). It is important to understand that futures contracts are tradeable instruments, meaning that you are free to sell (or buy back) your contract at any time before the expiry date.

For example, if you buy 1 "lot" (1 contract) of a gold future on the Comex exchange for the contract month of December 2016, then you entering into a contract to buy 100 ounces (the contract size) of gold at the price at which you buy the contract - not the spot price on the day of expiry when the contract comes to maturity. The December 2016 gold futures contract has an expiry date of 28 December. You are free to trade this contract at any time before its expiry by selling it back to another market participant. If you sell the contract at a price higher than you have purchased it, then you will realise a profit of 100 times the difference between the price you bought the contract and the price you sold the contract, where 100 is the contract size of the gold contract. Similarly, if you sell the contract at a price lower than the price you have purchased it, then you will realise a loss. (Commissions paid will also effect your net profit or loss).

If you hold your contract until the expiry date and exercise your contract by taking (or making) delivery, then you are obliged to buy (or sell) 100 ounces of gold at the price at which you bought (or sold) the contract - not the current spot price.

So long as your contract is "open" (i.e., prior to the expiry date and so long as you own the contract) you are required to make a "good faith deposit" to show that you intend to honour your contractual obligations. This deposit is usually called "initial margin". Typically, the initial margin amount will be about 2% of the total contract value for the gold contract. So if you buy (or sell) one contract for 100 ounces of gold at, say, $1275 an ounce, then the total contract value will be $127,500 and your deposit requirement would be about $2,500. The initial margin is returned to you when you sell (or buy) back your futures contract, or when you exercise your contract on expiry.

In addition to initial margin, you will be required to maintain a second type of margin called "variation margin". The variation margin is the running profit or loss you are showing on your open contract. For the sake of simplicity, lets look only at the case where you have purchased a futures contract. If the futures price is higher than your contract (buy) price, then you are showing a profit on your current position and this profit (the variation margin) will be used to offset your initial margin requirement. Conversely, if the futures price has dropped below your contracted (buy) price, then you will be showing a loss on your open position and this loss (the variation margin) will be added to your initial margin and you will be called to put up more money in order to show good faith that you intend to honour your obligations.

Note that neither the initial margin nor the variation margin are accounting items. In other words, these are not postings that are debited or credited to the ledger in your trading account. So in some sense "you don't have to pay anything upfront", but you do need to put up a refundable deposit to show good faith.

Answer 2

Here is some simple points for you, I hope you will get from these points.

People buy or sell futures for Profit or Lock the exchange rate for future transactions.

It is binding agreement between seller or buyer so it means you have to buy or sell at expiry although future trades in exchange, you can sell the contract before expiry as well.

Future is expensive due to Margin deposit requirement.

For Example (Ignoring Margin & Taxation Impact)

At 1-January 20x1 Mr. X (promise)/Future to buy the ABC company 50 shares at $100 each at 1-Feb 20x1 and also today share price is $95

At this point Mr.X don't need to pay full amount.

At 1-Feb 20x1 the Share price is $105 but Mr.X lock the rate at $100 means MR.X now purchasing 50 shares at $100 that equal to $5000

If the Mr.X didn't purchase the future, he would be purchase at $105*50 = $5250

It means MR. X gain $250

Answer 3

Let's assume I enter into a deal. I sell an asset to somebody on June 1^st. However he says, he would pay me the market value of that asset any time on or before August 1^st.

This puts me in a dilemma. What if the market price of that asset goes down before August 1^st and I have to accept a lower payment? If the price goes up, then obviously I'll make more money than anticipated.

This uncertainty causes me sleepless nights.

This is what happens on a futures market exchange. My asset could be sugar, gold, wheat, shares etc.. i.e. pretty much anything.

I short sell a future that just happens to be equivalent to the quantity of my amount I sold to the acquirer of my item. For example say I shorted at $100, with expiry on August 1^st. Now fast forward to August 1^st when the price is $120. We get paid from the guy who was supposed to pay on or before August 1^st. He pays $120, his bad luck, he should have paid us $100 on June 1^st instead of waiting till August 1^st. His judgement of the likely price movement was faulty.

I earned $20 more than I expected to earn on June 1^st. However for the other party, the futures short of $100 is now $120 and they must exit their position by purchasing it back. I.e. they sell at $100 and buy at $120 for a loss of $20. That $20 is forwarded to the exchange.

Thus we hedged our position on June 1^st and exited the hedge by August 1^st.

Answer 4

Futures contracts are a member of a larger class of financial assets called derivatives. Derivatives are called such because their payoffs depend on the price of other assets (financial or real). Other kinds of derivatives are call options, put options. Fixed income assets that mimic the behavior of derivatives are callable bonds, puttable bonds etc.

A futures contract is a contract that specifies the following:

1. The underlying asset.
2. An expiration date.
3. A "futures price".

Just like with any other contract, there are two parties involved. One party commits to delivering the underlying asset to the other party on expiration date in exchange for the futures price. The other party commits to paying the futures price in exchange for the asset. There is no price that any of the two parties pay upfront to engage in the contract. The language used is so that the agent committing to receiving the delivery of the underlying asset is said to have bought the contract. The agent that commits to make the delivery is said to have sold the contract.

So answer your question, buying on June 1 a futures contract at the futures price of $100, with a maturity date on August 1 means you commit to paying $100 for the underlying asset on August 1. You don't have to pay anything upfront. Futures price is simply what the contract prescribes the underlying asset will exchange hands for.