What is futures contract?

Futures contract is nothing but a standardised version of forward contract. It is just as the name suggests, two parties get into a contract to buy or sell an underlying asset at a fixed price at a certain future date. However, there are differences between the forward contract and futures contract but the idea behind them is the same. We will discuss the differences between them thoroughly.   

Understanding futures  

Market participants such as hedgers and speculators make use of futures contracts. Let us build a case study example to consolidate the concept. Let us assume that a stock ABC Ltd is trading at Rs 100 on BSE. And you have bought 100 shares of ABC at Rs 80. Based on your due diligence, you believe that the stock price may see a serious correction for the short term, and so, you want to hedge that downside risk. And so, you sell a futures contract (short position) for a lot of 100 shares at Rs 80 with an expiry of 30 days. That makes a total notional amount of Rs 8,000. You are not required to make an upfront payment of Rs 8,000. However, some percentage margin is to be deposited for fluctuating prices, which is called as initial margin. Someone else, who is bullish on the stock will buy the futures contract (long position). Here, Rs 80 is referred to as futures price. If the price falls below Rs 80, the short position will earn a profit, and if the price goes up, the long position will earn. As the prices fluctuate continuously, one party will always earn or lose on a daily basis and hence, the transactions are settled on a daily basis by clearing house in exchange. If you make a loss, you must put money to revive the initial margin, which is called a maintenance margin.   

Difference between forward and futures contract: