Futures contracts are exchange-traded obligations. The buyer or seller is contingently responsible for the full value of the contract. The buyer goes long, or establishes a long position, and is obligated to take delivery of the commodity on the future date specified.
Futures contracts explained
A seller goes short, or establishes a short position, and is obligated to deliver the commodity on the specified future date. If the seller does not own the commodity, his potential loss is unlimited because he has promised delivery and must pay any price to acquire the commodity to deliver.
As prices change, gains or losses are computed daily for all open futures positions on the basis of each day’s settlement price. Gains are credited, and losses are debited for each open position, long or short. All accounts for firms and traders must be settled before the opening of trading on the next trading day.
A long position in a futures contract is an obligation in the future – not an option in the future
Byers and sellers benefit from organizations that act as clearing houses for the contracts. Clearing house enables futures positions to be offset easily prior to delivery. To offset, close, or liquidate a futures position before delivery, an investor must complete a transaction opposite to the trade that initiated (opened) the futures position.
The offsetting transaction must occur in the same commodity, for the same delivery month, and on the same exchange. About 98% of futures contracts are offset before delivery. Futures may be highly leveraged, that is, controlling large amounts of cash commodities with comparatively small amount of capital.
The last trading day is the day that the commodity or the option trades, as established by exchange rules. It is therefore, the last day the contract may be offset by means of entering closing orders. Any short futures contract not offset by the end of the last trading day must be settled by delievery; any long futures contract not offset by the end of the last trading day must be settled by acceptance of the commodity.
Futures contract specifications
The exchange on which a futures contract is traded (designated contract market) establishes the uniform contract specifications – making all contracts for a given commodity interchangeable.
Example: Any December wheat contract on the Chicago Mercantile Exchange (CME) is interchangeable.
Typically, there are four standardized parts to exchange-traded futures contract:
Quantity of the commodity (e.g., 5 000 bu corn or 100 oz gold)
Quality of the commodity (specific grade [basic grade] or range of grades may be acceptable for delivery, including price adjustments for different deliverable grades); a lower quality commodity delivered will discount the price and a commodity delivered higher in quality over the basis grade will generate a premium price – exchanges set the grades that are eligible substitutes.
Time for delivery (e.g., December wheat to be delivered)
Location approved for delivery
Trading hours for futures and options contracts are also specified by the designated contract market (DCM) or exchange, such as open outcry from 7:20 am to 2:00 pm CT for CBOT-regulated Ultra T-Bond options.
Althrough price is not standardized in a futures contract (it is determined between buyers and sellers), the exchange will specify a minimum incremental price movement (known as a tick) as well as the maximum price movement permitted in one day’s trading (price limit).
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