The Anatomy of a futures contract
Understanding the basic attributes of a futures contract
In my previous story, Futures, Forwards, and Options introduced with examples, I tried to explain the basics of Futures, Options, and Forwards contracts with a few examples to demonstrate the details. This time, I’d like to bring a futures contract under some investigation so we can learn more about its structure. The exchange is the one responsible to specify these attributes or the way I call it, the futures contract anatomy. I enjoyed learning this myself, hope we’ll be on the same boat once you’ve read this article.
Road map
- The underlying asset
- The contract size
- Delivery — the arrangement and the timing
- Price
1. The underlying asset
Futures are the oldest way of investing in commodities. When the asset is a commodity, there is a possibility of having quite a various range of qualities that would be available through the marketplace at each point in time. Hence, the exchange has this responsibility to clearly specify the levels or grades at which a commodity is found acceptable. In other words, grade defines the quality at which the underlying asset will be delivered. In contrast, in financial assets, the grade loses its color as it makes no sense to have a grade against a currency such as the Japanese Yen.
2. The contract size
The size of a futures contract specifies the amount of the asset that must be delivered through that. For example, in a commodity futures contract that the underlying is sweet crude oil, the quantity could be 1,000 barrels which reflects the contract size. Or, to take another example, if this is about a stock or equity option, the usual size of a contract equals 100 shares. That means the party with the long position has to buy 100 shares per option contract.
Basically, specifying the contract size is of high importance for the exchange. Mainly because if it goes too small, then, it may not be cost-effective as there is always a cost for each contract to be traded. From another angle, if the contract size tends to be too large, then, those investors intending to go for small speculations would find it difficult to do so. And yet it proves again the crucial impact it could have on the exchange.
3. Delivery — the arrangement and the timing
Yet, another important job for the exchange is to define the delivery location for the assets that the party with the short position needs to send the assets to. They usually introduce warehouses under the license of the exchange as delivery locations. In some cases though, the location could change which consequently will affect the cost of the delivery too, that is, the further the location is from the commodity source, the higher the cost will likely to happen.
Now, the timing — basically the exchange must clear the exact period of the month that the delivery can be made. In most cases, that becomes the whole month. As a matter of fact, the exchange specifies the starting month that a contract can get traded, and also, the last day at which a trade can take place. The delivery month is usually what a contract is referred to by. For example, the March corn futures contract traded by CME Group.
4. Price
This comes with two different sections: Price Quotes and Price Limits. The former is when the exchange has to specify how the prices will be quoted. For example, dollars and cents in the US crude oil futures contract is the quote. The latter, Price Limits, specify the price boundary within which a trade can be done on a trading day — its main goal is to control the volatility that goes against a commodity each day. Let’s bring this into more detail below.
Limit up — as the name suggests, this is the maximum price a futures contract is allowed to rise to in the scope of a trading day. The exchange will specify this and it differs from contract to contract. Usually, when the limit up price is reached, the exchange will automatically cease the contract from being traded for that trading day. Alternatively, the exchange may decide to increase the limit-up price to allow further trading. One of the biggest advantages of the limit-up price is to make it difficult for those traders who intend to manipulate the market, that is, they could make a massive number of orders with high prices to bid up the initial price.
Limit down — as the name implies, this is the minimum price that a futures contract can decline to and being traded in a day. Again, the exchange will automatically halt the trading if the limit-down price is reached. And yet, they can step in to alternate the price and allow further trading for the day. One of the advantages of the limit-down price is to prevent the panic selling that would generate declines against the actual price.
Thanks for reading — keep learning :)
