An Overview of Futures Contracts and the Components Of a Futures Contract.

A futures contract is a legal agreement to buy or sell a commodity, or a financial instrument, at a future date.  This is done on the floor of a futures exchange between floor brokers on behalf of their respective clients or customers, or their own accounts.  Futures contracts are standardized according to quality, quantity, and the time and location of delivery.  The price that delivery will be made at is the only unknown and it is decided on the floor of the exchange at the date and time the contract is entered into.  At any time the contract can be offset, and the trade closed by the holder of the futures contract taking the opposite position to what he / she is currently holding. 

To be tradable on a futures exchange, the characteristics of the futures contract must be defined. The futures trader must know the underlying asset, the quantity of the commodity to be delivered, the delivery arrangements and the delivery date.

The Underlying Asset of the Futures Contract:

The underlying asset of the futures contract must be properly defined. If the underlying asset is a financial instrument, this is not a problem but if the underlying asset is a commodity, there may be quite a variation in the quality of the physical commodity available for delivery.  When the physical asset is specified, it is important that the exchange stipulate the characteristics that are acceptable for delivery of the actual physical commodity.

The Size of the Underlying Futures Contract:

The contract size is the amount of the underlying asset that has to be delivered for one futures contract.  This has to be a fixed size.  If the size of the underlying future or commodity is too large, it will make the futures contract too expensive to trade.  If the size of the underlying futures or commodity is too small the hedgers will not use the futures contract to because they would have to buy too many contracts to establish a hedge.  In both cases it would lead to a lack of liquidity in that particular futures market which would make it very difficult for speculators to trade in those markets and reduce the risks to the commercial interests and hedgers.

The Futures Contract Delivery Arrangements:

The exchange must specify the delivery arrangements. For some instruments delivery is impossible (for example a Stock Index). For delivery of a physical commodity, the delivery location must be specified because it may involve expensive transportation costs.

The Futures Contract Delivery Date:

A futures contract is referred to by its delivery month specified by the futures exchange. It can be or a date or a month depending on the nature of the underlying asset, but this is more for the over the counter markets.  Regulated futures markets all use the same commodity trading month symbols.

Futures Price Quotes:

The futures contract must be quoted in a way that is easy to understand. For example, crude oil quoted in dollar cents per barrel, Treasury Bond and Treasury Note futures in dollars and 1/32 of a dollar. From there some simple math will give you the the minimum price movement.

Daily Price Movement Limits:

Usually to avoid speculative excesses, daily price movements limits are fixed for each futures contract. Once the limit up or down is reached, trading is suspended.  Some markets, such as currencies do not have any daily trading limits.  If you are on the wrong side of one of these markets and you are not trading with stops, you are going to get hurt.

Futures Contract Position Limits:

The maximum position an investor can have on a specific instrument. This is to avoid any one individual or company from being able to corner the market and manipulate the price of the underlying future or commodity.