Futures contracts or ‘futures’ are an improvement over forward contracts as they are standardized and tradable. A futures contract is a legal agreement between a buyer and a seller and both parties are bound to uphold the agreement. As per the contract, the seller agrees to sell a specific asset to the buyer at an agreed price on a particular date in the future. The contract specifies quantity, quality, delivery time, place and date of delivery.

Futures contracts are highly liquid since they are standardized (i.e. all contracts are structured so that they conform to certain combinations of parameters in terms of quality, quantity, expiration date, etc.) and can be traded on an exchange. Besides, there is no counter party risk or risk of default, as a clearing corporation or clearing house assumes this risk. In fact, in a futures contract you are unlikely to even know your counter party, just as is the case with buying or selling stocks through a stock exchange. The clearing corporation plays a crucial role as it takes care of transaction processing and settlement and also guarantees trades. Further, as futures contracts are standardized and liquid, price discovery is far better than in the case of forward contracts, where direct negotiation takes place between two parties.

The commodity futures market like the Multi Commodity Exchange (MCX), National Commodity and Derivatives Exchange (NCDEX), National Multi-Commodity Exchange (NMCE) and the index and stock futures segment of the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) are some examples of futures markets.

One of the critical similarities between a forward and futures contract is that in both cases, buyers and sellers are exposed to an unlimited risk associated with the price. However, you can limit your risk by buying options as explained below.