Stock futures are contracts agreed upon between a buyer and a seller for commodities, such as soybeans or corn, or financial instruments, such as a US treasury note or gold, for delivery at a future date. These contracts are legally binding agreements between a buyer and seller that obligate both parties to the terms of the agreement. Most of the terms in stock future contracts are standardized, or established prior to any agreement.
Typical standardized conditions include the quantity and quality of the product being bought or sold. Traders who are active in a market are aware of these standards prior to buying or selling a contract. The life of the contract is also standardized in that at a specific month and year, a futures contract will expire. The only real variable in stock futures is the price where a buyer and seller agree to complete a transaction.
The standardizations in stock future contracts provide traders with certain expectations that allow them to enter and exit positions rather easily, which creates liquidity in a market. For example, a buyer of a contract may decide to offset a current long, or buy, position with a sale prior to the expiration of the contract. This is called hedging. A trader can do this since they know when that date will be.
A seller may opt to hedge his position with a purchase before the futures contract expires. Less than 3% of stock futures' contracts are actually held to the expiration of the contract. Hedging drives activity in the futures markets, as stock futures provide a way for traders to transfer risk.
For the small percentage of contracts that are held until the expiration date, the agreements are settled in one of two ways. Either there is a physical delivery or a cash settlement of a contract. Some stock futures' contracts result in a physical delivery, with the buyer receiving the product that the contract was made for. This delivery could be in the form of a commodity or a financial instrument.
Other contracts are resolved by cash settlement. In this instance, depending on the price a financial security closes at the contract's expiration date, the trader receives cash. If the settlement price is lower than where the trader purchased the contract, the trader's account is debited rather than being credited.
