Futures Contracts and Mechanics
Core concepts
A futures contract is a standardised, exchange-traded agreement to buy or sell a specified quantity of an underlying at a future date. Candidates must know contract specifications: underlying grade, contract size/multiplier, delivery months, tick size and tick value, last trading day, and settlement method (physical vs cash). Understand the daily mark-to-market cycle, initial and variation margin, and the role of the clearing house as counterparty to every trade.
Learn the mechanics of basis (spot minus futures, or futures minus spot - check the convention stated), contango (futures above spot) and backwardation (futures below spot), and how cost of carry links spot and futures: F ≈ S × (1 + r − income yield)^T for financials, with storage and convenience yield added for commodities.
Traps
Questions often test tick value: tick value = tick size × multiplier. A common error is applying the tick size to the notional rather than to the multiplier. Another trap is confusing initial margin (performance bond at trade inception) with variation margin (daily cash settlement of gains and losses). Be careful with delivery: cash-settled contracts never deliver the asset, and physical delivery obligations may be closed out before expiry.
Worked example
An index future has a multiplier of 50 and a tick size of 0.25 index points. Tick value = 0.25 × 50 = 12.50 per contract. A two-point move is eight ticks, worth 100 per contract. Confirm units before answering.
Rule of thumb
Long futures gain when price rises; short futures gain when price falls. Daily settlement means gains are credited and losses debited each day, so cash flow timing matters even when the final price is unchanged.