What are Future Contracts? Know the true meaning, how do future contracts work in reality? And go through practical examples of this financial instrument.
So once again, Welcome back to our derivative segment!! Oh, you didn’t know this was a segment? Well it is, it is, we have Options and Forward contracts here, this one is all about Futures. Also, we would like it to be on the record that we are personally, very offended with the fact that Futures market has nothing to do with time-machines (as the name gives the feeling), it is very misleading and its 2020, it’s about time we have time-machines. So, Let’s get into the real meaning of future contracts in the financial world.
What are Future Contracts?
First of all, let’s revise the meaning of a derivative. A derivative is a contract of buying or selling an underlying asset which it ‘derives’ value from, at a particular point in future.
Futures contracts are agreements made for an underlying asset; which can be in the form of a commodities, stocks, currency, metals, bonds, or any other securities. A contract with a fixed price wherein the buyer of the contract has the intention to buy the asset, and the seller of the contract sells the asset. This implies that the buyer is in long position, and the seller of the contract is in short position with regards to the underlying asset. And you, you’re in wrong position, straighten your back, it’s good for you, and also use this as a reminder to drink water.
Futures are traded both on exchanges as well as at over-the-counter market. However, a large number of Future contracts generally trade on the exchange, because the motive to have Futures as a system is to have the same basic nature of a contract, but also have a third party monitoring the financial transactions.
How do Future Contracts work? Example
Now, let’s see here’s how a future contract works with the help of a simple example.
Suppose you run a lemonade stand. Assume the price of lemons keeps fluctuating. This can be harmful for you, because when the prices go up, your margins decrease, and being a small operation they weren’t high to begin with.
So what you do is go to your lemon supplier, and tell him to enter into a contract with you to supply lemons at a particular price, sometime in the future. Now even if the price of lemons goes up, you are obligated to your previously ascertained price, keeping your margins intact.
That’s exactly how future contracts work. In addition to the above mechanism, because Future contracts are traded on an exchange, their real life process is a tad bit more complicated than this.
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How do Futures Contracts Work in Real Life?
Usually, things are the sum of their parts. Mostly, except Quantum physics. (Don’t ask, too much YouTube.)
Anyway, to understand how Future Contracts work in real life, lets break it down to its parts.
The first thing that you should understand is the mechanism. When you tell your stock broker that you want to buy futures of a particular asset, here’s what happens.
You’ll be asked to quote price, which is usually around last traded price, and how many lots you want to buy. A lot is simply a preassigned minimum quantity. It is the basic denomination, and you can either trade a single lot, or multiples of it. E.g. The lot size of ABC ltd. Futures is 25. You can buy a minimum of 25 shares, or 50, 75, etc.
Now what happens is when you enter this information, the system matches you, the buyer, with someone who wants to sell that quantity, which is easy because remember the lot sizes are pre-defined. Think of Futures markets as Tinder, but better.
The next requirement would be margin. A margin is usually the quarter of the value of Futures, which the stock broker locks in, basically a guarantee to the amount of financial loss you can sustain. This would be more clear when we discuss how Futures are settled.
Here’s what you need to keep in mind. With Future contracts, you don’t actually own the asset. You have the right and obligation to buy the asset at the end of the contract, which in most cases is accompanied by an instant sell order and you only see the profit or loss, given in the margin. Let’s get into a little more detail of how futures are settled.
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How are Futures Settled?
During the course of the contract, futures are settled several times before final settlement, on a daily basis.
Here’s how daily settlement works.
Suppose you bought 10 futures of ABC ltd. contract for Rs. 100. At the end of the day, the price of the contract is Rs. 105. (The actual process of calculating the last price, the settlement price is a little more complicated.) So per contract, you have made a profit of Rs. 5, and in total Rs. 50 ( Rs. 105 – Rs. 100 = Rs 5 * 10 Futures). This is your increase in margin, which would be credited in your account.
However, the same can happen in reverse, where instead of Rs. 105 the price closes at Rs. 95. Here, with the same logic, it results in a loss of Rs. 50, which you would have to put up alongside your initial margin.
This process is called mark-to-market settlement, and it is done on a daily basis.
Finally, future contracts are also settled at the end of the contract, which is done whether by delivery of the underlying asset, or cash settlement. It should be noted that in Future contracts, actual delivery of the asset rarely happens, as low as with 2% of the total future contracts.
Majorly, it is done through cash settlement, which in case of loss happens this way. The buyer pays the difference between the price in contract and last traded price, and the rest is earned through selling of the asset. It should be noted that in this scenario, the last traded price is lower than the contract value.
In case of profit, the difference is credited to the buyer’s account. In this case, the last traded price is higher than the contract value.
Where are Futures used?
Futures contracts can be used for both speculation and hedging. Firms use futures as a way to hedge and reduce market risk in commodity prices like oil, gold, silver, spices and raw materials, currencies and even shares.
They can be used for speculation in these avenues too, but the major difference here is Future contracts bought as a hedge have a bigger chance of settlement through delivery of the commodity than the ones bought as speculation, because the idea is to make money.
The Bottom Line
Future contracts can be a addition to the portfolio, but it can also be detrimental and eat away all the profits. Also, the timing is very important, because, personally, I know of people who were right about their speculation, but bought the futures too early and had to square up their position because they couldn’t pay the increasing margin. So be careful and drink loads of water!
Disclaimer: There is a high degree of risk involved in stock trading and investing in any risky asset classes. The details given on this website are for informational purpose only and cannot be constituted as professional advice in any regard. Please follow due diligence while investing your money.