One of the most exotic terms in trading is “Futures”.
A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a future exchange.
The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.
Let’s say there’s is a farmer who cultivates wheat and a baker who needs wheat as an input for making bread.
- The farmer thinks that the price of wheat which is currently trading at Rs.25/- could fall to Rs.22.50/- in 3 months.
- The baker on the other hand feels that the price of wheat on the other hand might become Rs.30/- in 3 months.
- In such a case both get together and sign a contract which says that at the end of 3 months the farmer would sell wheat to the baker at Rs.27.50/-. Thus, the farmer is protected against possible fall in prices.
- And the baker is protected against the price of his input going up beyond Rs.27.50/-
Such a contract is called a “Futures” contract because it is a contract that has to be executed at some future date.
Thus “Futures Trading” is nothing but having a point of view about the direction of the future price of a commodity/stocks/currency.
And when two parties have opposite views about future price movements they obviously are open to sign a mutually beneficial deal like the farmer and the baker did in our example.
Now, let’s say that after 3 months the price of wheat reaches Rs.30/-
In this case the farmer will have to sell for Rs.27.50/- as per the contract and undertake an opportunity loss of Rs.2.50/- as his call that prices would go down was not correct.
The baker on the other hand would be happy to receive wheat at Rs.27.50/- due to the “Futures Contract” at a time when the prevailing market price is Rs.30/-.
Thus, he clearly makes a profit of Rs.2.50/- because his expectation on price movement turned out to be correct.
- However, at the end of the period both parties achieve their goals of protecting their interests.
- While there may be an opportunity loss of the farmer but still he lands up making a profit of Rs.2.50/-
- At least he would have been at peace for the period of 3 months since he remained protected against any price fall or loss.
- The baker on the other hand gets wheat at Rs.27.50/- and makes a clear gain of Rs.2.50/-.
- He can now plan his manufacture more profitably than his competitors who would buy in the market at the spot price of Rs.30/-.
- Since his call was right about the price movement, he landed up making the gain of Rs.2.50/- due to the futures contract.
- Thus, in a sense both parties landed up meeting their business objectives and the “futures contract” helped them plan their business well by protecting their interests against unpleasant price fluctuations.
Thus, at the end one gains more and one gains less but both are happy that they could plan their business well.
