Derivatives : All about Futures

Having covered the basics of stock markets and short selling, lets try to focus on something that is a bit more complex. Let’s move into the derivatives segment of the markets. What are derivatives? Let’s not confuse with the general dy/dx that we study in engineering. Derivatives are the entities that depend on some underlying entity for their value. Futures and Options are the most common derivatives in the stock market.

So what are futures? A futures contract is an agreement between a buyer and a seller to be executed at a future date at an already fixed price. So either the buyer or the seller will lose money depending on the ensuing market value of the underlying asset. Let’s try to understand with the help of an example.

Suppose I am a building contractor and I need 1000 switches three months later. So I can either, wait and directly go to the market to buy 1000 switches when I need them, or book them (or in financial parlance, get into a futures contract) at a predefined price say 10 Rs. per switch. If I decide to wait and go to the market when I need 1000 switches, there may be a risk of not finding so many switches for sale in the market. Also I shall need to purchase from different vendors at the price which I don’t know now. So there shall be a lot of uncertainty. While if I get into the futures contract now, I have fixed the price , so I know what I am going to shell out and also I have taken care of the risk of not having the supply when I need it. Thus, futures ensure that you shall get a commodity or a stock at a specific date in future at a pre-decided price , no matter what the market price is on the day of delivery of commodity or stock.

One can buy a futures contract of a stock (generally there is a fixed lot of shares below which you cannot buy a futures contract), an index (like sensex, nifty , midcap index etc.) in addition to the commodity futures.

In futures market segment, there are a lot of speculators, who just want to make money. They are not at all interested in the underlying asset. For example, if I am a speculator in the futures market, I may buy wheat futures, of say 1000 tonnes. Now, I don’t need that tonnage of wheat at all but I just buy to make money. Now how can I make money? Lets say I buy a futures contract of 1000 tonnes of wheat which is to be delivered on 15th Aug 2008, at a price of Rs.10/kg. Now , suddenly the price of wheat increases in the market and the price becomes Rs. 12/kg . But I have a contract which gives me the right to buy at Rs. 10/kg. So I end up making a huge profit, on the basis of a small investment that I made while entering into the contract. But had the price been less than Rs. 10/kg then I would have made an equally huge loss. So one can make or lose a lot of money in the futures market. Hence futures are risky.

Now, I have a contract of buying wheat at Rs. 10/kg and the market price has reached Rs. 12/kg , so do I take the delivery of those 1000 tonnes after paying the other party of the contract the whole sum? No! Generally, there is a cash settlement, i.e. only the difference in the market price and the contract price is paid up. Its just like buying 1000 tonnes at 10 a kg from the contract party and selling at market price. Instead if that , you ask the other party to sell themselves at the market price after paying you out 12-10 =2 /kg .

In terms of stocks, all the futures contracts are traded through the stock exchange. One can square off ( a term used for settlement) the contract anytime before the actual expiry of the contract. For example , if I buy a futures contract of 1000 shares of Infosys at a strike price (price at which the deal is finalized) of say Rs. 2000 with expiry date of 15th Aug, and if the Infosys price surges to 2100 on July 10th , I can well square off the contract on that day itself. Also, one has to keep money equal to the loss in his account. For example, if in the case above, Infosys price tumbles down to 1900, then I stand to make a loss of 100*1000 = 100,000 rupees, in that case , I must keep Rs. 100,000 in my account with the exchange to keep the contract open, else the contract will be closed at the moment my loss on the contract as per the current market price just crosses the amount in my account . If the contract is squared off , then even if the price of Infosys goes back above 2000, I end up making loss, because I don’t hold that contract anymore.

So Futures, is an interesting type of derivatives. If traded wisely and with a knowledge of the markets, on can make windfall gains. Some good future trading can surely change your future for sure. Futures is perhaps one of those very few things which can make a man who came in a Rs. 500,000 worth Maruti Swift to the stock market, leave in a Rs. 100 million worth local train! ;-)

-KGV