Futures contracts simplified

The share market is a rather tricky place. It has the potential to help you create a huge corpus and overwhelm you at the same time. There is no death of investment instruments available in this market – each increasingly different than the other. Every investment is akin to a gamble – you may earn a huge profit or incur a great loss. Of these futures and options, also known as derivative trading, is regarded as one of the riskiest and yet the most profitable. As traders, you need to know what futures are and the basic difference between futures and options. In this article, we’ve simplified futures and explained the differences between the two types of investment.

What are Futures contracts – meaning and definition

A futures contract is simply a type of derivative in which an investor or trader agrees to purchase or sell a specific quantity of a given asset at a specific and predetermined price, on a pre-decided future date. This contract is essential since it helps investors escape the risks associated with fluctuations in the price of the underlying asset.

How does this contract work?

To understand the future’s market, we need to look at it with the help of an example. Let’s say a farmer who trades in cotton, enters into a futures contract through which he agrees to sell his entire harvest at a specific price on a future date. The farmer can lock in the price of his harvest using this contract. This helps him secure himself in case the price of cotton falls at a future date, especially when he is ready to sell the cotton.

Now, if the price of cotton increases on the stipulated date, the buyer is not obligated to pay this new increased price. Consequently, if the price decreases, the farmer does not have to worry about incurring a loss, since the buyer has to honour the selling price as mentioned in the futures contract. This saves the farmer from incurring any loss.

The use of the futures market

If you are a trader who has an underlying stock, you can hedge your exposure by selling stock futures. Trading in stock futures allows you to transfer your risk to the speculator, who may take a contrary view to yours i.e. the speculator buys from you. In case the hedging turns right, your loss on the cash market is offset by the gains you make in the future’s market and the speculator purchasing your stock futures, ends up incurring a loss. In case the price of the stock futures increases, then your buyer stands to incur a profit, while you are still stand little chances of losing your stock at a lower price, due to the contract.

Futures vs options contracts – the differences

There are two main points of differences between futures and options contracts. Firstly, the cash outflow differs and is usually large for futures contracts. The trader must provide the brokerage firm an upfront margin to buy futures contracts, whereas traders dealing in options contracts just have to pay a premium amount, resulting in low cash flow. Secondly, option contracts are used fundamentally for hedging instruments while a contract for futures is used for hedging and speculating risk and obtaining physical delivery of assets at a predetermined time and amount in future.

In conclusion, investing in futures seems to be riskier than options. It is the kind of agreement that can help you earn very high profits, but the possibilities of incurring losses are also significantly high. It is thus essential to be well-informed before investing in futures contracts.

Maithili Pawar is a finance professor. She has written on share market basics. Through this article, she has provided detailed information on stock market.