Futures and Forwards 101

A future is a very common form of tradable contracts, much like options and swaps. It is an agreement to buy or sell an asset at a specific price on a specific date.

Remember, an option gives you the right, but a future is an obligation. You can decide to purchase or sell an asset on or before the expiration date in an option, but in futures you HAVE to meet your obligation on a predetermined future date. 

People often enter into a futures contract either to hedge (limit risk) or to speculate (calculated bet) on price movements. Let’s take the above example where you source your coffee from a dealer X in Coorg. The price of coffee varies every month depending upon the water situation in Coorg and you don’t like this. This makes it difficult for you to calculate the average profit per coffee mug and to project if you’d have enough money for investments in future. Similarly, the coffee guy also doesn’t like when the price decreases. 

To overcome this uncertainty, you both enter into a contract wherein you’d buy a coffee at a fixed rate every month. You hedged (limited) your risk this way.

Consider another example, where you are bullish that the prices for coffee would shoot manifolds in next few months. You enter into a contract with seller Z to buy coffee from him at a fixed rate after two months. If the prices indeed rise, then you can buy coffee at an agreed-upon upon rate from Z and sell them at a profit. This is price speculation.

In both the above cases, what you traded were FORWARDS.

Don’t be confused, read on for futures.

Now consider, that you are tired of finding sellers every time you have to hedge or speculate. Also, sellers have a hard time finding buyers like you. A wealthy delegator, ‘Nirmala’ comes along and says I’ll do the same for you if you just come to my office. She takes care of the docs, the dates and everything else. 

Since the process is formalized now and the trades happen via an intermediary, the same forwards contract can now be classified as FUTURES.

Nirmala’s office acts as an exchange like BSE, NSE in real life with your futures getting traded like any other stocks on Nifty or Sensex. In India, futures are traded only for 1, 2 and 3 months in advance and are settled on the last Thursday of every month. However, to trade in them you require something known as margin and that’s kinda risky. But more on margins later. Bye for now!

Thanks.