Future Basics

My apologies for delay in posting on this blog. Navratri and Garba took a toll on my plans to write more. Nevertheless, I believe you all would also be busy in the same so it is about time that we play catch up.

Let us consider the example of Sugarcane farmer that we used on the NSE Options Trader for explaining options. In case of options, you would recall (In case you have not read options basic at NSE Options Trader, I would request you to kindly do so) that while the seller of the option had the obligation to fulfil his side of the contract, buyer had the right or choice to exercise the option contract. For this, seller would receive a premium for the risk he is taking. Now what happens when both buyer as well as seller has the obligation to come true to their side of bargain; well you have a futures contract.

In futures contract, both buyer as well as seller has the obligation to buy or sell the prescribed amount of underlying at the prescribed time. So you will have to buy from the sugarcane farmer and he has to deliver 10 Tonnes of sugarcane to you in two months’ time exactly. You do not pay any premium and he does not receive any. So how do the things work out and why can’t you run away.

This is where the exchange comes in to play. But before we get to the mechanism of futures trading and settlement, a little history about futures would be apt.

In North America, farmers used to produce whatever they could and bring it to the market place in anticipation of securing good price for it. However, neither they had any idea about demand for their crop nor traders (or buyers) had any idea of the supply they will get. This often led to mismatch between the two and uneven loss/profit to the parties involved. This need became the mother of modern futures contract. Farmers and traders started to tie up the contract beforehand which mentioned underlying, quality, quantity, time, etc. This led to a better regulated market with stable demand-supply equation and less volatility. That was the origin of the one of financial world’s greatest invention.

Farmers and traders were true to their business and used to settle future contracts as per terms. Not anymore, today, farmers and traders have been replaced by hedgers and we have speculators. This is not necessarily a bad thing and in fact much of the dynamics of derivatives market is a result of these entities.

In future posts, we will see explanation of all these future terms and also future margin and future settlement mechanism in futures.

All I can say is future is bright.