A futures trading is a contract between two parties to exchange an underlying security (currency, stock etc) at a future date. The trade on futures takes place through exchange. You get a benefit of investing less money for more quantity of underlying. This investment of lesser money is called as initial margin.
Before coming to the details of futures and options, let’s dig into the basics first.
1. What is a share?
To put simply, a share is a part of ownership of business. If you purchase a share of Google, you own a percentage of it’s business (although a very small one).
2. Why shares?
Well, let’s look at an example.
Martha owns a bakery. The bakery works good and is making good profits, let’s say $90000 per year. Now, since, the business is profitable, it is an income, so she will have to pay taxes and deductions. Her net profit is say $60,000. The bakery also owns a property of $400000 market valuations.
Now, suppose, she wants to buy a house which costs $300,000.
But all her savings are invested in the bakery. So, although she is not poor, she is short on liquidity. If she wants to purchase the house, she has broadly three options: 1. Take a loan 2. Wait a few years 3. Sell the business
Suppose, due to some constraints, option 1 and option 2 are not preferable. Thus, she decides to sell her business.
But, alas, she runs into quite a few problems. A reasonable value of her business would be $60,000 * 10 + $40,000 (Yearly earnings multiplied by 10 + the value of the property). The business is worth $1,000,000. Not many people have that sort of money at hand. Second, her business is not worth much without her expertise. So, people don’t want to own the business without her. Thirdly, she has absolutely no need of the extra $700,000 and would prefer to retain her business instead.
So, she comes up with an idea. She offers 30% stake in her business for $300,000. She maintains in the clause that she would pay herself a salary out of the business for her services and that this 30% would be of the profit after her salary (appropriately and as per Government’s laws). So, now, all three of her problems are solved.
But, there is a twist. $300,000 is still a large amount and not many people can afford it immediately whereas she needs to purchase the house immediately. So, although, this is a good plan, she is not getting the desired result.
So, here come, Shares to the rescue. She draws up 30 contracts each selling 1% of business each for $10000. Now, instead of having one partner, she will have 30 partners each with 1%. Technically, one person may own more than one such contract, so the number of partners may be less than 30. Thus, now even small investors can afford to be a part of Martha’s business and every body is happy. This contracts are called Shares or Stocks.
Place where people can buy or sell Shares is called Stock Market.
3. What are Futures Trading?
Future is simply put, a contract to buy or sell something in future at a price agreed upon today. (Actually, I say “simply put”, but that’s exactly what a future is, there is no simplification done.)
4. Why Futures Trading?
To understand the concept of futures, the best example is to think in terms of commodities.
Suppose, Ravi owns a factory of making steel pipes. His is a small business, doing turnover of say $200000 every year.
Now, the government has rolled out a search for quotation asking for supply of pipes roughly of the order of $2,000,000 over a period of 3 months. This is a big opportunity for Ravi and he is thinking very seriously about the contract.
But, there is a problem. The price of the raw material, iron ore, fluctuates a lot. Since, this is a big quotation, he cannot afford to quote higher margins to account for the fluctuation in price. Let us, for the sake of example, assign some numbers. So, let’s presume $1,500,000 worth of iron ore is required, another $400,000 is required to process it and $100,000 would be his margin.
Now, price of iron ore can easily move upto 40% here and there. So, his profit may be anything from -$500,000 to +$700,000.
Now, since his is a small business, he cannot afford such a big risk. But this is his chance to scale. One option which he has is to buy the iron ore today and store it for the future. But he doesn’t have that sort of cash today, nor does he have facility to store it.
So, he is disappointed. But wait, lo and behold, here come, futures to the rescue. He goes to his suppliers and explains his situation. Now, the suppliers are rich fellows and they are willing to take the risk. So, they say, “Okay, we shall provide you iron ore at the dates we decide at the price we decide today. You can make the payments on the date we agree. If the price goes up, you gain, if it doesn’t, we do. You cannot back out of it, neither can we.”
They take into account today’s rates and interest rates and storage costs and thus come up, with an idea has to at what price they don’t lose any money on average by selling to Ravi. Ravi contacts different suppliers with this scheme and makes sure he doesn’t end up with a deal in which he doesn’t lose any money on average.
So, they have now entered into a Futures contract, whereby Ravi is ‘Long’, ie he is going to purchase and the suppliers are ‘Short’, i.e. they are going to sell at the later date (the date of expiry).
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5. Where does stock market come in to picture?
So, here, let me introduce you to our star business man, Gujju Marwadi. Mr. Marwadi is a trader who believes in buying at lower price and selling at a higher one.
He has long known that he can earn huge margins in Iron Ore markets as he is reasonably sure that he can predict the direction of Iron Ore prices better than most of the world.
There is a catch though, the Iron Ore business deal in bulk quantities and he needs a lot of cash to have a position in the business. He has better uses for such a large amount of cash and therefore, does not enter the Iron Ore business since the ratio of profits to amount of cash blocked is too low.
Not any more, He thinks, “If Ravi can get into this contract, so can I. Now, to get into this contract, costs me a negligible sum of money. If I can sell this contract again at a later date, I have my position in the market and I don’t need to keep my cash idle”.
So, he starts Speculating which direction price will go and futures help him in doing and makes insane amount of money in Commodity Markets.
Now, jubilant by his success, he thinks, “Wow! Can I do this in stocks too? Entering into a contract to buy or sell in the future and trading in this contracts?”
Thus, Stocks Futures are born.
6. Options, what is that?
An option is a contract whereby one party has an option to execute the trade in the future.
7. Not so clear, is it?
Well, consider the case of Mr. Subbu. Subbu is a savvy investor like Mr Marwadi but unlike our beloved Gujju, he doesn’t believe in taking big risks.
His line of thinking is, “Wow! The upside of futures is cool, but the downside is not!”. Now, he doesn’t want to suffer the downside but wants the upside. I mean, who wants the downside anyways.
So, he goes to Mr. Marwadi and has a talk. Mr. Marwadi listens to his argument, uses his logic and comes back with an exciting idea.
He says, “Okay, suppose I give you an option to back out of the futures contract, i.e. we draw a futures contract, in which you have the right to withdraw but I don’t. How would that be?”
Subbu is delighted, “Awesome!”
Marwadi smiles and says, “Well, there is a catch though. Since, I am selling you an insurance, I will charge you a premium. So, for example, if I sell you a contract where by you can buy 100 tonnes worth of iron ores at $1000 per tonne, you can back off the contract if the price goes lower, but I cannot back off if the price goes higher (or lower, but you should back off in that case). Now, for this $100,000 worth of contract, I would need lump sum payment of $10,000.” If things go good, you have an upside of $30,000 as 40% changes in price of iron ore are pretty common. If things go bad, you cannot lose more than $10,000. What say?”
Subbu thinks, “If the price of the iron ore remains constant, I am down -$10,000 though. I doubt it will be this stable though.”. So, Subbu is okay with it and thus Subbu is long a ‘Call Option’ while Gujju is short a ‘Call Option’. Similarly, Gujju sells a ‘Put Option’ to the suppliers, where by they can sell him at the predetermined price, but have no obligation to do so, if the price goes higher.
Thus, Gujju has risks both ways, but is net +$20,000 and is hoping that prices don’t move more than 20% either side. On the other hand, Subbu is hoping price increase by more than 10%, while suppliers now, don’t have to worry about “What if the prices drop”.
Everybody has positions as per his own risk appetite, that’s Options for you.
Lets take an another example of reliance industries.
You should first know that the future lot size for reliance is 1000.
Assume price for reliance share is 950.
Now if you want to directly buy 1000 shares at 950, you would need to put 9,50,000. (which is a huge amount)
But if you buy a future, you will only need to put around 1,00,000 (the future margins are available on financial website) and you would still be exposed to a movement on 1000 stocks. The difference here would be that if reliance is at 950, this future will consider its price a little on the higher side(say 953).
Generally almost same movement on reliance will reflect on its future. So if reliance becomes 950+2 i.e. 952, its future price will become 953+2 i.e. 955 (giving you a profit of 2*1000 i.e. 2000).
In Indian markets, you get to choose only the next 3 months futures (this includes current month). So if you are in January, you can buy a Jan future, a Feb or a Mar future. On the last Thursday of that month you will have to book your profit/loss (but you can do that anytime before that Thursday too)
The basic rules as in stocks apply on futures as well – So if you are bullish on a stock, you will buy its future, if you are bearish, you should short it (Note that selling requires a little higher margin than buying).
A futures market is an auction market in which participants buy and sell commodity and futures contracts for delivery on a specified future date. Futures are exchange-traded derivatives contracts that lock in future delivery of a commodity or security at a price set today.
Futures Contracts: Agreement to buy or sell an underlying security at a predetermined date at an agreed price. The difference between futures and options is that with options, the buyer has the right, not the obligation. With futures, both parties are obliged to fulfil their part of the bargain.
A futures trading is a vital financial exchange where traders can trade standardized futures contracts to buy specific quantities of a commodity or financial instrument at a stated price with delivery set at a specified time in the future. It is also refers to as the derivative market trade.
However, you can also invest in stock and commodity market for high profit gains with the help of an advisory firm like 100mcxtips and khelomcx. They provide the accurate tips on the basis of technical and fundamental analysis of market.