Suppose you are a wholesale potato trader in Pilani and I run a restaurant in C’not. Every morning I buy my requirements for the day from you at the price fixed by the agricultural commodities wholesalers’ association. Now, potatoes are important to both of us. It is your main business; while I require them to run my business. I hope for low potato prices and you hope for the demand to increase so that the prices go up. One fine day, say two months before OASIS you come to me and say,” Let’s set our potato prices for October and pick a price that allows both of us a reasonable profit. That way neither of us has to worry about the prices around OASIS.” I agree, and we settle on a price of Rs.10 per kg. This agreement is called a ‘forward contract’ – forward because we’re going to make the transaction later.

Good idea, you may feel, but not really. What if the prices rose to Rs.15 a kg due to increased demand? You would want to get out of the contract. Or, say, there’s a bumper crop and the prices fall to Rs.6 a kg. Now I would like to find ways to exit the contract. It may also happen that a storm destroys the seasons’ produce and the contract would fail. ‘Futures’ contracts were devised to solve such problems. A ‘Futures’ contract is simply a forward contract with a few ‘wrinkles’ added.

One of these ‘wrinkles’ is standardization. A forward contract can be written for any commodity, any amount and any delivery time. On the other hand, a futures contract is for a specific grade, quantity, and delivery time. Grade, quantity and the delivery time are specified by the exchange when they design the contract. Only the price is left to be determined. This way futures contracts are interchangeable. Also, futures contracts are traded only on the exchange.

If two parties make a forward contract, no money need change hands until the cash transaction is completed at a later date. If you buy a futures contract, you will have to put up margin moneya good faith deposit. If you buy a futures contract and cash prices go up, so will the price of the futures contract as they tend to move together. In that event you would have an unrealized profit in your futures account. Without closing out in the futures position, you can withdraw this profit in cash.

One of the most important qualities of futures is its escape-ability. If you buy a futures contract and later decide that you don’t want to be a party to it any more, you can close your position and wipe the slate clean by selling the same futures contract. Futures provide other broader economic benefits that probably won’t affect us directly. Because they trade actively, futures markets are constantly “discovering” the current price for the particular commodity.

In many cases, Options are traded on futures. A put is the option to sell a futures contract, and a call is the option to buy a futures contract. For both, the option strike price is the specified futures price at which the future is traded if the option is exercised.

Abhishek Upadhyay

BITS – Pilani