Trading in future ~ stock market

Definition of future :

A Future is a commitment negotiated between two counterparties which allows buy or sell, a specified quantity of an underlying asset, on a predetermined date (the due date) at a price agreed in advance.

Futures contracts are standardized products negotiable on a regulated market through intermediaries specializing in derivatives. They can be bought or sold throughout their lifespan. Futures contracts are a firm promise. The purchaser of the contract on the expiration date undertakes to purchase the underlying asset at the agreed price. The seller of the contract must, on the expiry date, deliver the underlying asset or its equivalent in cash, according to the contract negotiated.

Characteristics of Futures.

1. The underlying

The underlying of a Future is the value to which the promise to buy or sell that constitutes the Future relates. It is, therefore, the value to which the return of a Future is linked. The specific assets can be very diverse and relate to indices, commodities, currencies, or even rates.

2. The deadline

The deadline is the expiry date of the contract. For futures contracts, the expiration dates are standardized (the 3rd Friday of the expiration month). The investor chooses the deadline on which he wants to trade. The most negotiated is generally that of the current month.

3. The value of a contract

The value of a contract is the nominal value to which the commitment relates. For each Future contract, a value is assigned to the underlying unit's trading unit. The value of a contract is therefore obtained by multiplying the current level of the contract (in units) by the value of a unit (in rupees, dollars, etc.).

Contract value = number of contracts x value of a unit of the underlying x price of the futures contract

4. The compensation price

The compensation price for a futures contract is established after each trading session. It is calculated at a fixed time at the end of the session on the basis of the last prices quoted before this time. It is used to determine margin calls and to value contracts in position.

5. Liquidation

The settlement of expired futures contracts takes place on the 3rd Friday of each month. In the vast majority of cases, it takes the form of cash settlement of the difference between the compensation price of the previous day and the liquidation price.

There is generally no delivery of securities at maturity. But depending on the type of contract, to avoid delivery of the securities, the investor must take care to close his position and resell the contract before the liquidation.

Example of understanding a future.

Take the example of a future involving a ton of wheat. If you think the price of wheat will go up, rather than buying a tonne of wheat, it's easier to buy a future. We then agree to buy a tonne of wheat at the current price later. If, conversely, someone thinks that the price of wheat will fall, then he will sell this future.

Suppose we buy this future, that it has a duration of three months and that it covers 100 tonnes of wheat at 16,000 rupees per tonne, or 16,00,000 rupees. Three months later, a tonne of wheat is worth 20% more, or 19200 rupees. Two outcomes are then possible:

If the contract provides for physical delivery, then the buyer actually receives 100 tonnes of wheat, which he pays 16,00,000 rupees on the agreed date. As on the day of delivery, these 100 tonnes are actually worth 19,20,00 the buyer is getting a good deal. The seller must respect his commitment, even if this is disadvantageous for him.

If the contract provides for a financial settlement, then there is no delivery, but the buyer receives on the agreed date 1,60,000 rupees from the seller, which corresponds to the gain realized. Again, the seller cannot shirk.

If we now consider the case where the price of wheat dropped by 20% in the three months:

In the case of physical delivery, the transaction takes place in the same way, at the same price, and on the same date. It is this time the seller who makes a good deal since he sells more expensive than the price of wheat on the day of delivery.

In the case of a financial settlement, this time the seller receives 1,60,000 from the buyer.

Things can get a little complicated since nothing forces the buyer and the seller to keep a future until its maturity. The buyer or seller can respectively sell or buy back the contract to someone else, and transfer the obligations related to the contract to them. The sale or redemption price of a future is based on the price of wheat at the time of sale.

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