UNDERSTANDING FUTURES

futures_derivatives

When you have just stepped on the income generation mode (say early 20s), you would have plans to set up milestones to ear mark each achievement. Purchase of a car, house and various other luxuries of life that actually form these milestones need some careful planning. One needs to know how to save what they earn so as to achieve the set targets. While there is no doubt that one needs to invest, on what will be the next question. This article will provide an understanding on one of the investment options available in the financial market namely futures. However, before getting into it let’s run through what derivates mean without further delay.

Derivatives

A derivative is basically a financial contract between a buyer and seller that derives its value from an underlying asset which does not have a value of its own but extracts a value based on its performance. By performance the indicative here is expectancy of the price movements of the underlying asset. This is mainly traded over the counter or in stock exchanges. Derivatives can be classified into many types such as options, futures, forwards and swaps.

Futures

These are financial contracts with strict obligations. Hence the investor (buyer or seller) is obligated to buy or sell his/her underlying asset mentioned in the contract for the strike price on the delivery date. Futures contracts are usually entered into for trading in commodities. Hence, future contracts will have a specified quantity, a specified price and a specific date. The person who plans to buy the underlying asset is said to be ‘long’ while the person who plans to sell the underlying asset is said to be short. Unlike in options where it is a win-win situation for both the buyer and seller, in futures one person gains while the other loses.

Futures Exchange

In order to monitor the transactions taking place under futures, an exchange has been set up. This is mainly done to ensure that there are no defaults since one person gains and the other loses out. Hence both the parties are expected to enter into a performance bond for which an intial sum of money is expected to be paid. Once the contract is entered into, the exchange keeps track of the daily price movements of the underlying asset which in this case is mostly the commodity. This is known as marked to market, where everyday price movements are noted and settled on a daily basis. The exchange will now use the initial sum paid to pay the daily variations to the right party thereby ensuring that the correct amount rests with the buyer or seller. If the amount deposited by either of them goes well below a level marked by the exchange, then extra amount is called for from the respective party.

Hence at the final date known as the delivery date the amount that rests with the parties is not the same as the strike rate. This is known as spot value.

Futures are used mostly by speculators who gain an upper hand if there is a price rise and then they can sell the contract by making more money. Hence if one knows the market well and knows how to play by its rules, then futures are the best investments. As the saying goes, high risk high returns.

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