What Are Futures (In Derivatives)? Basics Of Futures! (#8)

 

There are so many more things in Stock Market we can trade apart from just company's shares. Like- F&O (Futures & Options), Commodities & Currencies!

Today we are mainly focusing on the basics of Futures!

(Futures)! {Basics}

A Future is basically a Derivative!

I know it's just the start & here's a whole new term "Derivative".

It might not make enough sense, now; but you are just supposed to understand what a derivative basically is; in order to understand Futures!

Definition Of A Derivative!

A Derivative is a financial instrument which derives its value from an underlying asset!

It might seem complex at first. So let me explain with an example;

So, let's suppose that there is one "Treasure Box"

Which Is Empty!

So now, what's the value of the key of that "Treasure Box"?

Probably Nothing!

Right?

& NOW If I say that around A Million Dollars In Cash is Available in that same Treasure Box!

Then, NOW what is the value of the same key?

We can confidently say A Million Dollars!

Isn't it?

So, HERE,

The KEY is a Financial Instrument, which have derived its value from the underlying asset & we can say that the underlying asset is the money present within that Treasure Box Or we can say The Treasure Box, itself is the underlying asset.

So I hope that you understood the term "Derivatives".

Well, now....

Derivatives are of 4 types:

1. Forwards
2. Futures
3. Options
4. Swaps

& Today, within this blog; we'll mainly talk about Futures & understand what are they!

Lets first understand how/why a Future is a Derivative!

A Future is a financial instrument which derives its value from Shares/Share Price (underlying asset).

Well, just to inform you that Commodity Futures (they basically derives their value from commodities) & Currency Futures (they basically derives their value from currencies) do exist.

But today in this blog I'll mainly focus on Financial Futures (Futures which derives its value from shares, bonds, debentures, etc.)

Now, A Future Contract is a contract between a buyer & a seller made to avoid the loss which can be faced by one, because of the markets daily changes or share price fluctuations.

Just to explain you in a better way, here is a really simple example:

So let's suppose, that, there is a company which makes bread!

So we know that every company requires some sort of raw material OR here we can refer it towards as ingredient(s) required to make their final product.

& here just to keep it simple, the major material/ingredient required is "Flour".

So now let's say that the company purchases the flour from a person. Let's call him Mr. X (just for example) [Note - Well, I know that the making of bread may need some more ingredients & even the flour itself might be sometimes purchased from the farmer, himself in form of wheat, maybe. & later the company might have some other system & convert the wheat into flour by itself, OR the company itself might own a farm & grow wheat & all; over there, so it can be anything; etc, etc.

So by writing this 'Note'; I just wanted to let you know that this is just an example & the information provided here might not be 100% accurate. Anyways, back to the example....]

So Mr. X delivers flour to the company. Let's say he needs to deliver it to the company every 3-4 Months. & gets paid whatever the current price is in the market during that time (when delivering the flour).

Well, if you don't know then I'll like to tell you that flour's price also keeps on changing over time.

So even if it's 10$ or 12$ or 13$ or less or more; it just all depends on the current price of flour whatever is there in the market.

So now let us say that the current price is 4$/kg. So after 2 months from today, Mr. X is supposed to deliver flour to the company &'ll get paid whatever the price of flour may be during that time (after 2 months).

Which means that anything can happen after 2 months to the price of flour.... it may increase or decrease. & Mr. X have faced a loss last time because last time the flour price decreased to 2$/kg.

& this time he don't want to repeat the same.

So here's where future contracts come into play.

So,

Mr. X made a Future Contract with that Company. & now because of that future contract, no matter what the price of the flour may be after 2 months (during the time of the delivery), Mr. X will get paid 4$/kg of wheat flour he'll deliver to the company.

But, Why will the Company agree with the Future Contract?

Well, That is because, as much chances are there for the "flour" price to decrease, the same amount of chances are there for it to increase.

So if it rises to 6$/kg from 4$/kg, then it'll be a loss for the company.

So as we can see that the Future Contract, here.... have created a WIN - WIN situation for both (The Flour Supplier - Mr. X & The Flour Buyer - The Company!).

& just in case the price remains the same then it goes as it is.

BUT, this is a kind of example in which one may refuse.

Like, if I continue with the example then; If the price rised to 8$/kg then Mr. X may refuse to deliver flour for just 4$/kg.

& the opposite can happen too.... Like, if the price decreased to 2$/kg then the company may refuse to buy flour for 4$/kg.

So in this example there is nobody guaranting anything.

But you need not to worry, here.... because in REALITY there is a 3rd party involved while placing buy or sell order in futures & it maintains the security of both, the buyer & the seller.

The 3rd party who looks after everything is "The Regulator Of The Capital Market" itself, who also regulates the Financial Market/Securities Market (Share Market); Commodities Market, etc. within one's country. Like for example SEBI regulates the Financial Market, Commodities Market & the Currencies Market in India.

&

SEC regulates the Financial Market, Commodities Market & the Currencies Market in the US.

Stock Exchanges also plays a vital role in protecting one's rights while exchanging securities.

So, Stock Exchanges & The Regulatory Bodies makes sure that the buyer pays the amount it's supposed to & the seller sells the thing it is supposed to sell on time at a certain price (price on the basis of the contract) in futures.

So I think that this is something you should not worry about. Because this is a secured system.

Anyways, So now coming out of the example. Back to the reality, we know that in Reality Financial Futures are not traded with flour & all.

So now let's talk about how in REALITY are Financial Futures (in shares) traded!

(It's just an example, again. But NOW it'll kind of let you know how things work in reality.)

So first of all I'll like to introduce you with the term "Lots". Well, there are lots of shares in futures.

In other words, there are multiple number of shares of a company within a future.

So,

A "LOT" is basically a specific number of a company's  shares, a future carries/have.

For instance, let's suppose that there is a company named xyz. & it's future have a lot size of 10 shares (Here, in example we are just assuming that the lot size is of 10 shares. But in reality it may be of more). {The lot size of a future is decided by the Stock Exchange & it have the ability/power to change the number of shares present in a lot of the future, accordingly.} -Back to the example,-

& if the cost/price of 1 share of that company is 500$. Hence, 10 shares multiplied by 500$ will be 5000$ [10*500=5000]. Which means the entire value of the future is 5000$.

But the future's price on which one might buy it may be a bit less then 5000$. Because you know to earn some profit people buy stuff at less. Like let's suppose the price set of the future is of 4800$ instead of 5000$ for buyers. Hence, the buyer'll get 200$ profit in shares if it remained the same by its expiry. (Continue Reading to understand about expiry & all.)

So that is why future is a bit less in price then its actual value.

But here while explaining in this example I won't reduce the price of the future.... in order to avoid the confusion & keep it simple for y'all to understand.

Anyways,

So as I mentioned earlier that a future derives its value from an underlying asset (& the underlying asset here is the share of the company xyz).

& if the share of the company'll increase to 510$. Then the price of the future will also increase to 5100$.

So the price of future also keeps on fluctuating with the share price of that particular company.

{& also I would like to tell you that not every company offers futures to trade. Only a very limited number of companies have futures & offers people to trade them.}

Now you might have a question of Why To Trade In Futures When You Have Shares? Where you'll trade in a future of 10 shares by paying almost the same amount of 10 shares. So, Instead we can buy 10 shares directly!

This is very a valid question. & also for your information I'll like to tell you that, THIS IS THE REASON which makes people ATTRACTED towards FUTURES, so much.

So,

going with the same last example;

We know that the difference between 500$ & 5000$ is way too much.

& if a person who wants to buy the future don't have 5000$, then here comes a special offer by the Brokers & THAT IS "LEVERAGE/MARGIN" given by the Brokers.

Let me explain about, leverage/margin & How'll we trade with that?!

So leverage is basically a part of the entire amount given by the broker to an investor so that the investor can trade. & it is kind of money which don't even entirely belongs to the investors themselves. So which means investors are trading on someone else's money. So they may buy a company's future with that money.

The investor is supposed to pay just 10-15% of the entire amount to get the leverage.

Like, here, for in example;

The person who cannot afford the future of 5000$ is now just supposed to pay the 10% (which is 500$ in this case) & the rest is to be paid by the broker (which is 4500$)//or in other words the rest is the leverage given to you by the broker (which is 4500$).

So it might seem kind of really profitable, right!

Well, before I tell you something else let's first see how'll it impact the investor if the future price rises!

Example continued.......

So now lets suppose that the share price rises to 600$. & So did the future price. So, now the future is of 6000$ (don't forget it have 10 shares of the company xyz. Hence, now the future price is 600*10=6000$).

So the price of the share increased by just 100$ & you have made a profit of 1000$; don't forget that you just invested 500$ & the profit is of 1000$. It seems really cool, right!

-So basically this is one thing about futures is what makes people attract towards it, so much!-

"But here's one more thing they ignore...."

 Did You know?

Futures are More Profitable then shares & More Riskier then shares!

Now, with the same example let's see the downfall of the same future & monitor the changes in the price of the future & how'll it impact the investor!

So here we go;

Now let's suppose that instead of the share price rising, it decreases to 400$ from 500$. So the share price have just reduced by 100$. But the future is now of 4000$, hence, you've faced a loss of a 1000$.

But how can this be.... You just invested 500$!

How can you loose a 1000$?

Now you really have lost the money & you are the one to pay it off now.

Which means you have to pay the Broker the rest 500$ (because the 500$ you gave have been lost, already) to the broker within a specific period of time given to you by the broker.

& if you didn't then there are several mechanisms through which the broker will any how get back his money.... For example- he may deduct tge amount of 500$ from your bank account straight away or if just in case your bank account is empty then if there are any other shares present in your portfolio then he may sell them & get back his money.

Because (in simple words) you are under debt, NOW!

So Futures can be way too much profitable or they can cause just 10 times more damage then shares can, ever!

& this is what brings us here.......

Why Do Brokers Give or Provide LEVERAGE/MARGIN?

To be honest, I myself don't really know! Well, y'all might know that I write articles which are mostly based on my research. So the information provided might not be 100% accurate.... but the fact that I've been confused about is that why brokers give leverage/margin.... Because there are mainly 3 things I've came across & each one of them kind of seems a valid reason to me.

So, PAY ATTENTION & give me a chance to explain each one by one.

So here we go;

INTEREST

As per my research many people say that brokers charge around 10-18% of the interest. So again going with the previous example.... let's assume that the broker charged 10% of the interest here. So the investor have borrowed 4500$ from the broker. So 10% of 4500$ is 450$. Which means that the broker is charging 450$ of interest. Now, if you have a Far Month Future Contract (a contract which expires in 3 months), then if the broker's charging interest every month of owning the future then he'll make around 1350$.

If Next Month Future Contract (a contract which expires in 2 months) then he'll make around 900$ by charging interest.

& if Near Month/Current Month Future Contract (a contarct expiring within 1 month), then the broker may make 450$ as per of charging interest per month.

(I know that you might not be familiar with these all "Far Month", "Next Month" terms & all. But I'll encourage you to continue reading because it is something I will cover now within a while.)

Anyways, it is kind of profitable for the broker! Right?

Another valid reason because of which brokers might give leverage is to RAISE A SHARE'S PRICE.

Yes!

Some people says that brokers don't charge any interest instead they are giving you leverage so that you'll invest in a specific company & its share will go up.

Well, if you don't understand how will this really work or how will it help in lifting up the share price then I'll encourage you to read one of my recently published articles, which is - Who Decides The Price/Value Of A Share?

But there is a question of why will a broker try to lift up a share's price.

Well, it may be because he himself might have bought some shares of that company & as I told you to read "Who Decided The Price/Value Of A Share?" ; so after reading this you might have known that--> a share price rises when more people invest in it.

Anyways,

So another valid reason of why brokers give leverage I've came across is

BROKERAGE CHARGES

Brokers charge some amount of brokerage fee on every buy or sell order. So if brokers charge 1% per order. So 1% of 500$ will be 5$, hence they'll charge 5$. But if one buys multiple shares at a time (for in this example 10). Then they'll be able to charge 50$ now instead of just 5$. So ins't it profitable for brokers?

Yes, ofcourse it is!

So either way it may be some sort of advantage to the broker.

I've continued the same example many times & stretched it far enough to make you understand each term.

One more time going with the same example,

If the share price of the comapny xyz rises by 100$ then the future'll raise by 1000$. So if you earned more then the interest rates or whatever charges the broker may charge you, then you made a profit.

If a loss then you have to pay the loss, the interest & it's entirely different from the loss you personally would face without any payment made back to you.

Either way you have to return the amount borrowed from the broker.

& Also it is kind of neccesary for you to have around 3% to 18% of the future's price in your bank account in order to protect you, yourself & the broker against the losses.

That Amount is known as the Marginal Amount In Futures!

So now let's talk about how many types Of Future Contracts are there!

So here we go,

Types Of Future Contracts:

• Near Month
• Next Month
• Far Month

Let's understand each, one by one....

Near Month Future Contract - A Near Month Future Contract is a type of contract which expires in the next month (on last Thursday of the month it's supposed to expire) from when you've bought that future. For instance, if you bought a future on 7th April 2021. Wednesday. Then it'll expire on the last Thursday of the next month, which means that the contract'll expire on 27th May 2021. Thursday.

Next Month Future Contract - A Next Month Future Contract is a contract which expires after 2 months (on last Thursday of the month it's supposed to expire) from when you've bought that future. For example, if you bought a future contract on 7th April 2021. Wednesday. Then it'll expire on 24th June 2021. Thursday. (After 2 Months)!

Far Month Future Contract - A Far Month Future Contract is a contract which expires after 3 months (on last Thursday of the month it's supposed to expire) from when you've bought that future. Example - Let's suppose that you bought a future on 7th April 2021. Wednesday. Then it'll expire on 29th July 2021. Thursday. (After 3 months)!

So these are contracts in which we (investors) can trade in futures.

I've also mentioned that a future contract will always expire on the last Thursday of a certain month. As you can see in the example. But just in case, if there is a public holiday on the last Thursday when a future is supposed to expire then it may expire a day earlier (On Wednesday). But you'll definitely receive your shares of that future.

& Also I want to let you know one more thing about futures which is that, WE CAN TRADE FUTURES EVEN AFTER ONE HAVE BOUGHT IT. Which means that we can sell it further!

Lets make it a bit more transparent by giving an example.......

So let's say there is a future of 1000$ & it's lot size is of 100 shares; which means one share = 10$.

So you bought that future & let's suppose that you have a Far Month Future Contract.

But NOW, just after 15 days of buying the future contract the share's price rises to 50$ from 10$. Hence, the price of the future also rised to 5000$ from 1000$.

It's a huge profit.

So now if you cannot wait until the expiry & if you fear that by the time the future'll expire, it's price may reduce.

So in this case if you want to sell the future, YOU CAN!

You want to sell the future to claim profit!

But why will someone buy it?

Well, the reason for this can be any; one may think of a valid reason like- if this company's share have rised so much within just a small period of time then there's a huge chance that it may rise more upto or before its expiry.

It's a WIN - WIN situation for both!

So lets say that the deal have been made & you've sold the future & the buyer have bought it for 5000$ or just a little less as per futures price which is set.

So if you haven't really taken any sort of leverage then the profit is all yours. But just in case you did, then you'll have to pay the broker the interest or its fee or whatever the charges may be, etc. etc. & If the profit made is higher then that fee & all, then CONGRATS!

& also the future you sold may be traded further by that person who owns it now. & a future can always be traded until it's expiry.

But once expired then it cannot be traded, further. As the shares present in that future (100 shares are present in this future, as per this example) will automatically be transferred to the owners demat account at whatever rate/price they may be.

So taking this example, if the person you sold that future to have not traded it further until it's expiry; so Lets suppose that, upto its expiry the Share price raised to 70$ then the future'll be of 7000$. & when it'll expire then, as I said earlier the shares will be transferred to that person's demat account & added to his/her's portfolio at 70$/share price. So he/she bought it at the price of 50$/share & now it's of 70$; don't forget there are 100 shares in total. Hence the profit is of 3000$ & That person may sell it whenever he/she wants to.

& even if it's loss it'll be transferred to the account & the owner may sell them or they may hold them in hope of claiming a profit, somehow!

So that how things basically WORK!

---

Did You Know?

90% of shares are traded before reaching its expiry date.

---

RECAP!

Today's article/blog have been really long. So I think having a little recap of what we've learned/discussed today will be a great help to beginners!

So this is what we've learned about "Futures" today....

• What Are Futures? (In Derivatives!)
• What Are Derivatives? Definition & Example!
• Simple Example Of Future Contract (Bread Company!)
• Futures Is A Secured System Where The Buyer, Buys The Future & The Seller, Sells The Future At A Fixed Price At A Fixed Time!
• Example Of How In Reality Do Things Work In Futures!
• The Price Of A Future Which Is Set For The Investors May Be Low Then The Future's Actual Value!
• What Are Lots? Lot Size; Shares In a Lot!
• Future Price Also Fluctuates With Share Price!
• Why Should You Trade In Futures When There Are Shares To Trade?
• What Makes People To Attract Towards Futures, So Much?
• Why Are Futures Profitable & Riskier Then Shares?
• What Is LEVERAGE/MARGIN?
• Why Do Brokers Give Leverage Or Margin To Investors?
• It's Necessary To Have A Marginal Amount For The Investor In His/ Her Bank Account In Order To stay Safe Against Losses!
• Types Of Future Contracts!
• Expiry Of A Contract!
• Trading Contract Further Before Its Expiry!
• What Happens Once A Future Contract Expires?
• Did You Know?

Here's A DISCLAIMER....

I'LL JUST SAY THAT THE PEOPLE WITH NO KNOWLEDGE SHOULD NOT ENTER INTO FUTURES! BUT ITS UPTO YOU. I JUST WANTED TO MAKE YOU FAMILIAR WITH THE TERM "FUTURES"!

SO BE CAREFUL IF YOU ARE TRYING TO GET INTO THE FIELD OF FUTURES & WANT TO START INVESTING!

I PERSONALLY DON'T RECOMMEND ANYTHING!

Every profit Or loss faced by anybody is all of their own responsibility. So take action at your own risk!

So now, you tell me if you will ever invest in Futures?

MAKE SURE TO LEAVE A COMMENT!

Also don't hesitate to ask your doubts OR as I said the information might not be 100% accurate. So feel free to correct my mistakes if I'm wrong, somewhere!

Thanks For Reading!