I now intend to take you through a FACINATING Journey of the world of
and Options are two forward contracts in the gleeful domain of the Derivative
explain briefly the two wonderful concepts of futures and options, in layman’s
language, before I venture to deliberate on them, in detail.
Futures Contract, for example, a person enters into a legally binding contract,
either to buy or sale a commodity, based on the current market price and his
expectation of the future prices, in order to protect himself from price
fluctuations and with an intention to benefit himself from the prevailing
example, if a farmer expecting to harvest his crop after, say 2 months feels
that the price from the present level of Rs.200/- may rise to Rs.300/-, may buy
the same at the present level of Rs.200/- and enter into a forward contract to
sell at Rs.300/-, 2months later. He need not have to take immediate delivery
and make immediate payment under the present contract, but also protect himself
from adverse price fluctuations.
options contracts dear friends are even more fascinating and arouse great
curiosity. I will dwell into greater details, after a little while.
Derivative, my dear friends, is a financial instrument whose value depends on
the value of the underlying variables, which might be stocks, fixed-income
securities, derivative exchange or commodities. The most popular derivative is
a Forward Contract.
a forward contract is an agreement to buy or sell an asset, at a certain price
and at a certain future date. These are dealt with by the parties individually
and are not traded on any exchange. These contracts are useful to trades and
are routed through middlemen. Irrespective of whether, either the purchaser or
seller defaults, the middleman has to perform the contract. The presence of an
institution brings in stability in the system and lowers the transaction costs,
to the parties to the contract. The buyers take a LONG position and the sellers
take a SHORT position, in the contract.
CONTRACT, my friends, is an agreement between two parties, to buy or sell a
certain asset, after a specified period, during a specified period of time at a
specified price. These contracts are regarded as the refined version of a
forward contract. Futures are contracts that are traded on an exchange like any
other security. Futures are usually used, in order to hedge against a probable
risk. A farmer producing wheat may sell a futures contract and a baker may buy
a futures contract as they may not wish to take chances of adverse movement in
futures are traded on an exchange the terms of a futures contract such as
quality, quantity, expiration month, delivery terms, delivery dates, minimum
and maximum price, trading hours and days are standardized to facilitate easy
trading by the parties to the contract.
Futures trading it is requisite for both the parties to the contract, to
deposit some marginal amount equal to a certain percentage of the underlying
asset value with the broker who in turn deposits it with the exchange. This
amount is known as Initial Margin. A certain percentage usually 75% of the Initial
Margin, known as Maintenance Margin is to be present in the account.
differs with the exchange. The initial margin depends on price volatility of
the underlying asset. A gain or loss on the account is computed on a daily
basis. In the event of a fall below the maintenance margin, the broker asks the
account holder to deposit an amount to restore the margin to the level of the
initial margin. This additional money deposited is known as Variation Margin.
Such a demand for additional money is called Margin Call.
price or the spot price is the price of a commodity for immediate delivery in
the market. On the other hand, a futures price is the price of futures contract
determined by the trades based on the demand and supply of the undertaking
asset. There could be different cash prices for a single commodity at any one
point of time at different locations. The differences are due to the variations
in costs associated with transport, taxes etc.
of a futures contract, who has the obligation to buy the goods at a later date
can sell the contract in the futures market which relieves him or her of the
obligation to purchase the goods. Likewise the seller of a futures contract who
is obligated to sell the goods at a later date can buy the contract back in the
futures market, relieving him or her of the obligation to sell the goods.
Futures contracts are traded on organized exchanges.
condition in which the delivery prices of futures exceed the future cash prices
is known as CONTANGO.
Hedging is the opposite of speculation and is undertaken in order to
eliminate an existing physical price risk by taking a compensating position in
the futures market. Speculators look for the risk that hedgers are willing to
avoid. Hedging is a recipe to avoid risk.
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