Future Derivatives Explained [BCS 12/15] -WonderHindi

As we talked about in previous article, There are four types of derivatives – forward derivatives, Future Derivatives, options derivatives and swap derivatives.

In this article, we will discuss Future Derivatives in a simple and easy way, and understand its various aspects. So read this article till the end.

Note – If you want to understand the basics of share market from zero level then you should start with Part 1. – Share Market and Related

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| What is Derivatives?

Any instrument that has no value of its own, but derives its value from something else. They are called derivatives.

The thing on which its value depends is called the underlying asset. As the value of paneer depends on milk, so here milk is the underlying asset of paneer.

There are four types of Derivatives – Forward, Future, Option and Swap. In this article we will understand Futures Derivatives:

If you have understood the forward derivatives well then you would know that there were some problems in the forward contract like there was no transparency in it, if there is any dispute then its settlement was very difficult etc.

There is no such problem in futures and options, apart from this, there are many good things in it which keep the traders in confidence. So let us understand future derivatives in this article.

| What is Futures Derivatives?

Futures is a contract made for the future at today’s price at today’s date. That is, futures are also a contract like forwards.

But the difference here is that here there is an exchange for mediation. These exchanges keep track of all the transactions and they provide a legal platform to both the buyer and the seller.

There are basically two reasons people enter into futures contracts, either for hedging or for trading.

Hedging means to reduce your risk whereas the purpose of trading is to earn more and more money. What this means will become clear later.

| Some highlights of the future

Future derivatives are for short term and these short term is 1 month, 2 months and 3 months. If we do a futures contract of 1 month, then it is called near month and its validity is till the last Thursday of that month, that is, it is its expiry date.

Note – Remember here that shares do not expire but futures and options do expire.

Similarly, when you do a futures contract for 2 months, it is called the next month, and if you do a futures contract of 3 months, it is called a far month. Everyone’s expiry is only on the last Thursday of the last month.

The second thing is that this is a binding contract i.e. once you have entered into this contract then you cannot come back i.e. till the last thursday of the month for which you have entered into the contract. {Remember this point, this is the point that gives rise to the option}

The third thing is that since the futures are under the supervision of the exchange. That is why a Demat account is required for trading here . Let us understand this with the example of a share derivative.

| Future Derivatives Example

Let’s say that a wheat buyer has a future contract with a wheat seller that he will buy 1 quintal of wheat after 2 months for Rs 1000, and the farmer will sell it for that much even if it is sold in the market. No matter what the price of wheat was at that time.

Now the position of the farmer here will be called short position because the farmer is selling, while the position of the buyer will be called long position because he is about to buy.

Now both of them have contracted for 1000 rupees but the market price of wheat will be up and down daily. In such a situation, there can be three situations – after 2 months when the square off (ie the time of contract expires) then either the market or price of wheat will increase or decrease or it will be stable at the same price.

⚫ If suppose the market price of 1 quintal of wheat increases from Rs 1000 to Rs 1500 on the day of contract expiry, then what will happen in that situation? Now since both the parties are bound by this contract, therefore the buyer will have to take it and the farmer will have to sell it.

The contract of 1 quintal of wheat has been done for Rs 1000, so that buyer will get it for Rs 1000 only because this contract has been done. But since the market price of 1 quintal of wheat has now gone up to Rs 1500, that buyer will get a profit of Rs 500. How it will happen?

Obviously that buyer will buy from that farmer for 1000, but the price of the same wheat is still 1500 rupees in the market, so when he sells it in the market, he will get a profit of 500 rupees,

⚫ But at the same time that farmer will incur a loss of Rs 500. Why? Because the market rate is now 1500, while he had contracted to give only 1000. Therefore, he will have to bear a loss of Rs 500. So here you see that the farmer has lost and that buyer has profit.

This means that here one benefits only when someone is harmed. If one party gains, the other party will definitely lose.

That’s why it is called Zero Sum Game and this is what separates it from the stock because everyone can gain or everyone can lose in the stock.

Similarly, if we look at it, the farmer will benefit only when the market price of wheat falls below Rs 1000.

The lesser it is, the more the farmer will benefit. But if the market price neither decreases nor increases, then there will be neither loss nor profit for both.

Now let’s talk about its settlement, how do we get money in it?

| Process of future settlement

Before this remember that a fixed margin amount has to be kept in the trading account. How much is this, the broker decides. Margin amount is the minimum amount that the broker allows you to buy futures.

There are two types of settlement in this. The first is Cash Settlement and the second is Delivery Settlement. Most of the cash settlement is used only.

For example, if we assume that the farmer has a profit of Rs 500, then Rs 500 will be transferred to the farmer’s account. Similarly, if the buyer gains Rs 500, then Rs 500 will be credited to the buyer’s account.

But if the buyer does not want to take cash but only wants to take wheat, then that farmer will have to give the delivery of that wheat to him.

But usually this doesn’t happen. Why doesn’t it happen? Because there is a common market for buying and selling.

Overall, this is its basic, but if you want to understand it through share, then let’s understand that too. This will give a little more clarity.

| Future Derivatives Example 2

Suppose the value of a share of Reliance as on date is Rs 100. If you think that after exactly 2 months this share price will be Rs 200 then what will you do? You will be signing a futures contract for a date not later than 2 months today.

This means that no matter how much the price of that share is after two months, you will get it only for Rs 100 and if in reality the price of the share becomes Rs 200 after 2 months then you will get full profit of Rs 100. Because you got it only for 100 rupees but now its market rate has become 200.

⚫ Here you will notice one thing that you did not even buy the stock, you just bought its future. This is its basic concept but remember that the future of 1 share is never sold. This happens because if the future of 1 share starts selling, then what will be the difference between the normal share and the future.

⚫ Futures are different in that when you buy a futures share of a company, you get one lot of the shares. How many shares can be in a lot, it depends on the company-company.

For example, if you talk about Reliance, then it has 500 shares in one lot. This means that whenever you make a futures contract for the shares of Reliance Company, you will have a total futures contract of 500 shares.

Here the role of the broker is very important. How does it happen? Let us look at the above example again and understand.

⚫ Suppose you have only Rs 5000 and currently the value of one share of Reliance is Rs 100. That is, if you buy normal shares, then you can buy 50 shares of Reliance for this much money. Seeing the market trend, you would think that after 2 months the value of a share of Reliance will be 200 rupees.

That is, if you buy it today, then after 2 months you will get a net profit of Rs 100 on a share. If after two months the value of that share really becomes Rs 200, then you will actually make a profit of Rs 100 on one share. That is, there will be a profit of Rs 5000 on 50 shares.

⚫ But you think that if you get the future of Reliance for the same 5000 rupees that you have now, then how much will you benefit? Let’s calculate it.

Since Reliance’s futures have 500 shares, that’s why if you had bought a normal share, you would have had to pay 50000 rupees for 500 shares and after two months if the value of one share became 200 rupees, then you would have made a profit of 50000 rupees.

That is, if you put 50000 rupees for 500 shares, then you got a profit of 50000 rupees but what if you get 50000 shares in only 5000 rupees.

Yes it is so, your broker gives you leverage . Think of it as a kind of borrowing. That is, in the same 5000 rupees, where you could buy only 50 shares, if you buy futures, then you get 500 shares. Since you have given only Rs 5000, the broker will have to pay the rest of the money for you.

The amount of money that the broker charges for you is called Leverage and the amount you have to pay is called Initial Margin Amount. Usually the Initial Margin Amount is around 10 to 20 percent.

⚫ In our case the Initial Margin Amount is 10% i.e. Rs 5000. Why? Because we have 500 shares in one lot and the price of one is Rs.100. The cost of the whole becomes Rs 50,000, 10% of it is Rs 5000.

Now after two months, if the value of one share is Rs 200, then you will get a total profit of Rs 50,000. Why? Because you had shares worth Rs 50,000 in total. That is, with just Rs 5000, you have generated a profit of Rs 50,000.

Whereas if you buy normal shares, you would have to invest Rs 50,000 to earn the same Rs 50,000. This is the biggest advantage of Futures and for this reason most of the people come to it. Because even if the money is less, the profit is huge.

Note – This is just an example Actual Initial Margin Amount and Actual lot size may differ from this.

| Future Derivatives Problems

But all is not always well. Suppose what would happen if the value of a stock decreased instead of increasing. If the value of that Rs 100 share becomes Rs 50 after two months.

So it will happen in such a situation that since the value of the whole lot is Rs 50000, so after 2 months the value of that share will come down to 25000.

That is, a direct loss of Rs 25000. But you had invested only 5000 rupees, after that your broker gave you leverage. That is, the remaining money was given by your broker. That is why when there is a loss of Rs 25000, you have already given Rs 5000, so now you will have to pay Rs 20,000 from your possession to the broker.

⚫ This is its biggest drawback. Because there is a loss in one share as much as you have invested. But in futures, you can lose many times more than your principal amount.

You have already seen in the above example that when there is a loss, there is an additional loss of Rs 20,000. On the other hand, if there were shares in its place, there would have been a maximum loss of Rs 5000.

Overall, this is future derivatives, when a man earns in it, he becomes a millionaire overnight, but when he loses, he becomes a roadpati from crorepati overnight.

In this, the option was brought to reduce the risk a little more or reduce the losses . Which we will understand in the next article. His link is below.

Option Derivatives

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