from Forward Contract to Futures

In this post I am going to explain the concept of a Futures contract. Just like any other investment ideas, there are three things about Futures or Options that you must understand.

Underlying Concepts.
Practical Information e.g. How to buy or sell Futures and options using your online trading account?
Strategies

Since this is my first post on this topic, it will only cover the "concept of a futures contract". Futures are one of the easiest to understand. It is the probably unavoidable use of jargon that makes this simple looking concept seem complicated. Let me start with

The concept of a Forward contract.

Let us understand this simple idea by an example. Suppose you are a farmer who grows wheat. Your crop will be ready after one month. Now the price of wheat is good, say Rs. 15/- per kg. But you wonder, "will I get this price after one month? It would be so nice if i could sell my wheat RIGHT NOW!". Alas, your wheat is not ready. However you manage to find a Baker, who is worried by rising prices and would like to secure his next couple of months wheat supply at the current Rs. 15/- per kg. price. So you both enter an agreement : After exactly one month, the farmer (i.e. you) will sell 100 kg. of wheat to the Baker at Rs. 15/-. In other words, you enter an agreement where you decide to trade at a pre-decided price, but not today, after a pre-decided time, in this case one month. Such an agreement is called a Forward contract. The date, after one month, at which the contract will be settled is called the expiry date or settlement date. The pre-decided price, Rs. 15/- per kg, is called the strike price.

From Forward Contract to Futures

A Futures contract in stock markets like NSE/BSE in concept is just like the Forward contract for shares or stocks except with the difference that the conditions of the contract, for example the expiry or the settlement date can only be chosen from what the exchange decides. Currently, all Futures contract expire on the last Thursday of every month. There are also other restrictions. Let me explain this with an example instead of throwing lot of words (keep the above example in mind). Suppose you decide that this is a good time to invest in a particular company say Praj Industries. Then if you buy one Futures contract of Praj Industries, at strike price of Rs. 100/- per share, which expires after one month then that would mean that you will be able to buy 1100 Praj Industries at Rs. 100/- on the settlement date, which for one month futures contract is last thursday of the current month. 1100 here is the Lot Size for Praj Industries. The exchange decides Lot sizes for every stock (and even index) futures and you cannot enter futures contract for shares "less than 1100". If you however want to 'buy more' you can buy more than one futures contract.

By now the underlying concept of a Futures contract must be clear. However you will have to read my next posts for actual practical information on buying/selling futures, options and strategies. We will come back to the above example of farmer/baker when we discuss hedging strategies.

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