Futures Contract - Exchange Traded Product

Its an exchange traded derivative product ,similar to Forward trade , free from credit risk but market risk is there . . Frequently used for hedging and its one of the best way to take leverage in your portfolio !! Do you know how it works ??

Since its a derivative, it derives its value from the underlyer. Future contract gets traded on Exchange that means Clearing House removes the credit risk by becoming the cpty of each trade position be it Buy or Sell. Clearing Broker is registered with the Clearing House, allows a trader to Buy or Sell the underlying at a specific price in the future at a pre agree price . All the contracts are standardized. Best part about Futures is it gives leverage, example will help . .

Suppose I am into ATF oil manufacturing business used in aircrafts and my friend has a airline business. My risk is oil prices going down and my friend risk is oil prices rising. We both can hedge our risk by trading in Oil futures. We can suffer a huge losses even in $1 dollar movement in prices, so its important for us to hedge this risk to avoid huge losses in the future.

We can get into a future contract , for simplicity I will use liters. As per the contract, I will Sell Oil in Sep month on 3rd Friday business day, 1 lakh liters at price of $90 to my friend, total value $ 90 lakhs . Best thing about futures is I can get leverage by giving a minimum margin, like Initial margin, example 10 % to my broker and take a position .

On Day 1 , suppose price increases to $91 dollar, I will be in a loss of $100,000 dollar that I would need to pay to my Clearing House who in tern pays my friend. Profit and Loss is settled everyday until the Sep. This is known as Variation Margin . Initial margin was $9,00,000.

Now in Sep, Futures contract gives me option recontinue the contract to Dec , which is known as Rollover or I can close the contract if I don't want to hedge and settle the P&L. Settlement can be Cash or delivery where in I will actually transport oil to my friend based on a agreed parameters in the contract .

Futures contract are available on majorly everything, commodity, interest rate, currency, stocks, bonds and the qty varies based on underlyer like Gold has ounce, oil has barrel, stock has shares and so on. In Indian market also, there are stocks traded in futures as well in spot markets. When Future price> Spot, its called contango and when Spot Price > Future , its call backwardation . This depends on what investor predict the price of the underlyer on a future date.

Futures contract are used for hedging where if you have a shs position and want to hedge for price going down , you can Sell equity futures contracts and hedge your risk . Contracts are standardized , movement of price is fixed, also called as tick size. Futures has very high liquidity which means I can Buy and Sell anytime and in any qty provided I have margin.

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