Futures

 What are the futures contract?

In a simple words futures contract is a derivative instrument which is obligated to buy or sell a commodity on a predetermined rate at a determined time and quantity. Derivative contract means that it has no value of its own but the value of the underlying asset. An underlying asset can be anything Stocks, Commodity, Currency, etc.

History of the futures contract 

Futures contract came into existence in the 17th century by the Dutch empire who were the pioneers of financial markets but the dutch case of futures is not relevant today so we may skip that.

The first modern Future contract was executed in 1972 for agricultural commodity price swings. It was created to help instituional investors mitigate price volatility and when the agricultural market flourished metal and crude market demanded because after the 1973 oil embargo it become as necessary to a economy as oxygen is to human.

You can see how successful was this venture and now the majority of the trades happen in the commodity.

Function

In primary sector business prices of farm goods and metals such as gold, silver, copper, aluminium, etc are volatile and due to the stiff competition because of the easy entry and easy exit business model. the profit margin is a bare minimum so in order to hedge or insure the price volatility these future contracts come to save the day.

for example, A aluminium scrap recycler is buying aluminium scrap for 140 per kg and the aluminium ingot(pure aluminium) is trading at 145 per and the cost of converting the scrap into an ingot(brick) costs 3rs per kg then the profit is 2 rs per kg. Now if the price rises by 2rs then it will be profitable for the manufacturer if price falls then they will suffer loss.

However its not the only use of future contract many national and multinational companies use for price discovery process. for example, A company manufactures brake shoe of motorbike and car and it use aluminium as the core metal let say their an consumption is 20 tons or 5 tons for each quarter but they want to be competitive and for that they have to maintain the same price for almost an year. which means that they don't want the price of aluminium to effect the price of brake shoe so they can buy 4 future aluminium contract for each quarter now what happens is if price falls then the price of aluminium would decrease and aluminium would be cheaper in real market but you will suffer from future contract which off set the losses and profit simultaneously.

The purpose of this contract is to fix the price for an entire year and that is what it does which smooths the process of cash accounting and of calculating the price of the product for an entire year.

Retail traders also trade in  futures because they are less volatile, easy to predict and you only have to present 5% upfront amount for trading these instruments which make them highly attractive. 

for example if price of aluminium open at 145 then it will decrease to 144-144.5 but the single future contract is of 5000 kg that means if you buy at 144 and sell at 145 you have made a profit of 5000 rs with only 60000 as margin requirement. Return on capital is 8.75% which is great.

Thank you for reading.