Chapter 2: What are Futures Contracts?
Most people start trading futures to speculate and maximize their profits. Why? Because futures involve leverage, which is the ability to have exposure to a large contract value with a relatively small amount of capital.
Even then only a handful of traders succeed and the rest may not be as fortunate – they might make losses and some may completely exit the market Nevertheless, the ones who become successful and profitable seem to have a common trait -they get their basics right.
This includes understanding the risks involved and developing risk management skills even before they start trading futures. This is what we’re going to help you with. But that’s not all – we’re going to walk you through the entire journey of becoming a smart futures trader, starting with what is futures trading.
1.1 What are Futures?
A futures contract is a derivative financial instrument that derives its value from an underlying asset. To understand futures, let’s look at what derivatives are.
By The Way...
If you already know the basics of derivatives, you can skip to chapter 1.3.
1.2 Basics of Derivatives
A derivative is a financial instrument whose value is derived from the value of an underlying asset. The underlying can be a wide variety of assets like:
- Agri Commodities: wheat, rice, sugar, cotton, etc.
- Metals: gold, silver, aluminium, copper, zinc, nickel, tin, lead, etc.
- Energy Resources: Crude Oil, Natural Gas, Electricity, etc.
- Currencies: US Dollars, Pound Sterling, Japanese Yen, Euros, etc.
There are mainly four types of derivatives:
- Forwards
- Futures
- Options
- Swaps
We shall focus on forwards and futures for now. Forwards is a customized contractual agreement between two parties to buy or sell an underlying asset at a future date for a price that is pre-decided on the date of the contract.
Since these contracts are usually directly traded between the two parties, trade is carried out "Over-the-Counter", meaning there are no centralized exchanges involved.
1.3 Example of Forwards Contract
Mr. Nivesh, a renowned businessman, owns Niveshy which is the best bakery in town. He’s able to sell quality products consistently at a reasonable price for decades.
What's fascinating, he is consistently profitable despite fluctuations in the price of wheat, which constitutes 90% of his business’ total raw material consumption. Wondering how?
Mr. Nivesh gets a set supply of wheat from Mr. Kisaan at a fixed price at the start of the financial year via a forward contract. As we discussed earlier, forwards are a customized contractual agreement between two parties.
In this instance, the “parties” are Mr. Nivesh & Mr. Kisaan. They have agreed to buy and sell wheat, which is the “underlying” with a customized expiry date and price. Under this contract, both parties are obliged to honor their commitments:
- Making payments on time: Mr Nivesh
- Timely delivery of Wheat: Mr Kisaan
Mr. Nivesh requires 100 kgs of wheat for his products every month. The current market price is Rs. 16 per kg. He is well aware that demand for wheat increases during the festive season, which will directly impact his profit.
To avoid this price risk, he enters into the forward contract with Mr. Kisaan, where he agrees to buy wheat for a fixed price of Rs. 18/- per kg, which Mr. Kisaan will supply for the term of one year. Once both parties enter the contract, they are obligated to honor the above terms and conditions.
You must be thinking, why would Mr. Nivesh pay a premium price to Mr. Kisaan even though the current market price is lower? It's because Mr. Nivesh hedged his price risk by ensuring that he would get his supplies at a fixed price irrespective of market fluctuations.
With his experience, he knows that wheat prices can go upwards up to Rs. 20 per kg during festivals due to high demand. But now, Mr Nivesh is not worried. He will get wheat at a fixed rate of Rs. 18 per kg.
Mr. Kisaan, on the other hand, doesn't have to go and find multiple buyers in the market. Thus, this is a win-win situation for both.
To conclude, Mr Nivesh and Mr Kisaan find the forwards contract to be a great way to hedge their risk. Both had the same intent and requirements which they agreed to and executed the deal between them smoothly.
Imagine if Mr Kisaan’s capacity to produce wheat was lesser than Mr Nivesh’s requirement. Or, Mr Nivesh’s business slows down and he defaults on payments. In such a case, who would hold both parties accountable for the financial losses caused? Nobody. That’s why futures contracts exist.
1.4 The Problem with Forwards Contracts
Forward Contracts became popular and became widely accepted amongst buyers and sellers. They proved to be a great tool for hedging. But with the advent of globalization, traders began to increase their horizon and looked beyond geographical borders for trading.
This led to them buying or selling their products in the domestic markets and, at the same time, they started importing and exporting goods worldwide. That’s when traders found it difficult to utilize forward contracts. Some of the common limitations were as follows.
1. Lack of Standardisation & Liquidity Risk
Mismatch in requirements of buyers and sellers was the most common problem with forward contracts. That’s why it was difficult for a buyer to find a seller (and vice versa) who could fulfill the requirements of their terms and conditions.
Buyers would have to deal with multiple sellers for the same goods and sometimes buy the same products at a premium which impacted their profitability. That’s not all.
Most of the time, buyers had to hire professional investment banks or third parties who would create liquidity. As they say, there are no free lunches and the buyers & sellers have to pay from their pockets, thus impacting profitability in trading.
2. No Regulatory Control Over Settlements
There was no central authority to regulate and protect the interest of buyers and sellers who entered into forwards, which ultimately gave rise to default risks. A seller could do nothing if the buyer takes the delivery of raw materials but refuses to pay.
3. Default Risk
No regulatory control over forward contracts coupled with adverse market conditions often created huge volatility, potentially causing uncertain price fluctuations. Imagine a black swan event like a lockdown.
Mr Nivesh could run out of business sooner than anticipated and will default on payments. Mr Kisaan would have no doors to knock on! Hence, default risk was a major hurdle to the mass adoption of forward contracts.
Traders had to find out a way to reduce these risks. The need for a more standardized and regulated market gave rise to ‘Futures Contracts’. Let's look at how futures contracts work and helped overcome the limitations of forwards.