Technical Analyst’s Blog

Future Contracts are used as a risk management tool, by investors and trader to make huge profit with comparatively lesser capital.

Trading in futures is very risky because of High Volatility.

Investopedia defines -:

A futures contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price.

Lets break it down in a very simple language.

Example 1

Shyam wants to buy a TV, which costs Rs 10,000 but he has no cash to buy it outright. He can only buy it 3 months hence. He, however, fears that prices of televisions will rise 3 months from now. So in order to protect himself from the rise in prices Shyam enters into a contract with the TV dealer that 3 months from now he will buy the TV for Rs 10,000. What Shyam is doing is that he is locking the current price of a TV for a forward contract. The forward contract is settled at maturity. The dealer will deliver the asset to Shyam at the end of three months and Shyam in turn will pay cash equivalent to the TV price on delivery.

Example 2

Ram is an importer who has to make a payment for his consignment in six months time. In order to meet his payment obligation he has to buy dollars six months from today. However, he is not sure what the Re/$ rate will be then. In order to be sure of his expenditure he will enter into a contract with a bank to buy dollars six months from now at a decided rate. As he is entering into a contract on a future date it is a forward contract and the underlying security is the foreign currency.

The difference between a share and derivative is that shares/securities is an asset while derivative instrument is a contract.

If you have questions, please comment.