Forward contracts vs futures contracts
Understanding Derivatives, Futures, and Forward Contracts
When it comes to investing, terms like derivatives, futures, and options can seem complex and intimidating. However, understanding these financial instruments is crucial for anyone looking to navigate the stock market with confidence. In this article, we will break down these concepts in simple terms, making it easy to grasp their significance, benefits, and risks.
What Are Derivatives?
A derivative is a financial instrument that derives its value from an underlying asset. It has no intrinsic value of its own but gains value based on an external factor.
To understand this better, consider a simple analogy: Imagine I give you a piece of paper with "100" written on it and ask for ₹100 in exchange. You might hesitate. But if the paper is a currency note signed by the RBI governor, it immediately holds value. The note itself is just paper, but its worth comes from the authority backing it. Similarly, derivatives have no standalone value but derive their worth from underlying assets like stocks, commodities, or currencies.
Example: The Key and the Locker
Consider a locker key. If the locker is empty, the key has no value. However, if the locker contains ₹1 lakh, the key's value effectively becomes ₹1 lakh. Here, the key is a derivative, and the money in the locker is the underlying asset.
Types of Derivatives
There are four major types of derivatives:
1. Forwards
2. Futures
3. Options
In this article, we will focus on forward and futures contracts, as they share similarities and are fundamental to understanding derivatives trading.
Understanding Forward Contracts
A forward contract is an agreement between two parties to buy or sell an asset at a predetermined price on a future date. These contracts have existed for centuries and are particularly useful in managing price fluctuations.
Example: Farmer and the Potato Buyer
Imagine a potato farmer whose crop will be ready for sale in two months. Currently, potatoes are priced at ₹2 per kg, but the farmer worries that prices might drop by the time of harvest. If a buyer agrees today to purchase the potatoes at ₹2 per kg in two months, the farmer secures his earnings, regardless of future price fluctuations.
On the other hand, the buyer (such as a potato chip manufacturer) might be concerned about price hikes due to bad weather or supply shortages. By locking in a price today, the buyer also mitigates risks.
This mutual agreement forms a forward contract. While beneficial, these contracts carry the risk of default—either party might refuse to honor the agreement when the time comes.
Understanding Futures Contracts
A futures contract is similar to a forward contract but is traded on regulated stock exchanges. These contracts are standardized and involve a third party (the exchange) to ensure both parties fulfill their obligations.
Key Differences Between Forwards and Futures
| Feature | Forward Contract | Futures Contract |
|---|---|---|
| Traded On | Private Agreement | Stock Exchange |
| Default Risk | High | Low (Exchange ensures compliance) |
| Regulation | No | Yes |
| Flexibility | Custom terms | Standardized terms |
Since the exchange acts as a middleman, futures contracts provide more security than forward contracts. If one party defaults, the exchange imposes penalties, reducing risk.
How Do Futures Work in the Stock Market?
Let's assume you believe MRF shares (currently ₹60,000 each) will rise to ₹80,000 in two months. You can buy a futures contract today at ₹65,000. If the price increases, you profit. However, if it drops to ₹50,000, you incur a loss.
Futures contracts are available in three durations:
1. Near-Month Contract – Expires in one month
2. Next-Month Contract – Expires in two months
3. Far-Month Contract – Expires in three monthsWhy Trade Futures Instead of Buying Shares Directly?
You might wonder why traders prefer futures over simply buying stocks. The answer lies in leverage—futures contracts allow traders to control a large number of shares with a relatively smaller investment.
For instance, if buying 10 MRF shares directly costs ₹6,00,000, a futures contract for the same shares might only require ₹1,50,000 as a margin deposit. This means higher potential returns but also increased risk if the price moves unfavorably.
Conclusion
Understanding derivatives, forward contracts, and futures contracts is essential for making informed investment decisions. While these financial instruments offer significant profit potential, they also come with risks. Investors should gain proper knowledge and risk management skills before engaging in futures trading.
Stay tuned for more insights in our "Market Concepts" series, where we will explore options trading, commodities, and intraday trading in detail
Airfinac.com, its author/writer and associates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.