What is futures trading?

This edition of ET in the Classroom explains the basics of futures trading. Futures contracts derive their value from underlying commodities

1. What are commodity futures contracts?
They are contracts that facilitate the purchase or sale of underlying commodities at a fixed price for delivery on a future date.

2. How does this help?
Assume you are a jeweller whose raw material is gold. You need to deliver jewellery on, say, February 15. Your risk is that of gold prices rising in case you don’t want to buy the metal today. So, you lock in the price by buying a futures contract on gold on an exchange having a commodity derivatives segment. Assume one contract (1 kg) today trades at a base value of Rs 49,000 per 10 gm. You lock in at this price by buying the February 5 expiry contract. The seller of this contract expects the gold price to correct by Feb 5. If the price instead rises to Rs 50,000 base value at expiry, the jeweller can take delivery on the bourse by paying Rs 49,000 to the seller who is obliged to sell him gold at this rate. In this transaction, the seller loses Rs 1,000 per 10 gm. If, however, the price falls to Rs 48,000, the jeweller is obliged to pay the seller Rs 49,000 — the locked-in rate — while taking delivery. But then, he makes jewellery and sells it to the customer at the prevailing gold spot rate of Rs 50,000. While the futures contract seller made a gain of Rs 1,000 per 10 gm, the jeweller was hedged by being able to sell the gold in the spot market at Rs 50,000 per 10 gm. Thus, his loss of Rs 1,000 on the futures markets was offset by the rise in gold price on the spot market

3. Are futures contracts risky?
Yes, for uninformed participants looking to make a quick buck. This is because futures trading is highly levered, involving payment of a margin which typically is a fraction of the actual commodity cost. However, if the market moves against the trader, he has to pay the actual rise or fall in the commodity price multiplied by the lot size to the counterparty. This makes futures trading a high risk-high reward proposition.