Futures and Options - What it means ?

What Are Futures And Options? This article is based on the request of a few people who wanted me to throw lights on futures and options. To understand this first we have to understand what derivatives are. Derivatives are instruments whose value depends on the value of the underlying asset. What do you mean by the above-mentioned statement? Let’s take the example of orange juice. The value of an orange juice depends on the value of the underlying asset orange. Hence orange juice can be termed as a derivative of orange. Like that the value of derivatives that we are going to discuss here will rely on the value of the underlying asset. Here the underlying asset can be commodities (wheat, rice, oilseeds etc), metals, currency, stocks. basically, derivatives in finance parlance can be classified into four headings. • Forward Contracts • Futures Contracts • Option Contracts • Swap Forward contracts

It is nothing but an agreement between two parties to buy a product at a future date whose price is determined by the present. Why it happens? Generally, everyone in this world is scared about uncertainties due to inflation, monsoons, etc which leads to price rise. So a seller who is scared of a price fall in the future is ready to compromise on his high profits and agrees to sell his product for an optimal profit to a buyer who is scared about a price rise in the future. So the buyer agrees to buy the product at a future date at a price determined today with the risk-minimizing attitude of if the price goes very high I am safe that I can buy with the determined price. If the price goes very high the buyer is benefited and if it falls the seller is benefited. This generally happens in agricultural commodities because of the unpredictability of monsoons. But as we all know this is a risky transaction for one and the other is benefited. So in later days a lot of people started to take a backseat when loss comes to them. So people thought about other ways of solving this problem. Here came futures and options. 

Future contracts This is the same as forward contracts but here we have two differences. 1. It takes place with the presence of a third party (the exchange) 2. It is just a notional commitment between the parties. What do you mean by notional commitment? The actual seller produces the commodity and gives it to exchange and gets the receipt. The commodity is maintained at the exchange warehouses after a quality check. Now the receipt is traded as the commodity is traded and it passes on from people to people who are interested in buying.

 The exchange takes care of it at the maturity date. Every increase in price is a benefit to the buyer and it will be accounted for in his account because that is the value of that commodity that day. Any decrease in price is deducted from his account. This was `further modified and the concept of options came to play which I will explain in the next article 

  PRABHU.S