A futures contract is a legally binding agreement to buy or sell an underlying asset at a predetermined price and date in the future. It is a standardized contract traded on an exchange, which means that the terms of the contract, including the underlying asset, contract size, and delivery date, are standardized.
For example, suppose that you are a farmer who has just harvested a crop of wheat and wants to lock in a price for your produce to protect against any potential price declines. You can do this by selling wheat futures contracts on a commodity exchange.
Suppose that the current market price for wheat is Rs. 1,000 per quintal, but you are worried that the price may decline in the future due to factors such as oversupply or weak demand. You can sell a wheat futures contract that expires in three months with a contract size of 10 quintals at a price of Rs. 1,000 per quintal.
After three months, regardless of the market price, you must deliver 10 quintals of wheat to the buyer of the futures contract at the agreed-upon price of Rs. 1,000 per quintal. If the market price of wheat falls to Rs. 900 per quintal, you will have protected your profits by selling at the higher price of Rs. 1,000 per quintal. However, if the market price rises to Rs. 1,100 per quintal, you will have missed out on potential profits, as you would have to sell your wheat at the lower price of Rs. 1,000 per quintal.
Sure, here's an explanation of futures contracts, an example, and some strategies that can be used to earn profits through futures trading:
Futures Contract
A futures contract is a financial derivative contract that obligates the buyer to purchase an underlying asset at a specific price and date in the future. Futures contracts are traded on organized exchanges, and the terms of the contract, including the underlying asset, contract size, and delivery date, are standardized.
Futures contracts can be used for a variety of purposes, including speculation and hedging. Speculators buy and sell futures contracts with the aim of making a profit, while hedgers use futures contracts to protect against price fluctuations in the underlying asset.
Example
Suppose that you are a trader who believes that the price of crude oil is going to increase over the next six months. You can buy a crude oil futures contract on a commodities exchange to profit from this anticipated price increase.
Suppose that the current market price for crude oil is Rs. 5,000 per barrel, and the futures contract for crude oil with a delivery date of six months in the future is trading at Rs. 5,200 per barrel. You can buy one futures contract at Rs. 5,200 per barrel, which has a contract size of 1,000 barrels.
After six months, if the price of crude oil has increased to Rs. 6,000 per barrel, you can sell your futures contract at the higher price and earn a profit of Rs. 800 per barrel (Rs. 6,000 - Rs. 5,200). Your total profit would be Rs. 8,00,000 (Rs. 800 x 1,000 barrels).
However, if the price of crude oil has decreased to Rs. 4,800 per barrel, you would incur a loss of Rs. 400 per barrel (Rs. 5,200 - Rs. 4,800), and your total loss would be Rs. 4,00,000 (Rs. 400 x 1,000 barrels).
Strategies
a) Hedging: Futures contracts can be used to hedge against price fluctuations in the underlying asset. For example, a farmer can use a futures contract to lock in a price for his crops, protecting against any potential price declines.
b) Speculation: Traders can buy or sell futures contracts to profit from anticipated price movements in the underlying asset. For example, a trader can buy a futures contract for crude oil if he believes that the price of crude oil is going to increase.
c) Spread Trading: Spread trading involves buying and selling two or more futures contracts simultaneously to profit from the difference in price between the contracts. For example, a trader can buy a futures contract for crude oil with a delivery date six months in the future and sell a futures contract for crude oil with a delivery date three months in the future. If the price difference between the two contracts widens, the trader can earn a profit.
d) Arbitrage: Arbitrage involves buying and selling the same asset in two different markets to take advantage of a price difference. For example, if the price of crude oil is Rs. 5,000 per barrel on one exchange and Rs. 4,900 per barrel on another exchange, a trader can buy crude oil on the first exchange and sell it on the second exchange, earning a profit of Rs. 100 per barrel (Rs. 5,000 - Rs. 4,900).