Derivatives: Options, Futures, Others

An Easy Derivatives Tutorial

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A futures contract is the obligation to buy/sell a particular quantity of some asset at a specified price at some future date. The asset could be a physical commodity such as grain, orange juice etc, or a financial asset such as a stock, currency etc. In the case of physical commodities the futures contract also specifies the quality of the good to be bought/sold.

Unlike options, futures contracts MUST be fulfilled.

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Futures originated as a form of hedging risk by both consumers and producers of commodities. For example grain farmers could guarantee the price they would get for their crop before growing it, and bakeries could guarantee the price they need to pay for their ingredients X months ahead.

As time progressed futures contracts began to be bought and sold on the open markets, their prices fluctuating according to the likely (spot) price of the asset concerned at the fulfillment date.

These days the vast majority of futures trades are conducted through recognized futures exchanges by traders, or speculators, who have absolutely no intention of taking delivery of the underlying assets. Over the counter (ie non-exchange mediated) futures are known as "forwards".

A futures position may be closed by selling the contract, or buying an equal and opposite contract, eg suppose you had a contract to supply 10,000 tons of wheat, this position would be closed by obtaining a contract to buy 10,000 tons of wheat. Any profit/loss is taken/supplied in the form of cash.

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