Terms Beginning With 'f'

Futures Contract

What is a Futures Contract?

Futures contract refers to a binding agreement between two parties to buy and sell a fixed quantity of an underlying asset on a later date at a pre-determined price. The underlying asset upon which the futures contracts are made can be a commodity, shares of a company, or any other listed security. 

Futures contracts are exchange-traded contractsand all the contract specifications are defined by the exchange.

Unlike a forward contract, there is a clearing corporation which is associated with the respective exchange that guarantees the settlement of these trades. Therefore, there is almost no risk of default or counterparty risk associated with a futures contract which is one of the primary concerns in a forward contract.


How to Calculate the Contract value?

Future contracts are traded in lots which is essentially the quantity of underlying upon which the futures contract is made. Contract size or value is the total worth of the contract that is being traded. 

For, e.g. a futures contract of XYZ share having a lot size of 100 shares is currently quoting at $50. Then the contract value would be equal to $5000 ($50 per share for 100 shares).

What is Long/Short position?

A person having an unsettled or outstanding buy position in a futures contract is said to have a long position. Similarly, if a person has outstanding sell position which has not been squared off is said to have a short position.

What is Settlement Day?

All futures contracts have a limited span of existence beyond which they cease to exist. The last trading day of the contract is the settlement day. All the obligations of buyers and sellers are needed to be settled on this day.

There are two mechanisms in which settlement takes place, namely:

  1. Cash settlement

At the time of expiration, the seller of the contract does not deliver the underlying asset but instead settles his net obligation in cash.

For, e.g. If B goes long on a contract of 100 shares of XZY at $100 and at the expiration, the price settles at $110, then instead of delivering 100 shares at $100 (pre-determined price), the sellers settle his net loss in cash and pays the difference to the buyer. i.e $1000 

  1. Physical settlement

In a physical settlement, the obligation of both the parties settles through the physical delivery of the underlying by the seller. The buyer receives the asset, unlike price difference, in the case of cash settlement. 

In every case, it is the exchange which defines the settlement mechanisms, and the parties cannot deviate from it despite a mutual agreement.

How are futures prices determined?

The prices of futures contracts move in positive correlation with the spot market prices of the underlying assets. Spot market price refers to the current price of the asset in the physical market.

Let us assume a person wants to buy the shares of a company and he/she enters into a futures contract. Now if the share price of the company is rising, then it is highly likely that the futures price would also rise and the buyer can sell his futures contract at a higher price. However, many times, it is possible that the change in the price of the underlying asset does not have any impact on the futures contract prices.

Although there is a precise mathematical model, i.e. “Cost of Carry” which determines the theoretical price of a futures contract. In real-time, the current market price may not be equal to the theoretical price as the forces of demand and supply also fluctuate the price.  

ALSO READ: An Insight Into ASX 200 And Futures

What is ‘basis’ and the risk attached to it?

Although spot prices are highly correlated with the prices of the futures contract, these two prices are never the same. Basis refers to the difference between the spot price of an asset and the price of a futures contract of that asset. 

If the price of a futures contract is greater than the spot price, the basis for the asset is negative. Similarly, if the spot price is greater than the futures price, the basis for the asset is positive. It turns to zero at the expiry of the futures contract, i.e. there should not be any difference between futures price and spot price at the time of expiry of the contract. Basis keeps weakening and strengthening according to the market situation. Thus, there are certain risks attached to basis. 

What futures contracts do is that they convert the price risk, i.e., the risk attached to falling and rising prices of the underlying asset, into basis risk. Basis risk is better than price risk as it provides a window between which profits and losses are locked. Thus, with the correct hedging strategy, it is possible to set a limit beyond which losses will not be incurred to either the seller or to the buyer.

Who trades in futures contract and what are the benefits?

  1. Speculator/Trader

Futures contracts are well suited to place directional bets on interest rates, stock market indices, currency exchange rates etc. As futures is a leveraged product; therefore, the potential return on the capital deployed is relatively high as compared to transacting the same underling in the spot market.  

  1. Hedgers

Hedging was the primary reason for the introduction of the derivatives market. Corporations, Government, banks etc. all hedge their exposure to their underlying business through the derivatives market. Hedging simply means to make a counter position to mitigate the risk of the initial position.

  1. Arbitrageurs

Arbitrageurs are the once who try to make risk free profits by exploiting mispricing in the market. An Arbitrage opportunity occurs when a single asset is being priced differently in two different markets, and Arbitrageurs looks to buy in the market with less price and sell in the market with high price simultaneously. This helps to make the difference between the two as a risk-free profit.

What is Day Trading? Day trading is popular among a section of market participants. It is a type of speculation wherein trades are squared-off before the market close in the same day. An individual or a group is engaged in buying and selling of securities for a short period for profits, the trades could be active for seconds, minutes or hours.  One can engage in day trading of many securities in the market. Anyone who has sufficient capital to fund the purchase can engage in day trading. For a class of people, day trading is a full-time job.  Day traders are agnostic to the long-term implications of the security and motive is to benefit from the price changes on either side and make profit out of the asset price fluctuations within a day. They bet on price movements of the security and are not averse to take short positions to benefit from the fall in price.  Day trading is not only popular among individuals or retail traders but institutional traders as well, therefore the price movements are large sometimes depending on the magnitude of information flow and accessibility.  Everyone wants to make money faster, and many are inclined to speculate in markets, but it comes with considerable risk and potential loss of capital. People engaged in day trading also incur losses, and oftentimes outcomes are disheartening.  Day trading is a risky activity, similar to sports betting and gambling, and it could become addictive just like gambling and sports betting. Since the motive is to earn profits, the profits realised from day trading also tempt people to continue speculating.  People spend considerable time and efforts to make the most out of day trading. They have to continuously absorb and incorporate information flow, which has become increasingly accessible driven by new-age communications systems like Twitter, Facebook, forums etc. But not only information flows have been favourable, day traders are now equipped with best in class infrastructure to execute trades even on compact devices like mobile phones. The accessibility to markets is at a paramount level and gone are days of phone call trading and lack of information flows.  What are the essentials for Day Trading? Basic knowledge of markets With lack of basic knowledge of markets, day trading may yield unacceptable outcomes. It becomes imperative for people to know what’s on the stake. Prospective day traders should know about capital markets, and the securities traded in capital markets like bonds, equity and derivatives.  Buying shares and expecting a return from the price movements are on the to-do list for many. However, it is important to know about and risks and potential returns from speculating in capital markets.  After getting some basic knowledge about markets and securities, aspiring day traders should know how to analyse market prices of securities through fundamental analysis and technical analysis. Although day traders don’t practice fundamental analysis extensively, they spend considerable time to apply technical analysis, to formulate a entry and exit strategy.   Device and internet connection Trading is now possible on mobile applications as well as computer applications or websites. An aspiring day trader will likely begin with mobile phone given the accessibility, and laptops/computers are useful as scale grows larger and complex.  Internet connection is prerequisite to practising day trading, and it is favourable to have a fast internet connection to avoid glitches and potential problems. These perquisites are now available with large sections of societies.  Broker and trading platform A broker will facilitate a market for potential trades. The security brokerage industry has also seen a profound shift as technology has driven cost lower while competition is ramping up across jurisdictions. Large retail brokerages have moved towards zero commission trading in the U.S., and the same is seen being the trend across other geographies as well.  The entry of discount and online brokerages has perhaps given wings to the retail market participants as well as the retail market for security brokers. Robinhood has grown immensely popular in the United States, but there are many firms like Robinhood in other jurisdictions. Each country has some firms with business model on same lines as Robinhood.  Brokers now offer high-quality mobile applications and web services to clients, and trading security has never been so accessible. They also provide access to the global market along with a range of securities, including commodity derivatives, currency derivatives, CFDs, options, futures, bond futures etc.  Real-time market information flow   On public sources, market price information is at times not live due technical shortcomings, which will not work appropriately, especially for day traders. Brokers not only provide platform and market but several other services, including margin lending, real-time data, research.  Day traders closely track prices of securities and overall information flow to incorporate developments in bidding, and real-time data provides accurate prices throughout market hours.  Information flow largely relates to the news around the company, industry or economy. Day traders now have far better sources of information than the conventional sources, and sometimes these sources could be exclusive to a group.  What are the risks of day trading? Most of the aspiring day traders end up losing money, given the lack of experience and knowledge. They should rather only bet on capital that they are comfortable to loose, in short, they should avoid risk of ruin. Day trading is sort of pure-play speculation and application of knowledge, information flow, laced with good trading system is paramount. The only concern of day traders is movement in price, which contradicts from investments. Day traders try to time and ride the momentum in the price and exit the trade before momentum turns otherwise, which can happen frequently.  It consumes considerable time and induces stress on the individuals given the nature of security prices, which can move north and south abruptly throughout the day, hours, minutes and seconds. Day traders should have enough capital to trade in cash instead of margin.  Day trading on margin or borrowed money is extremely risky and has the potential to make a person insolvent, especially in cases of extreme risk-taking. The leverage associated with borrowed money magnifies profits as well as losses.  Aspiring day traders should equip themselves with adequate knowledge, competency and sound risk management process. Although fast money is dear to most, it is better to know what is at stake before jumping into markets with excitement.   

The average time taken by an entity to make payments to its creditors and suppliers is referred to as Days Payable Outstanding. It is impacted by the punctuality of making payments and by contractual terms.

Early Exercise is a term in the option contract. The process allows the investors to buy or sell the underlying asset before the expiration date. It could be exercised in both types of option, i.e., American-Style and European- Style.

What is earnest money? Earnest money refers to a sum of money that is paid by the buyer to the seller as a form of reassurance of future payments during the sale of a house. Paying earnest money is also beneficial to the buyer because it gives him leverage to arrange the remaining funds. Earnest money can be deposited via a direct home deposit, an escrow account or in the form of good faith money. How does earnest money work? Earnest money is paid before closing on a house sale. When the seller and buyer come to an agreement on the house sale, the seller must take the house off the market. Earnest money serves the purpose of assuring the seller that the deal would not fall through. The amount paid as earnest money is usually 1-3% of the total sale value of the house. Most sellers prefer to hold earnest money in an escrow account. In case the deal does not materialize, the money can be given back to the buyer directly from the escrow account. This removes the concerns any buyer may have about whether the money would be returned by the seller or not. In case the buyer and seller go ahead with the sale, the earnest money becomes a part of the down payment. Thus, the buyer would only pay the remaining amount of the down payment. However, in case the agreement does not materialize between the buyer and the seller, the earnest money is returned to the buyer after deducting the escrow fees from it. With money locked in on one house, buyers are less likely to close a deal with any other house seller. How is the amount of earnest money decided upon? The percentage of the total amount that can be taken as earnest money varies from state to state as policies are different. Additionally, the market scenario is also a major factor affecting the amount of earnest money to be paid. Under normal conditions, 1-2% of the total sale value can be taken as earnest money. However, if the market does not have a high demand for houses, then the percentage charged as earnest money could be lower around 1%. In markets with high demand, this percentage could be as high as 3%, or even 5%. To outbid other buyers, one can pay a larger sum of money as earnest money. This would increase the buyer’s chances of securing the property. Why is earnest money important? Earnest money may not always be mandated by the seller, but in a highly competitive market earnest money may be necessarily required. Paying the earnest money makes the agreement official. Without earnest money, the deal may not be considered official in many regions. It is one of the four stages of payment while making a deal on a house. However, in certain instances, even after the payment of the earnest money, the deal may not materialize. Typically, a buying agent should be able to assist the buyer in such a case. What conditions must be met for earnest money to be refundable? Earnest money has certain contingencies attached to it for the protection of both the seller and the buyer. Even after the seller has accepted the earnest money deposit, there are certain contingencies that must be met before the deal can be finalized. These include the following: Home inspection contingency: This contingency is placed so that buyers can back out of the agreement in case the there are some faults in the property, and it is in need of repair. However, it is not necessary for the buyer to call off the deal in such a case. He can simply work with the seller to reach a mutual decision rather than scraping away the deal completely. Financing Contingency: It might be the case that a buyer had not been approved for a mortgage before making the earnest deposit. Here the financing contingency would protect the buyer. If the mortgage does not get approved even though the earnest money had been paid, then the financing contingency allows the buyer to walk away from the deal along with the refunded earnest money. Appraisal Contingency: This protects the buyer in case the property has been overvalued. Here the lender can hire a third-party investigator who can examine whether the property has been priced at a fair value or not. If the value of the house comes out to be higher than the fair value, then the buyer can walk away with a refund. Additionally, this contingency can be used to bring down the price of the sale too. Contingency for Selling the Existing home: It is quite possible that contracts are made based on whether the buyer can sell an existing home or not. If the buyer is unable to sell the existing home, then he can walk away with a refund. These contingencies can be waived by the buyer in case he is sure that the deal would close and there would be no backing off. However, it is important to note that contingencies can provide an extra cushion against adverse circumstances and they might come in handy in certain cases. What is the difference between earnest money and good faith deposit? Both terms can be used interchangeably. However, all good faith deposits are not the same as earnest money. A good faith deposit can be made directly to the mortgage lender, while earnest money is usually held in an escrow account. Both serve the purpose if providing a sense of security about the buyer sticking to the same deal and not going elsewhere. The good faith deposit eventually forms a part of the lending process. However, in case the deal does not materialize, it is possible that the borrower would not get his good faith deposit back.

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