What are 'Futures'? Give me an Example.

Buying or selling “futures” involves entering into a contract today to settle the contract at a pre-decided price on a pre-decided date in the future. This future date is known as the expiry date. Futures contracts detail the quality and quantity of the underlying asset. They are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash.

Let us understand with the help of an example. Suppose Reliance Industries is today trading at RS.2000/- in the spot market. You are bullish on the stock and expect it to be available near Rs.2200/- before the month ends. You see that Reliance Industries futures expiring this month is trading at Rs.2040/-. So, you enter into a contract today to buy Reliance Industries on the last day of the month from a person X at a price of Rs.2040/-. The settlement will be at the end of the month, i.e. you will pay for your shares on the last day of the month. But, Mr. X does not trust you, so he says that if you give him 20% of the money now; he would deliver the shares to you on the last day after you pay the balance 80%. You agree to pay him 20%, which is known as the margin money.

Now, let’s go forward to the end of the month. As expected by you, Reliance Industries is now trading at Rs.2,200/-. So, you contact Mr. X, take the shares from him, pay him the remaining 80% of the money @ Rs.2040/- and sell those shares in the market at Rs.2200/-, thus making a clean profit of Rs.160/- per share. But what if Reliance falls to Rs.1900/-? Sorry, but you would still have to buy the shares from Mr. X at Rs.2040/-, thus losing Rs.140/- per share.