A “Futures Contract” is a agreement between buyer and seller to buy or sell an asset at a certain time in the future at a certain price. The contract has to be honored by both parties on the due date. This is used by traders or speculators who are engaged in arbitrage. Arbitrage means that the trader shall buy the stock at a low price today as he wants to sell it on a future date at a high price.

E.g: If a farmer is producing corn and make take 1 year for his produce to develop. Currently the price of the corn is Rs. 100 per kg and after 1 year he wants to sell it but he doesn’t know the price of the corn. So he enters into a forward contract or a futures contract with a buyer to sell at say “Rs. 110 per kg” after 1 year.

Now the buyer has decided this rate based on some mathematical calculations which could involve current rate of the commodity, probable future date, risk free returns etc. So he is willing to take the risk and buy corn at Rs. 110 per kg from the producer. He might make a profit or loss but this cannot be predicted but the producer makes a decent profit.

Commodity Exchanges trade in Future Contracts in Agriculture. They are regulated by SEBI.

Futures and options contracts

It is an Indian innovation that allows farmers to sell their commodities immediately through a trading platform. The presence of a large number of buyers and sellers on this platform could facilitate price discovery and also prevent cartelization. Buyers and sellers do not meet directly and so anonymity is ensured.

All contracts on the Exchange are compulsory delivery contracts.i.e., here all outstanding positions at the end of the day are marked for delivery, which implies that seller has to give delivery and buyer has to take delivery

An option is a contract that gives the buyer the Right but not the obligation to buy a commodity at a specified price at a specified future date.

If a farmer has 50 kg of corn and wants to sell it for Rs. 50000. Now a trader is interested to buy but he doesn’t have the money currently. So he enters into an “option contract” with the farmer. This contract states that the buyer shall have the Option to purchase the Corn at a specified price at a future date say 3 months. The buyer shall have to pay the price of the Option which is say Rs. 1000.

Now if the buyer returns after 3 months and the price of the corn is Rs. 5 lakh but he can still buy it for Rs. 50000 as he has bought a contract and wants to exercise his Right to buy. He thus makes a profit.

However if the Corn market crashes and the produce is worth only Rs. 5000 now he can exercise his Right to not buy the Corn from the farmer and the option contract expires. Thus he loses only the Rs. 1000 he invested in the Option.