How futures trade work?

The futures market is a centralized marketplace for buyers and sellers from around the world who meet and enter into futures contracts. Pricing can be based on an open cry system, or bids and offers can be matched electronically.

Risks involved
We have already seen the example of wheat being bought by us. See here if not yet seen.

Now suppose instead of you buying 5,000 kgs of wheat there is trade between wheat producer and the Hotel. In Economy there is a principle - As the demand of the commodity rises, the price also rises.

Risk involved with wheat seller
This explains the risk that wheat seller faces the risk like if demand falls price falls or may have worries about next season. So he may be trying to secure a selling price for next season's crop.

Risk involved with wheat buyer or Hotel manager
The wheat buyer / Hotel manager may be trying to secure a buying price to determine how much chapatis / chapatiss can be made and at what profit.

So what should they do?
So the farmer and the hotel manager may enter into a futures contract requiring the delivery of 5,000 kg's of grain to the buyer at a price of Rs.4 per kg in say June. By entering into this futures contract, the farmer and the hotel manager secure a price that both parties believe will be a fair price in June. It is this contract - and not the grain(or any physical commodity) - that can then be bought and sold in the futures market.


Strategies in Futures Market
So, a futures contract is an agreement between two parties:
a short position - the party who agrees to deliver a commodity - and
a long position - the party who agrees to receive a commodity.
In the above scenario, the farmer would be the holder of the short position (agreeing to sell) while the hotel manager would be the holder of the long (agreeing to buy).

In every futures contract, everything is specified: the quantity and quality of the commodity, the specific price per unit, and the date and method of delivery. The “price” of a futures contract is represented by the agreed-upon price of the underlying commodity or financial instrument that will be delivered in the future. For example, in the above scenario, the price of the contract is 5000 kgs of grain at a price of Rs.4 per kg.

Transactions
DAY 1 : The price of the grain rises to Rs. 5 from Rs. 4
The profits and losses of a futures contract depend on the daily movements of the market for that contract and are calculated on a daily basis. For example, say the futures contracts for wheat increases to Rs.5 per kg the day after the above farmer and hotel manager enter into their futures contract of Rs.4 per kg. The farmer, as the holder of the short position, has lost Rs.1 per kg because the selling price just increased from the future price at which he is obliged to sell his wheat.
The hotel manager, as the long position, has profited by Rs.1 per kg because the price he is obliged to pay is less than what the rest of the market is obliged to pay in the future for wheat.

On the day the change occurs, the farmer's account is debited Rs.5,000 (Rs.1 per kg X 5,000 kgs) and the hotel manager's account is credited by Rs.5,000 (Rs.1 per kg X 5,000 kgs). As the market moves every day, these kinds of adjustments are made accordingly.

Unlike the stock market, futures positions are settled on a daily basis, which means that gains and losses from a day's trading are deducted or credited to a person's account each day. In the stock market, the capital gains or losses from movements in price aren't realized until the investor decides to sell the stock or cover his or her short position.

As the accounts of the parties in futures contracts are adjusted every day, most transactions in the futures market are settled in cash, and the actual physical commodity is bought or sold in the cash market.


Note that futures are not always deliverable in cash when the futures contract expires. Eg. the gold futures require the delivery of 100 troy ounces of gold per contract. Others like index futures and currency futures settle in cash.

Prices in the cash and futures market tend to move parallel to one another, and when a futures contract expires, the prices merge into one price. So on the date either party decides to close out their futures position, the contract will be settled. If the contract was settled at Rs.5 per kg, the farmer would lose Rs.5,000 on the futures contract and the hotel manager would have made Rs.5,000 on the contract.


But after the settlement of the futures contract, the hotel manager still needs wheat to make chapatis, so he will in actuality buy his wheat in the cash market (or from a wheat pool) for Rs.5 per kg (a total of Rs.25,000) because that's the price of wheat in the cash market when he closes out his contract. However, technically, the hotel manager's futures profits of Rs.5,000 go towards his purchase, which means he still pays his locked-in price of Rs.4 per kg (Rs.25,000 - Rs.5,000 = Rs.20,000). The farmer, after also closing out the contract, can sell his wheat on the cash market at Rs.5 per kg but because of his losses from the futures contract with the hotel manager, the farmer still actually receives only Rs.4 per kg. In other words, the farmer's loss in the futures contract is offset by the higher selling price in the cash market - this is referred to as hedging.

Now that you see that a futures contract is really more like a financial position, you can also see that the two parties in the wheat futures contract discussed above could be two speculators rather than a farmer and a hotel manager. In such a case, the short speculator would simply have lost Rs.5,000 while the long speculator would have gained that amount. In other words, neither would have to go to the cash market to buy or sell the commodity after the contract expires.)
Taking out Credit :
Also the person who gets credit can take out the profit from the account he holds. Eg. The hotel owner had the profit of Rs. 5000. He can take it out keeping the initial margin in the account intact. Or if there are more number of transaction, he can take out all the money but keeping the account at initial margin.

Entering into Contract - Some terms
Initial margin

So the farmer and the hotel manager may enter into a futures contract requiring the delivery of 5,000 kg's of grain to the buyer at a price of Rs.4 per kg. But both have to pay for the risk that involves as the price of the wheat changes. This amount will be a small percentage of the total contract. This amount is called the initial margin. Suppose 1 future contracts = 100 kg of wheat. Also for entering into 1 future contract, Rs. 100 are to be paid. Now what is the initial margin?
Initial margin = (price per contract X number of contracts) 
In our case number of contracts = 5000/100 = 50
So initial margin = 50 X 100 = Rs. 5000

VARIATION MARGIN
As we see that as the price of commodity rises, the seller is debited with the loss and buyer is credited with profit. In case of fall, it is opposite. So this brings variation margin.

MAINTENANCE MARGIN
If the futures contract continues to go against the client, the client's account is debited, and the initial margin of the client's account continues to fall. It will reach the minimum point where the exchange member that carries the account call on the client to deposit more funds such that the account again reaches at the minimum point.

Importance of Futures
Futures markets though risky but still serves purpose for some people.

Price Discovery - Due to its highly competitive nature, the futures market has become an important economic tool to determine prices based on today's and tomorrow's estimated amount of supply and demand. Futures market is informed of continuous change of price through various factors.

Risk Reduction - Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced because the price is pre-set, therefore letting participants know how much they will need to buy or sell. This was shown in example above.