Let’s start with a small story that will allow us to understand the working of futures market. Two women, Sita and Noor are both active in the housing market of Mumbai. Sita is looking to buy a 2 bedroom apartment. Noor is planning to sell her 2 bedroom apartment for about Rs.1 crore and utilize the proceeds to set up a catering business.
Sita does like Noor’s apartment but is not able to pay immediately. Her money is locked in fixed deposit which will mature in 6 months and Sita does not want to redeem it before the maturity date. However she wants to seal the deal and agree on the purchase consideration as she is concerned that prices might go up in the future. Noor is also keen to seal the deal. However since she has not yet found another rented accommodation to move into, she wants some grace time before handing over the possession of the apartment to Sita. Hence Sita enters into an agreement with Noor to buy the house after six months for a consideration of Rs 1.1 Crore. This way both were able to achieve their respective objectives.
This is a basic futures contract. Sita has agreed to buy the house and hence holds the long position. Noor has agreed to sell the house and hence holds the short position. A long position holder buys the “underlying” asset whereas short position holder agrees to sell the asset.
What is an underlying asset though? An underlying asset is an item that has been agreed to be bought or sold. In the above example the underlying asset is the 2 bedroom apartment. Futures are more standardized contracts which are traded on exchanges and have underlying’s like stocks, bonds and commodities.