Many of you might have listened the term Future Trading and would be keen to know about it and how it works. What are it’s demerits and why is it preferred by most of the people while buying stocks. Here’s a comprehensive guide about it.
Before explaining the Future Trading, it’s important for you to understand its primitive trading i.e. Forward Trading.
Forward Contract or trading is a contract made between two persons for a future purpose entity. Let’s have a practical example to understand it better,
There’s a farmer who farms potatoes and want to sell it for 5 cents. The farmer have sold them for 4 cents last year and got a loss in his revenue last year.
There’s a multinational company which makes potato chips out of potatoes and want to buy potatoes at 5 cents. They have to buy those potatoes at 6 cents last year due to some natural calamity and face a loss last year.
Here comes the forward contract where the both parties (farmer & company) agrees to buy and sell the potatoes at 5 cent price, even if the price go down or up in the market.
Now, the farmer’s crop harvests after the months (Future time) and farmer sells his entire crop to the company for 5 cents but do not gets his payment from the company. Farmer can sue the company but it would cost his a lot of money.
Here, comes the Future trading, which is quite similar to the Forward trading, where a third party gets involved into the trading process which takes care of the funds to be allotted to the seller.
Future trading has become quite popular now-a-days because of its ease and high profit margins.
Many of the trade exchanges provide the option of future trading. There are even some of the crypto exchanges which provide the option of future trading, where people can trade on the crypto-currencies.
How Future Trading Works?
In a future trading contract, a person doesn’t actually buys the share of a company initially. They buy a token of the share which has equal value a per the share. After a specific time, the token converts into the actual share and has the market value as per the future time, irrespective of the price, it was purchased.
Let’s take another example to understand it better,
There’s a company “A” which has shares in the market open to be purchased. The price of the share in 2021 is $100. A person future trades the share of the company “A” by purchasing its token at $100.
Now, after a year of the grace period of the future trade contract, one share of company “A” reaches the price of $150. After an year, the token which was purchased at $100 now converts into a an actual share of company “A” which has value of $150 now. This gives a profit of $50 to the buyer.
The person holding the token of the company “A” can also resell that token to another person at the current price of that share, which is helpful in case a person want to sell the token of a particular share before the grace period.
Don’t get too much excited, the token can also have a value lower than the purchase price in future, which can give you a high loss.
Risks Involved in the Future Trading
There are many risks involved in the future trading. It works the different way.
In the future trading, a person buys the token of the share in bunches (Like 10 shares at a time) and the price which is to be paid is about 10-20% of the price of that bunch. The rest 80-90% cost is paid by the stock exchange. A person buying that bunch of shares have to give a specific interest on that 80-90% shares, whose interest rate is determined by the stock exchange.
Confused? Let’s have another example,
There’s a company “A” which has a share price of $100 in Jan, 2021.
Its future trade grace period is one year i.e. Jan, 2022 & has a bunch of 5 shares which costs $500
A person “B” has $500 in his trading wallet. “B” buys 10 future share token bunches i.e. 50 shares of the company “A”, as the amount to be paid by “B” is 10% of the amount of the bunch.
So, practically, “B” buys 50 share tokens of company “A”, whereas, a person “C” who would have purchased the shares (not tokens) in Jan, 2021 would get 5 shares of company “A”.
Now, the shares of company “A” reaches the price of $50 per share.
Person “B” would have to bear the profit/loss of (Current Price)x(No. of Shares/Tokens). Thus, “B” would have to bear a loss of $50 x 50 = $2500. The extra loss i.e. $2000 ($500 in person “B” Wallet) would have to be paid off by the person “B” otherwise the specified legal actions would be taken against the person “B”
Person “C” who traded in the normal shares would have to bear the loss of just $250 which is 10 times less than that of person “B”.
This way, “B” has to bear a huge loss at the times, the price goes down, but also gets huge profits in case the share prices goes up.
PS. We do not recommend you to invest in future trading options as it has a huge market risk. All the examples & references taken in this article are for educational purpose only. We are not liable for any action arising due to your own activity. We do not guarantee the complete correctness of this article. Manually read all terms and conditions of the 3rd party exchange platform before investing.