Suppose the current price of Tata Steel is Rs. 200 per stock. You are interested in buying 500 shares of Tata Steel. You find someone, say John, who has 500 shares you tell John that you will buy 500 shares at Rs. 200, but not now, at a later point of time, say on the last thursday of this month. This agreed date will be called the expiry date of your agreement or contract. John more or less agrees but the following points come up in your agreement.
John will have to go through the hassle of keeping the shares with him until the end of this month. Moreover, the economy is doing well, so it is likely that the price of the stock at the end of the month will be not Rs. 200, but something more. So he says lets strike a deal not at the current price of Rs 200 but Rs. 202/-. The agreed price of the deal will be called the Strike price of the futures contract. He says you can think of the Rs. 2 per share as his charge for keeping the shares for you until the expiry date. This difference between the strike price and the current price is also called as Cost of Carry.
The total contract size is now Rs. 202 for 500 shares, which means Rs 101000. However both you and John realise that each of you is taking a risk. For e.g. if tomorrow the price of the stock falls from Rs. 200 to Rs. 190, in that case it is much more profitable for you buy shares from the market than from John. What if you decide not to honour the contract or agreement? it will be a loss for John. Similarly if the price rises you are at a risk if John doesn't honour the futures contract. So both of you decide that you will find a common friend and keep Rs. 25000 each with this friend in order to take care of price fluctuations. This money paid by both of you is called Margin paid for the futures contract.
Finally you decide that the futures contract will cash settled. Which means at the expirty date of the contract, instead of actually handing over 500 shares - John will pay you the money if the price rises, or if the price falls you will pay John the balance amount. For example at the end of the expiry date if you find out that the price of the share is Rs. 230, then the difference
Rs. 230 - Rs. 202 = Rs. 28
will be paid to you by John. You can then purchase the shares fromt he Stock Market at Rs. 230. Since you will get Rs. 28 per share from John, you will effectively be able to buy the shares at Rs. 202 , the agreed strike price of the futures contract. Similarly John can directly sell his 500 shares in the market at Rs. 230 and give you Rs 28 (per share) which means he effectively sold each share at Rs. 202, the agreed price.

So Trading in this manner is called the Futures Trading!!


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