stock market, or the overall market are not limited to the cash market.
Instead, investors can employ equity futures and options contracts to
capitalize on their expectations about a decline in value of a stock or
stock index. In this chapter, we describe the basic features of equity
futures and options contracts, their profit and loss profiles, and how
investors can use them to benefit from a decline in value.
FUTURES CONTRACTS
A futures contract is an agreement between a buyer and a seller wherein
(1) the buyer agrees to take delivery of something at a specified price at
the end of a designated period of time and (2) the seller agrees to make
delivery of something at a specified price at the end of a designated period
of time. Of course, no one buys or sells anything when entering into a
futures contract. Rather, the parties to the contract agree to buy or sell a
specific amount of a specific item at a specified future date. When we
speak of the “buyer” or the “seller” of a contract, we are simply adopting
the jargon of the futures market, which refers to parties of the contract in
terms of the future obligation to which they are committing themselves.
The price at which the parties agree to transact in the future is
called the futures price. The designated date at which the parties must
transact is called the settlement date or delivery date. The “something”
that the parties agree to exchange is called the underlying.
To illustrate, suppose there is a futures contract in which the underlying
to be bought or sold is the stock of Company X and the settlement
is three months from now. Assume further that Chuck buys this futures
contract, Donna sells this futures contract, and the price at which they
agree to transact in the future is $100. Then $100 is the futures price.
At the settlement date, Donna will deliver the stock of Company X to
Chuck. Chuck will pay Donna $100, the futures price.
When an investor takes a position in the market by buying a futures
contract (or agreeing to buy at the future date), the investor is said to be
in a long position or to be long futures. If, instead, the investor’s opening
position is the sale of a futures contract (which means the contractual
obligation to sell something in the future), the investor is said to be
in a short position or to be short futures.
The buyer of a futures contract will realize a profit if the futures price
increases; the seller of a futures contract will realize a profit if the futures
price decreases. For example, suppose that one month after Chuck and
Donna take their position in the futures contract, the futures price of the
stock of Company X increases to $120. Chuck, the buyer of the futures
contract, could then sell the futures contract and realize a profit of $20.
Effectively, he has agreed to buy, at the settlement date, the stock of Company
X for $100 and to sell the stock of Company X for $120. Donna,
the seller of the futures contract, will realize a loss of $20.
If the futures price falls to $40 and Donna buys the contract, she
realizes a profit of $60 because she agreed to sell the stock of Company
X for $100 and now can buy it for $40. Chuck would realize a loss of
$60. Thus, if the futures price decreases, the buyer of the futures contract
realizes a loss while the seller of a futures contract realizes a profit.
From this discussion it should be clear that if a futures contract in
which a stock that an investor is interested in shorting is available, then
selling a futures contract can accomplish the same objective as selling
the stock. The advantages of using futures to short rather than shorting
in the cash market will be explained later after we describe the mechanics
of futures trading.
Read More : Futures Contracts
