The same goes for investments as well. If I buy a stock today, then I might be worried about fall in prices 3 months down the line. Hence, I might like to get into an FUTURE agreement with some other party, at a pre-specified and agreed FUTURE price, for some such quantity of stocks. So I will enter into a future contract with another party, and the price at which the agreement is made is called the FUTURE price. At the expiry of the contract, I will deliver the shares to the other party, and the other party will deliver me that much future price for each of my share.
This is typically what you observe when you see the so called “F&O” section or the “Futures and Options” section of the stock market. The future business relates to these future contracts that traders make with each other, obviously via the exchange.
Let’s take an example. Say it is January 1st, and I bought 100 Microsoft shares today at $30. I have an investment horizon for 3 months i.e. till March end and I am worried that the price may fall. So what I do is that I place a SELL order for a future contract for my desired future price that contract will last till March. Say I expect a 10% return on Microsoft stock, i.e. the stock to reach $33 in 3 months time. Therefore, I will place the FUTURE SELL order for selling 100 Microsoft shares in future (3 months) at the expected future price of $33. Since I am willing to sell the Microsoft shares in the month of March, it is called March Future.
The order will be placed through my broker and will remain open at the exchange, unless someone is willing to BUY that future order. Hence, there has to be a buyer who is willing to buy my sell future order at my desired price, otherwise my order will expire. So let’s say I place my sell order at 10 am and at 2:30 pm, someone agreed to buy my future contract of Microsoft. A deal is done and we are locked into an agreement via the exchange.
Interestingly, nothing is exchanged at present – it’s only a contract that we’ve agreed on.
Exchange happens only on the expiry date, i.e. after 3 months, I will deliver 100 shares to the stock exchanges and I will receive $3300 in my bank account (less the brokerage). The other party, whom I may not even know because of the stock exchange in between, will receive 100 shares from the exchange and will have to deliver $3300 to the stock exchange.
Practically, the shares are not exchanged. It all is settled in cash. Hence, If say the price of Microsoft goes to $35, then I will still have to pay $2 * 100 shares = $200 to the other party via the exchange. I will make up for my $200 loss by selling my shares in the open market at the price of $35. Hence, I will get $5 as profit from selling my share, and $2 as a loss due to futures contract. The net return for me would be $3, which is what I wanted to achieve (10% return on $30 buy price).
Say if the price falls down to $25, then I will receive 33- 25 = $8 from my future contract counterparty, and I will sell my shares at a loss of $5 each. Again, I will get $3 as my profit.
So, either way the stock price moves, just because I have secured a future contract, I was able to achieve my desired profit level of 10%. However, nothing in this world comes for free. If I had not entered into the future agreement, I would have made (35 -30 = $5) per share profit instead of $3. So while going for hedging, I am loosing future potential of profit. Anyways, hedging is done to achieve a certain level of risk management. Therefore, one must then not worry about his hypothetical losses in case there is a significant bull run in the market or the stock.
Continue to Part 3: How to know if company I’ve invested in is hedging?
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