Accounting for Future and Option

Future Contract

Future is the contract which both seller and buyer agree to trade in the future date at a specific price. It is the obligation for one party whether the seller or buyer to commit the transaction upon demand from another party.

Future contracts give buyers the obligation to buy the asset even it does not provide any financial benefit. The payment and delivery of the product will be made in the future. The buyer will have a long position while the seller will have a short position.

Both buyer and seller want to lock the asset at a specific price and prevent any change in future price which can impact their profit. Without a futures contract, the price can change and it may be a benefit or damage the company’s profit. However, the contract will ensure they keep the price the same even the market move in any direction.

The assets under the future contract can be the share, commodity, corn, oil, and even the currency. It is the contract which the buyer must buy or the seller must sell the asset at a specific price.

Future Contract Example

ABC is a food manufacturing company, they usually purchase a large amount of corn from the supplier. In order to lock the price, ABC and the supplier have made a future contract to sell and purchase corn. The contract state that the seller/buyer need to sell/buy corn at \$ 50 per ton even the market price increase or decrease. There are 1,000 tons per contract which equal \$ 50,000. They have signed 100 contracts and they will exercise at the end of the year.

At the end of the year, even corn drops the price to \$45 per ton, the buyer still needs to buy at \$ 50 as it set in the contract. On the other hand, if the price increase to \$ 55, the seller still sells at \$50 to ABC. However, both parties can exercise only 100 contracts which equal to \$ 5,000,000 (100 contracts * \$50,000).

Option Contract

Option is the contract that allows the party to buy or sell the share at a specific price. It is the option so the party does not have obligation to complete the transaction.

Option is the futures contract that allows the buyer to buy the asset if the price in their favor. So the buyer or seller will exercise the option when the market price moves in the opposite direction. For example, Buyer and seller have signed the option to buy the commodity at \$100 per unit in the future. So the buyer will exercise the option if the price increase more than \$ 100. If the price drop below \$ 100, they will not buy the commodity.

It sounds good for the buyer if we compare it with the future contract. However, this option contract requires the buyer to pay a high premium fee. It is the most value that buyer can lose while the future contract the loss can be much greater. To understand more about option please refer to the article relate to call and put option.