- Futures contracts refer to an agreement signed between a buyer and a seller wherein they agree to trade futures derivatives at a fixed futures price on a future date.
- It involves trading in four different assets – stocks, indices, currency pairs, and commodities.
- Trading in futures in India means transacting assets on both the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE).
- The exchange where the assets trade becomes the clearing house for all futures contracts.
- Two types of participants are involved in futures trading – speculators (who aim at earning profits) and hedgers (who aim at reducing risks).
- Index futures are contracts signed to trade a financial index at a current price on a future date.
What Are Futures Contracts?
Before discussing what is a futures contract, let us understand what are futures?
Futures are defined as derivative financial instruments that can be traded at a fixed future price. A derivative is a financial vehicle that extracts or derives its value from underlying assets or commodities. For example, if you buy NIFTY stock futures, it will be evaluated on the basis of how the NIFTY stocks (underlying commodity) in the market perform.
Futures contracts refer to an agreement signed between a buyer and a seller wherein they agree to trade futures derivatives at a fixed futures price on a future date. This agreement obligates the parties involved and they become legally bound to transact even if the market turns against them. A futures contract is the extension of any forward contracts to speculate on profitable positions or hedge risks.
What is Futures Trading in Simple Terms?
As soon as the futures contract is signed, the buyer and seller of an asset agree to transact it at a predetermined future date and price. As a result, if the price of the asset in question decreases on the specified future date, which is basically the expiration date of the futures contract, the seller will be bound to sell or transact the asset to the buyer.
In such a deal, the seller will remain at a loss as he is compelled to sell the asset at a predetermined price, which is lower than the current futures market’s price of it. On the other hand, the deal serves to be profitable for buyers as they receive the item at a lesser price.
Futures trading involves trading in four different assets – stocks, indices, currency pairs, and commodities. Two types of participants are involved in futures trading – speculators and hedgers.
- Speculators are those who speculate the value of the assets will go up or down in the future. As a result, they involve in a futures contract and sign an agreement to buy or sell the asset or futures derivatives at the predetermined price on a future date (expiration date).
- Hedgers are those who want to avoid sale and purchase risk in the future. People who think the value of an asset will rise or fall in the future book a deal with the asset in question at a predetermined price to be bought or sold on or before the expiration date.
Whether the one investing in the futures contract is a hedger or speculator depends completely on the intention of the trader. If the trade is done to avoid risk, it’s hedging whereas if the trade is to earn profit no matter what the market condition is, it’s speculation.
For example, A and B are two entities interested in stock trading. While A speculates the stock prices will go up in the future, B has an opposite opinion and wants to hedge risk. Both of them enter into a futures contract at a predetermined price to trade the assets on a future date. If A’s speculation is right, it will be able to buy stocks from B at a lower price and if B as a hedger is right, he can sell the stocks to B at a better price as per the futures contract.
Example of Future Trading
Chris harvests wheat in bulk during the season. Though the market price of wheat is lenient when it is harvested, the prices go down in the future, which worries Chris. The situation of the wheat users is no different. They need wheat in bulk for the bakers and other entities throughout the year, but they cannot but the cereal all at one only to get spoilt.
While Chris harvests wheat and sells the currently required volume of the grain to users, he signs a commodity futures contract with the future users who agree to pay the predetermined futures price for the cereal to be bought and sold throughout the year without any influence of the current market price applicable for the commodity futures.
Advantages vs Risks of Trading Futures Contracts
Futures trading in the futures market has a lot of benefits, but they are not free of cons. Here is a list of advantages and limitations of trading futures:
Advantages of Futures Trading
Standardized Contracts: The futures contracts are non-negotiable. They are created as per exchange standards and buyers and sellers are connected based on their agreement on the terms for a future deal.
Futures Contracts are tradable: Futures contract can be traded anytime. If at any point, traders change their minds and wish to transfer the contract to someone else, they can easily do so and get rid of the contract.
Futures Market is regulated: The futures market is regulated by the clearing house or exchange where the asset in question trades.
Futures Contracts are time-bound: A futures contract is valid only until it reaches its date of expiry and the contract expires.
Cash settled: The futures contract mostly involves cash settlement. In short, there is no physical movement of assets, only cash flow is involved.
Disadvantages of Futures Trading
Expiry date: Futures contracts come with a specified date that marks the end of the agreement. Hence, these contracts do not remain valid for as long as traders want. Instead, there is a specific date they expire on.
Valuation: The value of the futures derivative depends on an underlying asset. Thus, predicting the future price is difficult as the price of the underlying assets, like stocks, keeps changing.
Unpredictable: The future events of the futures market cannot be predicted accurately. Hence, how fruitful or less worthy the futures contract would be cannot be observed so easily.
Significant fluctuation: High leverage leads to more frequent changes in the price movements, affecting the futures price. The prices, therefore, can move up and down every minute within a trading day.
5 Benefits of Trading in Future Contracts
Futures contracts are not the only options available for traders. Still, they are widely opted for. This is because of the features such financial vehicles offer.
Futures trading has its own set of characteristics. Let’s have a quick look at the same:
1. Designated exchanges
While other contracts or derivatives are traded in the over-the-counter market, a futures contract has an organized exchange having a physical location where trading takes place. As a result, the traders involved in the agreement have a ready liquid market where the asset transaction takes place.
In forward contracts, there is a scope for negotiation, be it the amount of commodity or the maturity date. On the other hand, in futures contracts, the standards are set by the exchange in which the trade occurs. The exchange also mentions the minimum size of price movement, referred to as tick. In a few cases, it might impose a ceiling on the maximum change in the price in a day. For commodity futures trading, the quality and quantity standards are specified by the exchange in a single agreement.
3. Clearing House
The exchange where the assets trade becomes the clearing house for all futures contracts. As the name suggests, it is the platform where the deal between two parties involved in the agreement gets cleared. Here, the two contracts – one signed between A and the clearing and another between B and the clearing house are taken care of.
4. Margin oriented
To activate the futures contracts, the parties involved in them need to deposit a specific amount with the clearing house. This indicates the level of seriousness of people in the deal. This deposit amount is the margin, which varies between 2.5% and 10%. However, it might be different as there is no such standard to be followed.
5. Marking to market system
The marking to market system is used at the end of every trading session by the stock exchange. This is the time when all outstanding contracts of that trading session are reprised and settled at a price. While some reap profits after the settlement, some suffer losses.
How Do you Trade a Futures Contract?
When two parties agree to futures contracts, they do not exchange stocks. Instead, they pay a differential amount for the derivatives. This price is obtained as a difference between the market price and the predetermined futures price as agreed upon by both the parties in the agreement.
Trading in futures in India means transacting assets on both the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). The two trading entities sign the futures contracts through a clearing house that makes sure the futures deal is achieved on the specified future date.
Through the clearing house or stock exchange, a person can either place a purchase order or sell order to buy or sell derivatives at the predetermined fixed price on a future date. The buyers and sellers get connected and a futures contract is created between them. While a buyer goes for a bullish stance, a seller opts for a bearish book.
For futures, the contract expired on the last Thursday of a month. All settlements are done on the same day along with the creation of other new contracts.
Quick Guide: How trade settlement happens in stock market?
After buying the futures via the clearing house, traders are free to sell the assets to other market participants.
Futures are bought in lots, the size of which varies with the type of futures traders opt for. You can buy a lot of 30 shares or 300 shares as per your wish.
How to Analyze the Future Contract Table?
Instrument Type: The type of the futures derivative is chosen here. Traders can choose whether it is stock futures, indices, currency pairs, or commodities.
Symbol: The symbol signifies the alias used for a company whose assets are in question. For example, it’s Reliance for Reliance Industries Limited.
Expiry Date: This is the future date on which the futures contract ends or expired. It is mentioned under the Expiry Date dropdown for the assets in question. It is the last Thursday of the ongoing month.
Previous Close: The price at which the trading session ended the previous day.
Open: The price at which the first transaction of the day occurred.
High: The maximum price for the contract on the trading session on the current day.
Low: The minimum price for the contract on the trading session on the current day.
Underlying Value: As already stated, futures is a derivative that derives value from an underlying asset. For example, the futures for Reliance derive their value from the stocks of the company. It is mentioned in one of the rows of the table with all details.
Market lot (lot size/contract size) :
The lot size of a futures deal in the futures market is fixed. If a trader opts for a lot size of 300 and the price of the futures for the day is 2000, the contract value would be:
Futures contract value = Lot size* price of futures
= INR 6,00,000
What are Leverage & Payoff in Future Trading?
Surprisingly, there are other forms of trading too available in the market, which are neither time-bound nor make it an obligation to obey any contract, still, people opt to trade futures. The reason behind making this choice is the leverage and payoff features that trading in futures offers.
For example, if you have INR 500 available with you and you want to spend in a future derivative, you can pay a certain percentage as margin value to enter into the futures financial contracts. The percentage varies, say it’s 10% for this deal. Thus, you have to pay (10% of 500) as a margin, which comes to INR 50.
You buy a lot size of 25 shares worth INR 15, amounting to INR 375. After investing the margin amount and paying for the lot size, you will still be left with INR 75. Thus, you decide to buy five more shares as you still have INR 75 available with you. Hence, the total lot size you invested in is 30 shares worth INR 450.
At the end date, i.e., the expiration date, the market price of the asset turns to INR 10, and the price of your lot size goes down to 300. But as you have a futures contract signed with the other party, you can sell your lots at the predetermined price, leveraging a profit of INR 150 on 30 shares or INR 5 per share.
This is what makes futures contracts preferred over other trading options.
What are Index Futures?
As stated above, a futures contract is not only meant for stocks, commodities, and currency pairs, but also for a stock index. An index is a representation of the changes that occur in the price movement of stocks over a period of time. An index is formed with a collection of stocks of companies offering similar goods and services and dealing with similar types of customers.
Read more: Indian stock market index
Index futures are contracts signed to trade a financial index at a current price on a future date. Some of the popular indices available for index futures contracts include – NIFTY 50, Nifty Bank
Here are some features of the index futures:
- Like stock and commodity futures, there is a lot size for index futures as well.
- The asset here cannot be settled or transacted by buying or selling an underlying asset. In fact, you cannot even go for a physical settlement for these abstract market concepts. Thus, the open positions can only be settled by conducting an opposing transaction.
- It comes with an expiry date.
- Like stock futures, index futures also have three contract series applicable – the near month (the next month of signing the futures contract), the middle month (the next two months), and the far month (the next three months).
- If the index stands at 500 points today in the futures market and you but NIFTY 50 Oct future, you will have to buy it at the current price.
How Futures Trading Differs from Other Financial Instruments?
There are a number of options trade and other financial instruments you can invest in. However, among all of the investment options available, futures contracts are the most preferred. Here are a few points that make futures trading different from other financial instruments:
- Futures have no inherent value. They depend on another underlying asset for their value.
- Futures come with an expiration date.
- Futures make the contract an obligation.
- Equity in a company could be held for a long time but futures need to be dealt with within a fixed time period.
Can we short-sell futures?
Yes, we can short-sell futures. There is no restriction regarding shorting the futures derivatives.
How much money do you need to trade futures?
You can trade futures with whatever amount you have and invest as per your affordability.
How are futures contracts settled?
The futures contracts are settled mostly in cash. Normally, there is no physical movement of assets involved. Cash settlement, in any way, is the easiest way to settle a futures contract.
Can I sell futures before expiry?
It is not necessary for traders to wait for the expiry date to sell the assets. They are free to trade before the expiration date is achieved.