Futures Trading

What are futures?

In the past, if someone said futures contract, you’d probably have drawn a blank look. That’s not the case any longer, especially since these were introduced in stocks and indices in the year 2000. Since then, `futures’ – as these contracts are known in stocks – are becoming increasingly popular among retail investors.

Of course, these aren’t restricted to stocks alone. They are used in multiple markets like agricultural commodities, currency and minerals, including wheat, oilseeds, cotton, gold, silver, petroleum, natural gas, shares, and so on.

What is a futures contract, and how does it work? Before we get to know what are futures, we must understand the concept of derivatives. A derivative is a contract based on the ‘derived value’ of an underlying asset.

Definition of a futures contract

A futures contract gives the buyer (or seller) the right to buy (or sell) a specific commodity at a specific price at a predetermined date in the future.

Let’s illustrate this with an example. Let’s say you work in a company making baked goods and want to purchase large amounts of wheat at frequent intervals. You will need 100 quintals a month down the line. However, wheat prices are volatile, and to protect yourself; you enter into this type of contract to purchase 100 quintals of wheat at Rs 2,000 a quintal a month down the line. In the meantime, wheat prices go up to Rs 2,500 a quintal. However, you will still be able to buy it at Rs 2,000. Thus, you would have saved Rs 50,000 because of this type of contract! However, if wheat prices fall to Rs 1,500, you would have lost Rs 50,000.

This is an example of someone who wants to hedge against an increase in prices. This is a prevalent form of hedging and is undertaken by large and small organisations as well as by governments. For example, a country that imports large amounts of petroleum will hedge against price rise by going in for oil futures. Similarly, a large chocolate maker will hedge against an increase in the prices of cocoa by going for cocoa futures. 

Futures trading

However, futures contracts aren’t restricted to them alone. Speculators too are enthusiastic participants in the futures market. They can reap the benefit of movements of asset prices without having to purchase the underlying asset through futures trading.

If you want to make money by betting on wheat futures, you don’t have to take delivery of large quantities of the commodity. You don’t have to spend large amounts either since you don’t have to deal in the underlying asset.

Futures contracts enable you to trade large quantities. This is because to trade, all you need is to deposit an initial margin with the broker. For example, if the margin is 10 percent, if you want to buy and sell futures worth Rs 20 lakh, all you need to deposit is Rs 2 lakh.

Generally, margins in commodities are low so that traders can deal in massive amounts. This is called leverage and can be a double-edged sword. The opportunities for profits are enormous because of the large numbers involved. However, if you don’t get it right, the losses can be considerable indeed. When you make losses, you may get margin calls from brokers to meet the minimum requirement. If you don’t meet it, the broker can sell the underlying asset at a lower price to recover it, and you could end up with more losses.

It’s essential to understand what are futures before venturing into them. Commodity markets are especially risky since price movements are volatile and can be unpredictable. The high leverage also adds to the risk. Generally, the commodities markets are dominated by large institutional players who can deal with risk better.

Futures trading in the stock market

What are futures in the stock market? Like many other assets, you can also trade in futures contracts on the stock exchange. Derivatives made their debut in the Indian stock market a couple of decades ago, and since then have become popular with investors. You can get these contracts for specified securities as well as indices like Nifty 50 etc.

Prices of stock futures contracts depend on demand and supply of the underlying. Usually, stock futures prices are higher than that in the spot market for shares.

Here are some of the features of a futures contract in stocks:

Trading in stock and index futures contract can be rewarding since you don’t need much capital as on the spot market. However, there is a danger of extending leverage too far and biting off more than you can chew. If you can stay within bounds, you can steer clear of the risks. 

Let’s look at different types of futures.

Types of Futures

Stock Futures

Index futures first appeared in India in the year 2000. These were followed by individual stock futures a couple of years later. There are several advantages of trading in stock futures. The biggest one is leverage. Before trading in stock futures, you need to deposit an initial margin with the broker. If the initial margin is, say, 10 per cent, you can trade in Rs 50 lakh worth of futures by paying just Rs 5 lakh to the broker. The larger the volume of transactions, the higher your profit. But the risks are also more significant. You can trade stock futures on stock exchanges like the BSE and NSE. However, they are available only for a specified list of stocks.

Index Futures

Index futures can be used to speculate on the movements of indices, like the Sensex or Nifty, in the future. Let’s say you buy BSE Sensex futures at Rs 40,000 with an expiry date of the month. If the Sensex rises to 45,000, you stand to make a profit of Rs 5,000. If it goes down to Rs 30,000, your losses, in that case, would be Rs 5,000. Index futures are used by portfolio managers to hedge their equity positions should share prices fall. Some of the index futures in India include Sensex, Nifty 50, Nifty Bank, Nifty IT etc.

Currency Futures

One of the different types of financial futures is currency futures. This futures contract allows you to buy or sell a currency at a specific rate vis-à-vis another currency (Euro vs USD, etc.) at a predetermined date in the future. These are used by those who want to hedge risks, and by speculators. For example, an importer in India may purchase USD futures to guard against any appreciation in the currency against the rupee.

Commodity Futures

Commodity futures allow hedging against price changes in the future of various commodities, including agricultural products, gold, silver, petroleum etc. Speculators also use them to bet on price movements. Currency markets are highly volatile and are generally the domain of large institutional players, including private companies and governments. Since initial margins are low in commodities, players in commodity futures can take significant positions. Of course, the profit potential is enormous, but the risks tend to be high. In India, these futures are traded on commodity exchanges like the Multi Commodity Exchange (MCX) and the National Commodity and Derivatives Exchange.

Interest rate futures

An interest rate future is one of the different types of futures. It’s a contract to buy or sell a debt instrument at a specified price on a predetermined date. The underlying assets are government bonds or treasury bills. You can trade these on the NSE and the BSE.
 

How to buy futures

Buying a futures contract is essentially the same as purchasing several units of stock from the cash market. The fundamental difference is that in the case of buying future, you don’t take immediate delivery.

Let us look at future trading basics and ways to go about futures trading.

It is important to understand the definition of a future. Futures are nothing but, a financial contract which obligates the buyer to purchase an asset or the seller to sell an asset at a pre-determined future date and a pre-determined price.

How futures trading is different from other financial instruments?

Futures don’t have any inherent value. Its price depends on another derivative. 

Futures are standardised contracts that promise physical delivery of the goods on a certain date, which is not the case with other financial instruments. 

On the contrary, the stock investment represents your ownership of the company’s future income and profit. Stock investors can hold their investment for as long as they want. Futures expire, but stocks don’t. Hence, the time factor is crucial in futures trading. 

How to trade futures

Investors in India can trade in futures on the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). Let us see how to trade in futures in India.

 

  1. Understand thoroughly how futures and options work: Futures are complex financial instruments and are different from other tools such as stocks and mutual funds. Trading in futures can prove to be a challenge for an individual investing in stocks for the first time. If you want to start trading in futures, you need to know how futures work, as well as the risks and costs associated with it.
  2. Get a fix on your risk appetite: While all of us want to make profits in the markets, one can also lose money in futures trading. Before you get into how to invest in futures, it is essential to know your risk appetite. You should know how much money you can afford to lose and if losing the amount will affect your lifestyle.
  3. Determine your approach to trading: It is important to decide one’s strategy to future trading. You may want to buy futures based on your understanding and research. You may also hire an expert to help you with the same.
  4. Practice with a simulated trading account: Once you have understood how to trade in futures, you can try and practice the same on a simulated trading account, which is available online. This will enable you to have first-hand practical experience on how future markets work. This makes you better at trading in futures without making any actual investments.
  5. Open a trading account: To start trading in futures, you need to open a trading account. Do a thorough background check before opening a trading account. You also need to inquire about the fees. While investing in futures, it is important for you to select a trading account that suits you best.
  6. Arrange for the margin money requirement: Future contracts require one to deposit some amount of margin money as a security, which can be between 5-10 percent of the contract size. Once you know how to buy futures, it is essential to arrange for the margin money required. When you purchase futures in the cash segment, you have to pay the entire value of the shares purchased, unless you are a day trader.
  7. Deposit the margin money: The next step is to pay the margin money to the broker who in turn will deposit it with the exchange. The exchange holds the money for the entire period you hold your contract. If the margin money goes up during that period, you will have to pay extra margin money.
  8. Place buy/sell orders with the broker: You can then place your order with your broker. Placing an order with a broker is similar to buying a stock. You will have to let the broker know the size of the contract, the number of contracts you want, the strike price, and the expiration date. Brokers will provide you with the option to select from various contracts available, and you can choose from them.
  9. Settle future contracts: Finally, you need to settle the future contracts. This can be done on expiry or before the date of expiry. A settlement is nothing but the delivery obligations associated with a futures contract. While in some cases such as agricultural products, physical delivery is done, when it comes to an equity index, and interest rate futures, delivery takes place in terms of cash paid. Future contracts can be settled on the expiration date or before the expiration date.

Let us take an example to understand futures trading basics. Suppose you have purchased a lot XYZ stock futures consisting of 200 shares with an expiration date of August 25 for Rs 200. You’ve paid the margin amount and placed an order with the broker. On August 25, let us assume that XYZ stock is trading for Rs 240. You can then exercise the contract by purchasing 200 shares at Rs 200 and making a profit of Rs 40 on each share. Your profit will be Rs 8,000 minus the margin money paid. The money you have earned will then be deposited in your account after deducting commissions and fees. If you have made a loss, then that amount is deducted from your cash account. When you go for settlement before the expiry date, your gains and losses are calculated after they are adjusted against the margins you have paid.

Futures trading can turn out to be profitable, but one needs to take precautions to limit the exposure to risk and maximise returns. Also, trading in futures requires a lot of knowledge and experience, so a beginner should tread with caution.

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