Futures Trading is an advanced stock market trading technique mainly used by traders. If you want to start Futures Trading & learn regarding the same, you have come to the right place.
Know everything here like its meaning, valuation process, examples, stock & index futures, significance, risks & more.
About Futures Trading
A Futures Trading or Futures Contract pertains to an agreement between a buyer and a seller. Under such agreement, they enter into a trade on a defined underlying asset.
It is meant to undergo execution at an agreed price and on a specific date. Thus, the basic elements of a futures contract or Futures Trading include:
- A definite underlying asset
- Fixed date of expiry
- An agreed price
Thus, a futures contract does not undergo the impact of time decay, as options contracts do. Although options contracts are rewarding enough for investors, should the strategy fail to move in the expected direction, they can make huge losses.
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How to value futures?
As opposed to the cash segment of the market, valuation of futures is slightly different. Futures pertain to the derivative segment of the market.
Hence, they derive their value from underlying security till the time it does not approach its date of expiration.
The value of the underlying security itself has a major role to play in determining the value of futures. However, the element of time value contributes to a significant impact on the futures valuation.
Due to the element of time, the value of futures can undergo a change in price from the time when it was taken to the time of its expiry. The alteration between this time value can yield a profit or loss to the investor in a futures contract.
Thus, a futures contract is one where the buyer to the agreement agrees to buy a derivative at a fixed price in the future. With the passage of time, the value of such an agreement will keep changing.
The difference between the price at which the contract was made and the price of the contract on the date of expiry spells the returns to the investor.
Every futures agreement involves two parties, a hedger and a speculator. The one who purchases the futures contract will have to pay a small marginal fee at the time of taking the contract.
Trading in Futures Contracts
An investor may choose to trade in one of the four types of futures contracts. These include stocks, currency, commodities and indices.
The aim of a futures agreement is to benefit from the fluctuation in prices of the underlying security. This means that the investor altogether avoids the sale and purchase of the underlying security.
In order to execute any future trading contract, two parties to the contract are needed. These are hedgers and speculators.
A hedger could be an individual or a business who usually deal in cash commodities. Their task pertains to protect a cash commodity against the sudden and irrational movement in prices.
For example, let us consider the case of an oil producing company who cans olive oil. If the prices of olives rise, the company will have to make more payment to procure the requisite olives to produce oil.
So, in order to protect against a significant rise in prices of olives, the company may decide to hedge their risk. They will do this by purchasing olive future contracts which will cover the value of olives that they expect to purchase.
Normally, in any market, the prices of cash and futures will move in a parallel direction. Thus, the company stands to make a gain with their futures position as long as the prices of olive rise enough.
This way, they will counter the losses which will arise from purchasing olives at a higher price in the cash market.
On the other hand, are speculators who are the other major party to a futures contract. Mostly, it includes floor traders and investors who handle the futures contract.
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What makes Futures Contract different from any other financial instrument?
The fact that a futures contract does not have any value of its own, makes it different from other financial instruments.
Since it is a derivatives contract, it derives its value from the value of underlying security. Most financial instruments are ever lasting and do not have a date of expiration.
Futures contract instead has a capping on its life and a date of expiry after which it ceases to exist. There is a fixed period of time for which an investor can hold on to a futures contract.
This is why it is vital to watch the direction of the market and the time of taking the contract. Lastly, the use of leveraging makes future contracts altogether different than any other form of financial instrument.
What is Leveraging inn Futures Trading?
When a futures contract starts, the investor makes a payment for an upfront amount initially. This amount is usually just a margin of the contractual value of the futures.
The value of such margin and maintenance of the contract are set by the concerned exchange. Using a futures contract involves using the concept of leverage in the market.
A futures contract can be traded in lots. It is the minimum amount by which the quantity of a future will have to be purchased by an investor.
What are Stock Futures?
Consider stock futures as derivatives contracts which allow an investor to buy and sell stocks. This trade can be completed on a fixed date and for a certain price.
Some of the elements of stock futures are as follows:
- Contracts are never traded in odd numbers or even for a single or few shares. The investor has to trade in specific lot sizes for every futures contract. An exchange is responsible to fix the size of such lots and it is possible for these lot sizes to be different for one exchange to another.
- Every Futures contract has a fixed date of expiry which is on the last Thursday of every month. If this day happens to be a holiday, the contracts will expire on the previous working day at an exchange.
- A futures contract determines the duration for which the underlying security will be held by the investor. It could be one, two or three months, and their names are, near month, middle month and far month respectively. With the expiry of each futures contract, a new contract comes into effect. Every such contract undergoes issue on the next day after the expiry of the contract.
- No physical settlement of stocks occurs in the case of a futures contract.
A simple example can illustrate the effect of a futures contract
Let us assume that an investor wishes to trade in futures of ABC Ltd. Let us assume that the January futures of the stock are trading at INR 1000 for every share at present.
Accordingly, the investor makes an agreement to buy or sell the security at a price of INR 1000 on the last Thursday of January.
However, in the cash market, the price of the security may be anywhere lower or higher than INR 1000 on the date of expiry.
It is entirely dependent on the forces of the market and no single investor has any control over it. It is this difference in the price at which the agreement takes place.
The actual price of the security then accounts for profit or loss to the investor.
What are Index Futures?
An investor has the option to trade even in index futures. Unlike an ordinary futures contract which measures the change in the price of a single security, a stock index measures the overall changes in the prices of a group of stocks.
Usually, an index future comprises of stocks from similar sectors and they form one index future by clubbing together securities from the same industries.
The price movement of a certain index is proportionate to the market sentiment pertaining to that particular sector alone.
There are many popular indices such as Nifty 50 and S&P 500 which are traded hugely by the investors. Some of the prominent features of the index futures are as follows:
- Same as a future for stocks, there is a lot size applicable even in index futures. For this purpose, the points of the index are converted into monetary terms. So for example, if the exchange deems the value of each point of the index to be INR 1, and if the present point value of an index is 6000, then the value of the index in monetary terms will be INR 6000.
- Since an index future is only an abstract concept, no physical settlement of the contract is possible. Thus, an investor needs to cross out an open position with a settling position on the date of expiry to close the index future contract.
- Same as stock futures, even index futures have three openings. These are the same as one, two and three months as discussed above.
Let us take an example to understand the concept of index futures.
Let us assume that the point valuation of an index is 3550 on a given date. An investor plans to purchase a Nifty 50 future option for January.
So, the price of one such contract may be close to INR 355000. On the date of expiry, the price of the index could be higher or lower than this and may open an opportunity to make a gain for an investor.
How to start trading in a Futures Contract?
Any underlying security derives its value from the forces of demand and supply. These act in the market to determine the value of any asset, be it a stock or a commodity.
An investor needs to understand that while entering into a futures contract, they aren’t really paying for the cost of the underlying asset itself.
Instead, they will be paying the amount of difference between the cost of the asset and the agreed upon prices of the futures contract.
In the Indian context, the two major exchanges, National Stock Exchange and Bombay Stock Exchange, both provide the option to trade in futures.
Thus, an investor who is willing to trade in futures is able to place various orders in the derivatives segment of the market. They can buy a stock at a fixed price in the future, or sell the securities at prices fixed for the same.
Since the exchange offers an interface for buyers and sellers to connect, it is possible for them to enter into futures contracts with one another.
Usually, a buyer looks ahead at a bullish perspective to a contract and a seller reserves a bearish perspective.
On the last Thursday of every month, all futures contracts undergo settlement as per the original terms.
At the same time, fresh contracts undergo inception at this time. An investor is eligible to sell a futures contract that they may have bought, to other participants in the market.
As a rule of thumb, the price of a future will increase with the increase in the value of the underlying security. However, if the same falls, the value of the futures will also fall.
Every investor pays a margin to enter into a futures contract and this is why every futures contract is different from the equity in general. An investor has the option to purchase futures in lots, which are usually of definite quantities.
At the face of it, futures trading might appear simple and easy, while it is not so in reality. Since it involves dealing with derivatives, it is a complex area for an investor to understand and implement.
Since the level of leverage involved in such trades is high, there is a high risk of losing a lot of money, as much as there is a potential to make huge returns.
What are the benefits of Trading in Futures?
When it comes to trading in the futures segment, an investor stands to make two vital gains.
As opposed to the cash segment of the market, an investor need not pay the complete amount of security to purchase it in the futures segment. The investor pays only a portion of the entire value of the futures contract to initiate the trade.
This chunk of the payment is known as a margin and can vary for different stocks. As a result of this, an investor will be in a position to trade for a far greater value of futures than what they actually pay for.
For example, the margin fixed for stock trading at INR 100 is 20%. Thus, the investor will need to pay only INR 20 margin to enter into a futures trade for that stock. It is clear that there is a 5 times margin associated with such stock.
This ratio itself is the leverage of the stock. While this leverage can easily multiple the profits which an investor can make, it also opens the door to increasing losses that the investor may have to sustain.
Futures contracts offer a chance to the investor to hedge their risk against possible losses in the future.
Thus, an investor can choose to sell a futures contract at a high price as compared to the price for which they have bought equity for the same underlying security.
In this case, there must be equality between the number of futures and equity bought and sold. In this way, any fall in the prices of security can be offset by the futures contract.
Any fluctuations in the market will have little impact on the returns which the investor makes.
What are the advantages of Futures Trading?
As such, the performance of a futures contract is largely dependent on the participants of the market. Here are some vital points which highlight the advantages and risks associated with a futures contract:
- With the help of a futures contract, a hedger can transfer the risks of market movement to a speculator.
- An experienced trader can get an efficient idea about the price of a future or a stock in the days to come.
- The future demand and supply of shares can also be predicted with the help of the present prices of the future.
- The futures contract is based on margin trading so even small scale traders can get a chance to trade in the future segment. They will not need to pay the entirety of the amount of the contract but only a small margin.
- The futures contract is not without risks. An investor who does not have enough experience in this area of the market may end up in losses. The habit of over speculating can be costly for investors.
- Due to leveraging, while the scope to make profits increases, the chances of incurring heavy losses also rises.
- Lack of knowledge in this section of the market can drive many investors to flunk and enter into a state of losses.
What are the risks involved in Trading in Futures?
Due to the nature of futures contracts, there are certain risks which come with the trading in this segment:
- In any trading session, there might be wide fluctuations in the prices of the underlying security. This includes any unexpected market development, the release of any economic data or political issues could bring a haphazard change in the movement of prices of a security. Thus, the scope to incur a loss cannot be disposed of.
- Since the futures contract work on leveraging, there is an equal chance to undergo a loss as there is to make a profit.
An investor must always manage the risk associated with future trade. To ensure the safety of the capital it is pertinent to watch the movement of the investment and withdraw from it if the scales are not tipping in the favor of the investor.
To Conclude Introduction to Futures trading
Trading in a futures contract is a financial opportunity with endless possibilities. While there is a significant risk in trading in this segment, the zenith of making profits is no less.
An investor must preserve a serious outlook towards the potential risks associated with the derivatives market and then make an investment move to make rewarding returns.
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