Understanding Futures Contract and their importance: The Futures and Forward Contracts are a financial instrument that derives their value from the value of the underlying asset. Basically, the futures contract are contracts between buyers and sellers, where the buyer agrees to buy a fixed number of shares from the sellers, at a specified time in the future and at a pre-determined price. The futures contract derive their value directly from the value of the underlying asset. Moreover, they are one of the highest traded derivative instruments in the world.
In this article, we are going to discuss futures contract in detail including the importance of these contracts and how to trade in futures contract in India. Let’s get started.
Difference between Futures contract and Forward contract
There are two major points of difference between Futures and Forward contract. Firstly, futures are a legally binding contract to buy or sell the underlying asset or a specific date. Secondly, the futures contract are done via Futures exchange i.e., they are regulated.
A standardized contract specifies the time, quantity, value, quality, time, and location of the underlying asset. The product can be a commodity, currency, stocks, index, etc. The standardization of contract sets the same rules, specification of contract for all the participants. And because of the standardization, the ownership of the contract can be passed to any other trade by way of a trade.
As the Futures contracts are exchange-traded, it guarantees the parties involved that the contract will be honored. All the futures contracts are centrally cleared via exchanges thus eliminating the counterpart risk.
How are Futures contract traded in India?
In India, the futures contract are mainly traded in two forms – Stock Futures and the Index Futures.
— Index Futures
The index is the grouping of stocks. It simply measures the change in the prices of group stocks over time. Say, for instance, Bank Nifty represents the top 12 banks in the Indian Banking system. These banks are from both the public and private sectors. And any movement in the share price of these banks directly impacts the index. Future contracts are also available for these indexes. They directly derive their value from the value of the index. The following are some of the characteristics or traits of these indexes:
- Size of the contract: Each and every contract in the futures contract have a specified fixed size. Anyone willing to trade will have to buy the full contract or multiples of it. Say, for instance, if I am trading Nifty 50 Index, then each lot has 75 shares in it. And in the Bank Nifty, each future lot has 25 shares in it. These are the two most actively traded Index futures in the Indian equity market.
- Expiry: Each and every index futures have a specified date of expiry. All the Index futures are settled on the last trading Thursday of the month. If the last Thursday is a holiday, then the expiry happens on the previous working day. Since the index are the culmination of various stocks, hence there is no physical delivery of the shares on the index. Only the cash differential is to be paid.
- Time frame: The Index futures have three contracts running simultaneously all the time i.e., the near month (1-month), the middle month (2-month), and the far month (3-month). As and when the near month contract expires, a new far month contract is added to the series.
- Margin Required: The margin required to trade the futures contract is comparatively high, as the position are exposed to market to market (M2M) risk and the brokers and exchanges will have to safeguard their interest in case the index becomes very volatile on a particular day.
— Stock Futures
The basic premise of trading stock futures is very similar to Index futures. Stock futures are the derivative instruments, that derives their value from the value of the underlying security/stock. The contracts have a specific size, fixed price, and specified date. Once the contract is entered, it will have to be honored. Following are some of the characteristics of Stock futures:
- The size of the contract: All the stocks trading in the futures market, have a different number of shares in each lot. We can’t trade just one share to trade futures. A minimum of one lot has to be traded. For example, one lot of futures contract of Reliance industries has 505 shares, one lot of Maruti has 100 shares, one lot of ICICI bank has 1375 shares etc.
- Expiry: All the stock futures contract have a fixed maturity. They expire on the last trading Thursday of the month. And if the last Thursday is a holiday, then they expire on the previous trading day. The stocks have three expiring contracts – near month (1-month), middle month (2-month), and far month (3-month).
- Margin: The margin required to trade stock futures contract is very high to cover for Mark to Market (M2M) losses. This is basically done to protect the interest brokers and the exchange.
How Are Futures contract Priced?
Futures contract derive their value from the value of the underlying assets. There is always a variation/difference in the prices of the cash segment and derivatives segment. There are basically two methods of pricing the futures contract: The Cost of Carry Method & The Expectancy Method.
— The Cost Of Carry Model
Under this method, the market is assumed to be perfectly efficient. There is no difference in the value of cash market and futures contract. So, the profit made by trading the cash segment or futures segment is same, as the movement in the prices are aligned. Following is the process of calculating the prices under the Cost of Carry model
Futures Price = Cash Price + Cost of Carry
The cost of carry here refers to the cost of holding the futures contract till maturity.
— The Expectancy Method
Under this method, the futures prices are the expected cash price of the underlying asset in the Future. So, if the market is positive/conducive for the underlying asset, then the futures price will be higher than the cash price. And if the market has a weak sentiment towards the underlying asset, then the futures price will be lower than the underlying asset.
Advantages of Trading Futures contract
Here are a few of the major advantages while trading in the futures contract:
- Futures contract are one of the safest mode to hedge one’s exiting position in the market i.e., if I am long in shares of a particular company, I can hedge my position by taking short in futures contract of the same underlying Asset
- The futures contract are high leverage instruments i.e., to trade futures contract we have to pay only a fraction of the total value. In general, the margin amount is just 10% if total value. This margin money acts as a collateral, in case the value of the underlying asset goes opposite to the views of the investor and he incurs losses. Say, if one futures lot of XYZ company has 1000 shares. And if the price of one share is Rs.100. So, if one were to buy 1000 shares, then the total value to be invested will be Rs. 100000 (1000*100). But, to trade futures contract, one has to keep only Rs. 10000 (10% of total value) as margin.
- Because the futures contract are regulated by exchange, liquidity is never a factor while trading futures contract. One can exit their position anytime from the market.
- Because of the low margin requirement, small players and speculators get to be a part of bigger game
- Short selling becomes very easy while trading Futures contract. And one can legally short position in the shares of the company, by shorting futures contract.
- The buying or selling pressure in on particular underlying asset can help us to gauge the future demand and supply of the shares
In this article, we tried to cover what are futures contract, how they differ from forward contracts, how are futures contract traded in India, and the advantages of trading futures contracts. Here are a few of the key points to remember from this post.
- Futures contract derive their value from the value of the underlying assets.
- Because of the low margin requirement, the futures trading is very popular amongst traders
- The futures contract are exchange regulated, there is never the question of trust amongst the traders
- One can exit their existing futures contract position anytime from the market by taking an opposite position in the futures market.
- It is also a very popular hedging instrument for already existing long position in the cash market
- The Index futures are cash-settled
- There are two methods of calculating the futures contract value – The cost of carry method or the Expectancy method
That’s all for this post. I hope this article on what are futures contract is useful to you. If you’ve got any queries related to this concept, feel free to ask below in the comment section. I’ll be happy to help. Happy trading and investing.
Hitesh Singhi is an active derivative trader with over +10 years of experience of trading in Futures and Options in Indian Equity market and International energy products like Brent Crude, WTI Crude, RBOB, Gasoline etc. He has traded on BSE, NSE, ICE Exchange & NYMEX Exchange. By qualification, Hitesh has a graduate degree in Business Management and an MBA in Finance. Connect with Hitesh over Twitter here!