Futures contract & How does futures trading works

Introduction

Organised Futures trade can be traced back to the Dojima Rice Exchange in the 18th century Japan and the London Metal and Markets Exchange founded in 1877. Fast forward a hundred years, and in the 1970s, the trade in Derivatives such as Futures exploded in its volume exponentially. In India, F&O trade resembles the most popular trade in Derivatives. That makes it essential for traders to know everything about this growing sector of the global financial market.

Features of Futures contracts

Before exploring how Futures trade works, we must clarify the fundamental aspects of Futures contracts:

• Futures contracts are standardised and regulated by a recognised agency. In India, the trade in Futures is regulated by the Forward Markets Commission.
• Futures can have any class of underlying assets such as commodities, equities, currencies etc.
• Futures contracts clearly state the expiration date, the settlement method, the quantity and quality of assets to be delivered and the currency in which the payment is made.
• Futures are settled with a central counterparty (CCP).

How does the trade in Futures work?

• Futures work by price determination of the future price of underlying assets, which traders then use to make considered trade decisions.
• Futures allow traders with less capital to participate in higher value trades since they require only an initial margin deposit.
• The trade in Futures involves margin trading. Since Futures require margin deposits, they are subject to margin fluctuations. A trader can use accurate predictions of these fluctuations to gain higher profits than is possible with just the deposit.
• A trader can buy Futures contracts, assuming a long position, when they are feeling bullish, and they believe the price of underlying assets will go up.
• Speculative traders sell Futures contracts when they believe the price of underlying assets will go down.
• If a trader faces loss from one transaction, they can negate it with profits from another transaction. That is known as assuming an offset position.
• The resulting difference from both ends of Futures contracts is calculated and settled, usually with cash.

Advantages of Futures trade

• Traders of Futures can participate in higher-value markets than otherwise possible due to the requirement of only a margin deposit, keeping the underlying asset secret for now.
• Futures trade represents high liquidity which mitigates price fluctuations and allows traders opportunities for profit for now.
• Traders are required to pay little while signing the contract.
• Futures are clear and concise, avoiding confusion.

Disadvantages of Futures

• Futures traders are vulnerable due to the exact nature of the trade. While futures provide probability of something happening, their accuracy depends on various factors that affect them.
• High leverages make Futures vulnerable to price fluctuations.
• Due to the limited term of Futures contracts, the value of the underlying assets can be lower significantly. This can result in complete financial loss.

Conclusion

Trading in Futures requires an in-depth knowledge of finance and a sound mind for gauging probabilities. F&O trade has come to represent the largest segment of Derivatives trade in India. As such, traders interested in benefiting from this growing segment need to consider Futures and weigh them against their interests carefully. Only a cautious and methodical trader might be able to achieve significant profit from the trade in Futures.