5 Things to Know About Futures Trading

We have all heard of various terms being used in the world of investing. Futures and options are among those that are frequently used.

However, while people know about the terms ‘Futures’ and ‘Options’, most don’t know enough about them and therefore consider them to be esoteric practices.

While futures and options are commonly seen together, in this blog, we will specifically go over things that one should know about before trading in futures.

To understand what futures are, let's first understand what derivatives are.

Just like one can invest in shares, bonds, mutual funds, etc., which are known as financial instruments, derivatives are also another type of financial instrument that one can invest in just like the other types of instruments.

These derivatives, as the name suggests, are instruments that derive their value from another financial product or asset which is termed as an ‘Underlying Asset’.

The underlying asset can be anything such as a currency, stock, commodity, etc.

Derivatives are broadly of 4 types:

1. Forwards                 2. Futures               3. Options               4.Swaps

Coming to futures, futures is essentially an agreement between two parties, not known to each other, for buying and selling something at a specific price and a specified time in the future. This involves one party wanting to buy that underlying asset being traded, and one wanting to sell, at the end of that period, for the decided price.

A futures contract is usually used to speculate the price of the asset being traded or hedge your positions in that asset.

 So as for this blog, we dive into futures and cover what one must keep in mind before investing in the futures market.

1. Predetermined date and price

As discussed above, the contract is based on a specific time and price which cannot be altered.

This means that if Ram and Shyam want to get into a futures contract with each other, none of them can carry the position beyond the expiry date of the contract at their convenience. The expiry date of the futures contract in case of stock futures is the last Thursday of the month.

Let’s say Ram is making a profit at the end of one week while the contract duration is a month, Ram can decide to square off the contract at that time with other users on the stock exchange while Shyam can carry his position till expiry.

2. Expiry period

Remember the duration of the contract we spoke about? That’s also called the expiration period of a contract. The contract ends as per the duration of the contract.

With respect to the timeline considered in futures trading, there are 3 terms used, ‘Near’, ‘Next (or ‘Mid’), and ‘Far’.

These refer to the 3 months from the present. The ‘Near’ month is the present month, the ‘Next’ month is…..well, the next month, and the ‘Far’ month is the one after that.

3. Obligation not a right

In a futures contract, the contract between the two parties is agreed upon mutually. This makes it a legal agreement between the two parties. This means that if Ram and Shyam enter a futures contract, and Shyam realizes that he stands to lose money at the end of the decided period, he will have to pay the difference (i.e. the money he lost) and cannot get out of the transaction.

Therefore, it is wise to study your decision before entering into a futures contract since the contract is an obligation, and not a right.

4. Buying happens in lots and not in terms of the number of shares

The contracts are not as per a loose count of the entity. It’s not like shares in the market of which we can even buy just one share of an individual company. Futures contracts take place for what we call ‘lots’. And yes, sometimes a ‘lot’ is a lot. These lots consist of a predetermined quantity of that entity being traded. Therefore, one must consider the size of the lot and lot value (Lot size X Price) and analyze the financials as well as the risk-taking capacity based on the lot value as well. Lot value of a futures contract for stock or index futures is a minimum of Rs. 5 lakh.

5. Cash-based vs Delivery based settlement

So what happens at the end of the contract duration and in between the contract period?

To avoid any default risk, both parties need to deposit a certain margin with the stock exchange. In addition, both parties also need to settle their profit and losses daily, known as Mark to Market (MTM) settlement.

In a cash-based settlement, at the end of the contract period, both parties settle the difference in cash, with one party losing money and one gaining. That difference in money is debited from one party and credited to the other.

Whereas in a delivery-based settlement, let’s say Shyam has a buy position and he does not square off his position, he will have to take delivery of the decided quantity of the underlying shares, i.e. agreed quantity of shares will actually be transferred to his demat account post which he will have to sell it in the open market if he wishes to encash.

In the case of Index futures like Nifty futures, delivery based settlement is not allowed.

 Key Takeaways:

1. Futures contracts are binding in nature once agreed upon. You are obliged to pay the losses, if any, once you enter into a contract. Similarly, in case of gain, you are entitled to receive the profit from the other party.
2. Futures contracts are only available for periods of 1 month, 2 months and 3 months.
3. To avoid any default risk, both parties need to deposit a certain margin with a stock exchange and need to settle their daily profit and losses.