What is future trading?
Futures contracts are financial derivatives, meaning their value is derived from the underlying asset. The underlying asset may be anything from stocks to bonds to commodities. They are agreements between two parties in which one party commits to acquiring a specified number of shares from the other at a specified price in the future.
These contracts are traded on exchanges because their expiry dates and contract sizes are standardized. The stock market regulates every contract that is entered upon. At the end of the contract term, both the buyer and the seller must complete what they have committed in the contract.
If you understand how to trade futures, you can earn a lot of money. First, you need to understand what a futures contract is and how it works.
How does futures trading work?
Every futures contract is made up of the following things:
- A previously agreed-upon fixed price
- A date specified in advance
- The buyer and seller are the two parties involved.
When you enter into a futures contract, you agree to purchase or sell the underlying securities at a future date.
- If you purchase the contract, you agree to pay the agreed-upon price within a given time frame. Due to your expectation that underlying asset values will grow, you pre-purchased the asset.
- If you sell it, you must ensure that it is transferred to the buyer at a predetermined price in the future after the sale. You anticipate that underlying asset values would decrease; therefore, you sold the asset ahead of time to minimize your loss.
Interesting Fact:
The BSE and NSE launched futures trading services on the Sensex and Nifty 50 indexes, respectively, in the year 2000. Nowadays, there are many stock specific futures contracts and sector-specific index futures available on both BSE and NSE.
Basics of Indian Futures Contracts
- Lot Size: When you invest in futures, you're usually purchasing stocks in bulk. For instance, Reliance has a lot size of 250. Here's an example of a transaction. Buying one futures contract for Reliance is equivalent to purchasing 250 shares of Reliance stock in the short term. It means that a one rupee fluctuation in Reliance will result in a gain or loss of Rs.250
- Expiration Date: Each futures contract has a predetermined expiration date. In India, all futures contracts have an expiration date on the last Thursday of each month. If the final Thursday of the month is a holiday, the contract will end on Wednesday.
- Underlying Price: The cash market share price of Reliance is the underlying asset in Reliance futures contracts. Futures prices should be moving in the same direction as the assets they represent.
- Margin: You must deposit a certain percentage of the entire contract value as margin money before you can begin trading in futures contracts. Trading stock futures contracts require a high margin to cover losses due to Mark to Market (M2M) losses. In addition to the protection of brokerage and exchange interests, this serves to shield others as well.
For example: When you purchase Nifty futures at a price of 17,300 and the Nifty falls to Rs.17,200, you incur a loss, which is your risk. Markets are inherently volatile, and these margins are therefore collected to offset the risk associated with this volatility.
Important note:
To comply with the SEBI circular of November 19, 2019, brokers will not be able to offer more than pre-set margin in any segment, including intra-day trading on the BSE, NSE, or MCX after September 1, 2021. The exchange now determines the margin, and it's the same for all brokers going forward.
Margin in the futures markets is mainly classified into two types:
a) Initial margin
The term 'initial margin' refers to the amount that a trader must deposit in order to enter a transaction. In the event that a loss occurs on that particular day, this sum is intended to compensate for the possibility of loss. Margin calculations are performed using software called SPAN® (Standard Portfolio Analysis of Risk), which use a scenario-based method to arrive at margins. Initial margin is applied to derivatives contracts in accordance with the procedures determined to be viable by the exchange.
VAR (Value at Risk) Margin
In order to calculate the SPAN margin, a statistical concept known as VAR (Value at Risk) is used. The Value at Risk (VaR) is a margin designed to cover the biggest loss that can occur on 99% of the days (99% Value at Risk). In practice, this entails that your initial margin should be big enough to cover the losses of your position in 99% of situations.
b) Maintenance/Exposure margin.
The exposure margin is collected along with the initial margin. Every trader's margin account is updated after each session to reflect their profit or loss. If a trader makes a profit, the funds are added to his or her account; however, if a trader makes a loss and the account falls below the original margin, the account must have enough money to take the loss.
- Contract Value: The cash market share price of Reliance is the underlying asset in Reliance futures contracts. Futures prices should be moving in the same direction as the assets they represent.
- Futures contract settlement: All futures contracts have an expiry date and must be settled. Buying a futures contract requires selling it before or on expiration.
There are two ways for settling future contracts:
Mark to Market (MTM) Settlement on a daily basis
At the end of each day, the profits/losses are computed based on that day's trade. This implies that the contract's value has been marked to reflect the current market price. MTM margin from the loss-bearing party will be collected by the broker and paid to the eligible gain party.
Final Settlement after expiry
When futures contracts expire, the exchange adjusts all open positions to the final settlement price, and the resulting profit or loss is settled in cash.
Example: If an investor purchases one lot (250 shares) of Reliance Futures on September 14th, when the price was Rs 2450, he must provide a margin of 22% of the lot value, which equaled Rs 1,34,750 (22%*250*2450). if the Futures prices close at Rs 2480 on September 15th, the investor would have profited by 7500 rupees (Rs 30 times 250). On account of mark to market settlement, this gain would be credited to his account and debited from the seller's account. Trading will resume the next day at Rs 2580.
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What are the advantages of futures trading?
- Perhaps the most significant reason futures trading is so popular is because of the critical benefits leverage brings. Unlike stock, buying futures does not need complete payment. Depending on the value of the contract, you must make a small deposit to either buy or sell in the futures market.
- Since the futures market and contracts are highly regulated, there is no danger of non-compliance, and all contracts are settled at expiration.
- You may get started trading futures with a smaller amount of cash. Just as shown in the preceding example, you would need to invest Rs. 612500 to trade in 250 shares of individual stocks, but you would need Rs.134750 to purchase one lot of Reliance futures (which would include 250 shares). Additionally, you will benefit from greater returns on your investment.
- When trading futures, liquidity is never an issue because many participants are eager to trade futures or hedge their current positions in the market at any given time.
- Futures contracts assist in hedging by protecting the trader's position from future price fluctuations. To make his costs and profits more predictable, a trader uses futures contracts to lock in a future price for an asset. In other words, he uses futures to hedge his business's exposure to risk. Traders typically participate in the futures market in order to lock in a better price ahead of a transaction.
What You Should Know About Trading Futures Before You Start
Even if you have an outstanding track record as a stock trader, futures can be riskier and can easily see you losing your money. Here are some pointers gleaned from long-time futures traders, brokers, and educators if you decide to go forward with your plans.
- Futures are usually more leveraged than stocks, so you stand to lose more money if you trade in futures. Always be cautious while using leverage.
- Don't confuse futures trading with traditional investment. Futures are more about trading or speculating in the short term. When you purchase a futures contract, you buy a financial instrument that has an expiration date and may compel you to sell due to short-term losses. On the other hand, stocks and mutual funds can be held for years before you decide to sell.
- No strategy is effective indefinitely since the market is constantly evolving. The same goes for you: you must grow and educate yourself regularly as well. Keep learning, and knowledge is readily available from everywhere. Ensure that you are obtaining information from a trustworthy source if you are online.
- If you can't afford to lose money, don't trade with it. The essence of futures trading is that you can start with a small amount of money and use leverage to transform it into a lot more money. Prepare yourself to lose everything. Be extremely cautious when trading with money you don't have or want to risk losing.
Summary:
To profit from derivative trading, detailed awareness of stock markets, underlying assets, and issuing entities, among other things, must be maintained. Futures provide several advantages that appeal to a broad range of investors. Even for small market moves, highly leveraged positions and big contract sizes expose the investor to significant losses. To be successful in futures trading, one must conduct careful research and planning beforehand and be aware of the possible dangers.
