Futures Contract – How do they Work
We see a lot of dare-devil stunts shown on TV with a warning for users “Do not try this at home”. A few stunts are impossible or very difficult to perform, while a few could be attempted provided you have the right training, skill and guidance. Futures Contract, quite simply, is an agreement to buy or sell an asset at a future date at an agreed-upon price. They are standardized agreements that typically trade on an exchange.
Now if we extend the same example to financial markets the word “derivatives” or “futures and options” are seen as the most dangerous financial instruments in the planet. Yes, it is true that these instruments carry high risk and are difficult to comprehend.
However, if a normal investor or trader acquires some education and experience with these instruments, they can derive benefit from these and mitigate some risks as well.
Before we go further I would strongly recommend you to make sure you understand the basic workings of stock markets.
Disclaimer: This article is only for knowledge purposes. Readers are requested to take professional advice or training before operating in the derivatives market.
Decoding ‘Derivatives’ and ‘Futures’ Contracts
A derivative is an instrument which derives its value from its underlying asset. The underlying asset can be a stock, gold, crude oil, etc. Futures and options contracts are some of the common examples of derivatives, which enable traders/investors to take a longer term trading view for 1-3 month or more.
A futures contract is an agreement between two people to buy or sell an asset at a certain time in the future at a certain price. These contracts are processed within the framework of a stock exchange like NSE, BSE, etc.
Key Features of a Futures Contract
- Spot Price: Current Price of the share in the market.
- Futures Price: The Futures price of the respective futures contract (generally there are contracts month-wise for the next 3 months).
- Market Lot: Minimum trading quantity or multiple (changes per the stock or instrument).
- Contract: Assuming current date to be July 9, 2012, there would be 3 contracts to choose from which are July, August and September, respectively. These contracts expire on last Thursday of respective month. This means you can trade with a time horizon of up to 3 months.
Without going in to technicalities lets take an example keeping above points in mind.
Example: On 9th July 2012, there are two people Surya and Chandra who are trading or taking a view on Infosys Tech stock, which is announcing its results in July 2012. Surya is bullish on the stock and expects good results while Chandra is bearish. Since their time horizon is a month away they plan to use futures market to trade/speculate.
Infosys is currently trading at Rs.2436 (spot price) and its futures price (July contract) is at Rs.2439. The contract is valid till 26th July 2012. Trading lot for Infosys Tech is 125 shares so each contract is a multiple of 125 shares.
Surya buys (goes long) on Infosys Tech at Rs.2439 and expects it to reach close to surpass Rs.2,500 after announcement of results.
Chandra sells (goes short) Infosys Tech at Rs.2439 (same price) and expects the stock to fall significantly given the issues in US and Euro economies and markets.
How is this different from buying or trading a share?
In case of futures contracts you don’t have to buy the underlying shares or take delivery (in to your demat account) as in the case of normal trading. The benefits can be summarized as below:-
|Strategy||Normal Trading||Futures Contract|
|Long Trade||For trading beyond a day you have to take delivery and bear the associated charges||No delivery required. Trade gets nullified on expiry of contract|
|Short Trade (short selling)||Can be used for taking a position within a day only||Can be used for longer periods like 1-3 months (This does not require physical delivery)|
The brokerage and holding charges as well as delivery charges will make a buy and hold strategy significantly expensive than a long futures trade. This is one of the reasons why some individuals opt for futures contract instead of buying or selling the stock directly.
Profit or Loss
Taking the earlier example forward lets assume that on expiry (i.e. July 26 2012) the futures price settles at Rs.2489 (settlement price). What will Surya and Chandra gain or lose?
In simple terms Surya gains Rs.50 a share while Chandra loses Rs.50/share since he took an opposite view.
We can elaborate Surya’s and Chandra’s positions are as follows.
Surya = Profit of Rs.6250 (Rs.50/share X 125)
Chandra = Loss of Rs.6250 (-Rs.50/share X 125)
Futures trading is not different from regular share trading if one understands the underlying trading principles and its practical dynamics.
What if Infosys Stock fell to Rs.2399 ?: In this case Surya makes a loss of Rs.40/share (Rs.2439-2399) or Rs.5000 loss in total. We are not considering brokerage or transaction costs here.
Advantages of Futures Contract (compared to spot trading)
- Ability to take a trading call without holding the stock.
- Flexibility to trade long or short for a longer horizon up to 3 months (or more in certain cases.)
- Leverage (Margins): This is a kind of double edged sword. You can pay a small % (say 20%) of the value of stock traded as margin to trade, which involves relatively lesser capital. The example above involving trading 125 shares of Infosys would involve significant capital.
- Brokerage Costs: This works out cheaper considering the high value of contract or position.
- Leverage: You can lose a significant amount of capital if your position starts making losses.
- Margins: In case of losses you will be called upon to arrange additional funds for meeting the margin requirement.
There is a potential for high risks and returns in derivatives, however one can minimize risk by using stop loss or careful monitoring of positions. Further, one has to budget for higher funds for meeting margin requirements, which will change based on the position’s profits or losses.
Conclusion – Futures Contract
So far we have just looked at using futures for mere trading or speculation to start with. Interestingly investors can also use futures for hedging, that is for minimizing their downside in their portfolio by taking opposite position in futures market.
We will discuss this and more interesting strategies in the next article in the derivatives series. I welcome you to share any feedback, queries or comments, if any.