What are Futures? – Meaning of Futures
Futures are a type of derivatives. What are derivatives? Derivatives are weapons of mass destruction! These are not our words. These words belong to the world’s greatest investor – Mr Warren Buffett.
But we would like to respectfully disagree. Futures can be a real money maker provided you know how to trade them. And the first step in trading futures is to understand exactly what are futures and how a futures contract works.
But before understanding what are futures, we need to take a small detour and first understand what are derivatives. Because futures are after all a type of derivative.
Derivatives are financial contracts which derive their value from the value of the underlying asset.
Let’s take the typical example of milk and curd. Curd is made from milk. So, if the price of milk rises, the price of curd will also increase. This means that curd has no value of its own. It ‘derives’ its value from the value of the underlying asset ‘milk’.
- If price of underlying asset increases – the price of derivative will also increase.
- If price of underlying asset decreases – the price of derivative will also decrease.
There are 4 types of Derivatives Contracts in India
Now that you understand derivatives, let take another example to understand what are futures.
Suppose you plan to travel to Dubai after 3 months. The flight cost today is Rs 35,000. Now we all know that booking in advance is always better. So, you book a ticket today with Emirates to fly for Dubai after 3 months. This transaction between you and the airlines is like a futures contract.
Watch this video to know everything about Futures Contract in India
What are Futures? – Example of Futures
Futures is a standardised agreement to buy or sell the underlying asset at a pre-determined price on a specific date. The underlying asset can be a stock, currency, commodities or an index.
In the above example: You have already decided that you will pay Rs 35,000 for a Dubai ticket. This is your pre-determined price. Even if the airfare increases after 3 months to say Rs 40,000 you will still pay only Rs 35,000. Similarly, even your date of travel is already decided in advance. This is your specific date. Both you and the airlines are bound by an agreement. You have to pay them Rs 35,000 and they have to reserve a seat for you on a specific date.
So, every futures contract has the following:
- A pre-determined price
- A pre-determined date
- 2 parties – the buyer and the seller.
An important point to note here is that both the buyer and the seller will have different views on the underlying asset. In the above example, you expect the ticket prices to rise, hence you bought the tickets in advance. While the airline expects the ticket prices to fall hence they sold the ticket in advance to reduce their loss.
Let us now use this example to understand what are futures in the stock markets.
Suppose you expect the stock prices of Reliance Industries to increase in the coming months. And you want to make money from this opportunity. You have two options –
- Buy shares of Reliance Industries from the spot market.
- Buy futures or options with Reliance Industries as the underlying.
Let’s explore the first option. Suppose the market price of one share of Reliance Industries is Rs 2,000. You want to buy 100 shares. The cost of 100 shares will be Rs 2 Lakhs!
But you only have Rs 1 Lakh. So, you end up buying 50 shares. As expected, the price of Reliance Industries rises to Rs 2,500 after 3 weeks. You sell your 50 shares and book a profit of Rs 25,000. You made 25% returns in just 3 weeks! You are on top of the world! But could you have made more profit?
The answer is Yes. You could have made much higher profits if you had explored option two – Investing in Reliance Futures. Let us see how scenario two would play out.
You have Rs 1 lakh for investment. Let’s assume that one Reliance futures contract is available at Rs 2,186. One Reliance futures contract contains 250 shares. So, the total value of the contract is Rs 5,46,500. The good news is that you do not have to pay the entire Rs 5,46,500 to buy a Reliance futures contract. You simply need to pay an initial margin. We will learn more about this later.
For now, assume that the initial margin required to carry one Reliance futures contract is Rs 64,700. You can calculate margin requirements here.
So, you buy one Reliance futures contract for Rs 64,700. As expected, the share price of Reliance Industries rises from Rs 2,000 to Rs 2,500 in the spot market. Remember I told you that if the price of underlying asset increases, even the price of the derivative will increase.
So, the price of your futures contract increases from Rs 2,186 to Rs 2,558 after 3 weeks. Now you decide to sell your contract before expiry. Your buying price is Rs 2,186 and your selling price is Rs 2,558. So, you made Rs 372 per share. Since, one lot of Reliance Industries contains 250 shares, your total profit is Rs 93,000!
This is a gain of 144% in less than 1 month!
Now you do not have to be a financial genius to know that 144% gain is better than 25% gain! So, here’s what you got by trading Reliance futures instead of buying from the spot market:
- Superior returns – 144% vs 25%
- Access to better volumes – In the spot market you could buy only 50 shares. But in the futures contract, you bought 250 shares!
- Lower Capital – In spot market you invested Rs 1 Lakh, whereas in the futures market you invested only Rs 64,700.
Before you get too excited and start futures trading, here are the 10 basics of futures that you must know.
Basics of Futures Contract in India
1. Lot Size: Lot size is similar to buying milk from the market. There are standard lots. You can buy milk in 250 ml, 500 ml and 1 litre quantities. You cannot ask the shop keeper to give you half a glass of milk! Similarly, futures contracts also have lot sizes.
- The lot size of Reliance Industries futures is 250 shares.
- The lot size of State Bank of India is 3000 shares.
- The lot size of Nifty Futures is 50 shares.
2. Futures Price: This is your buying price per share. The price of a futures contract tracks the price of the underlying asset (in our case stocks) and is generally higher. For example:
- The price of 1 futures contract of Reliance Industries is Rs 2,186
- The price of 1 futures contract of State Bank of India is Rs 386.75
3. Contract Value: Contract value is the actual value of your position. It is calculated by multiplying the lot size by the price of the futures contract.
- The contract size of 1 Reliance Futures contract is Rs 5,46,500 (Rs 2,186*250)
- The contract size of 1 State Bank of India futures contract is Rs 11,60,250 (Rs 386.75*3,000)
4. Expiry Date: Every futures contract comes with a fixed expiry date. All futures contracts expire on the last Thursday of the month. In case the last Thursday is a holiday, the contract will expire on Wednesday.
At any given point of time, there are 3 futures contracts available for trading. In the below snapshot –
- Futures contract expiring on 25th March 2021 – Current Month
- Futures contract expiring on 29th April 2021 – Next Month
- Futures contract expiring on 27th May 2021 – Far Month
5. Underlying Price: This is the price of the underlying asset. In case of Reliance futures, the underlying asset is the share price of Reliance in the cash market. The futures prices will ideally move in the same direction as the underlying prices.
6. Buyer of a futures contract: The person who buys the futures contract is known as the buyer of the futures contract. Buyers have a bullish view on the stock. This means that the buyer expects the price to increase in the future. Hence, he is buying it at a lower price today itself. When you buy a futures contract, you are said to be long on a stock..
7. Seller of a futures contract: The person who sells the futures contract is known as the seller of a futures contract. He has a bearish view on the stock. His aim is to lock-in the sell price today itself so that a fall in the future will not cause him a loss. When you sell a futures contract, you are said to be short on a stock.
8. Settlement of a futures contract: Majority of futures contracts in India are cash settled before expiry. What does this mean? All futures contracts come with an expiry date. So, you have to settle them. This means that if you bought a futures contract, you will have to sell it before or on expiry. Similarly, if you sold a futures contract, you will have to buy it back on expiry.
Prior to October 2019, futures in India were cash-settled. But since then, if you do not settle your position before expiry, then you will have to settle your transaction physically. But what does physical and cash settlement mean in futures? Let’s understand how a future contract works with this example.
How Do Futures Work? – Workings of a Futures Contract
Suppose you buy one lot of Reliance futures expiring on 25th March 2021. Your cost price is Rs 2,186 per lot. Your contract value is Rs 5,46,500. You are the buyer so you expect the share price of Reliance Industries to increase. Since you are the buyer, there definitely must be a seller who sold you the futures contract.
So, the seller’s position will be also be worth Rs 5,46,500. You have till 25th March 2021 to square-off (close) your position. On 20th March 2021, the value of your Reliance futures contract increases from Rs 2,186 to Rs 2,500.
So, you have made a profit of Rs 93,000. Your profit is the seller’s loss. So, the seller makes a loss of Rs 93,000. This is why futures are known to be a zero-sum game.
By selling your futures contract, you have squared-off or closed your buy position. The exchange will debit the sellers trading account by Rs 93,000 and credit your trading account with Rs 93,000. This is known as cash-settlement. Here only the difference amount is credited or debited to buyers and sellers trading account. But cash settlements can be done only if you square-off your positions before expiry.
Let us assume that did not sell your futures contract till 25th March 2021. In that case, you will actually have to take delivery of 250 shares and the seller will have to make delivery of the 250 shares. This is known as physical settlement. This happens only if you DO NOT square off your position before expiry.
9. Open Interest: Open interest or OI, shows the number of open contracts or position on a given date. A high open interest shows high liquidity.
- Open Interest increases when new contracts are added
- Open Interest decreases when contracts are settled / squared-off.
A very high Open Interest may indicate an over-leveraged market.
10. Change in Open Interest: This shows the daily change that has taken place in the futures contract. A positive change in OI along with increase in price shows that more contracts have been added and that people are going long (buying) on the futures contract.
Let us now try to spot all these basic parameters in the below image.
Now that you understand what are futures and how they work, the next question you might have is, ‘Are futures Safe?’ ‘Why are they known as weapons of mass destructions?
The futures market in India is highly regulated by Securities and Exchange Board of India (SEBI). SEBI works to protect investor’s interest in the stock market. It has put strict mechanisms in place to ensure that neither buyer nor seller defaults on their agreement. One such measure is by keeping the exchange as the counterparty. In a forwards contract, either the buyer or the seller could back out from honouring their promise if the price moves against their expectations.
But this is not possible in a futures contract. The exchange ensures that both the buyer and the seller honour their contract by acting as a counterparty. So, the buyer is buying from the exchange and the seller is selling to the exchange. The exchange then takes money from the buyer and gives it to the seller.
In case the buyer fails to pay the required amount, the exchange will pay the seller instead and recover the money from the buyer. So, there is no scope of counterparty default in case of a futures contract.
Another important point to note is that the futures market is quite popular in India and has very high liquidity. Here is the trend of futures markets in India over the last 20 years.
So, there you go, futures contracts are highly regulated and enjoy high liquidity. And the main benefit of a futures contract is that you get to earn superior returns. Remember how you earned 144% instead of 25%?
While the possibility of high returns is one of the biggest advantages of futures, it’s not the only advantage. Let us look at the best advantages of Futures.
Advantages of Futures
- Leverage: This is one of the biggest advantages of a futures contract. When you buy equity shares in the spot market, you have to pay the entire contract value upfront. This is not the case with futures as you can take exposure to positions by paying just the initial margin. As we saw in the previous example, you could take positions worth Rs 5,46,500 with an initial capital of Rs 64,700 only. This helps trader’s access huge positions with limited capital.
[Read More: How Leverage Works in Trading]
- Higher Returns with Limited Capital: The by-product of high leverage is that investors get the opportunity to earn higher returns. Since investors can access higher positions, they can earn superior profits compared to the spot market. In the previous example, the profit in the cash market was 25% whereas futures profit was a whopping 144%. Hence, higher returns due to high leverage is the second biggest advantage of futures.
- Hedging of Risk: Futures is not only for speculators or arbitrageurs. Futures are actively used by hedgers to hedge their spot market positions. Suppose an investor holds 250 shares of Reliance Industries in the spot market. However he is worried that the stock might fall in the short-term. To hedge against this, he can sell futures contract on Reliance to hedge this spot market position.
- Short-Selling Opportunities: When you short-sell in the spot market, you have to cover your position within the same trading day. Due to this, investors are forced to square-off even if they are facing a loss. However, this is not the case with futures. In futures, you do not have to square-off your position in the same day. You can hold your futures contract till expiry. So, investors have ample time to cover their short selling positions.
But as lucrative as they might be, futures do carry substantial risk. Imagine if instead of rising, the share price of Reliance Industries falls? What happens then? There is a high chance that your 144% profit can turn into 144% loss!
But don’t be discouraged. As long as you follow sound risk management policies including a strict stop-loss, futures trading is a lucrative investment option.
In fact, we’d remark that ‘futures are weapons of mass wealth creation!’ And this weapon is free for everyone. So, start your futures trading journey with the best broker in India – Samco.
Open a FREE Samco Demat and trading account and get access to high leverage, a superior trading platform and lots of FREE futures trading tips from experts.Open a FREE Samco Demat and Trading account today! The account opening is 100% online and takes just 5 minutes. So, use the weapon of mass wealth creation and brighten your future in the stock market!