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 is a futures contract and how it 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 futures contract.
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.
What you have done is basically entered into a futures contract with Emirates.
A futures contract is a standardised agreement to buy or sell the underlying asset at a pre-determined price on a specific date.
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 airlines increase their prices after 3 months to say Rs 40,000 you will still pay only Rs 35,000.
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.
- You expect the ticket prices to rise hence you bought the tickets in advance.
- The airline expects the ticket prices to fall hence they sold the ticket in advance to reduce their loss.
Now let’s finally get to futures contract 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 contract on Reliance Industries.
Let’s explore option 1. The cost of 1 Reliance share 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 2 – Investing in Reliance Futures. Let us see how scenario 2 would play out.
You have Rs 1 lakh for investment. 1 Reliance futures contract is available at Rs 2,186. 1 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 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 1 Reliance futures contract is Rs 64,700. You can calculate margin requirements here.
So, you buy 1 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. 1 lot of Reliance Industries contains 250 shares. So, your total profit is Rs 93,000!
This is a gain of 144% in less than 1 month!
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 a futures contract 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 75 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 going long on futures.
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 going short on futures.
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 Oct 2019, futures contracts 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.
What does physical and cash settlement mean? Let’s understand how a future contract works in reality.
Suppose you buy 1 lot of Reliance futures expiring on 25th March 2021. You bought this 1 lot at Rs 2,186. 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 grew 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.
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. 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) 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 investors interest in the stock market. It has strict mechanisms in place to ensure that neither buyer nor seller defaults on their agreement.
One such measure is 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.
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%?
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.
Infact, 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.
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