What is Futures Trading?
The goal of this post is to explain the basic idea underlying a futures trading or futures contract by means of an example. Market derivatives like Stock Market futures and Options have the reputation of being 'hard to understand' although the underlying idea of futures trading is not that hard as it seem and is best understood by studying an example.
1. Stock Futures Contract.
2. Index Futures Contract (like Dow Futures, Nifty Futures, Sensex Futures, etc.)
3. Commodity Futures (like Gold Futures, Crude Oil Futures, etc.)
Although it looks like '3 types' the underlying principles and ideas behind trading any of the above futures contract is the same. Let me try to explain futures trading with the help of an example.
Futures Trading: Example of a Futures Contract:
Suppose the current price of Tata Steel is Rs. 200 per stock. You are interested in buying 500 shares of Tata Steel. You find someone, say John, who has 500 shares you tell John that you will buy 500 shares at Rs. 200, but not now, at a later point of time, say on the last thursday of this month. This agreed date will be called the expiry date of your agreement or contract. John more or less agrees but the following points come up in your agreement.
1. John will have to go through the hassle of keeping the shares with him until the end of this month. Moreover, the economy is doing well, so it is likely that the price of the stock at the end of the month will be not Rs. 200, but something more. So he says lets strike a deal not at the current price of Rs 200 but Rs. 202/-. The agreed price of the deal will be called the Strike price of the futures contract. He says you can think of the Rs. 2 per share as his charge for keeping the shares for you until the expiry date. This difference between the strike price and the current price is also called as Cost of Carry.
2. The total contract size is now Rs. 202 for 500 shares, which means Rs 101000. However both you and John realise that each of you is taking a risk. For e.g. if tomorrow the price of the stock falls from Rs. 200 to Rs. 190, in that case it is much more profitable for you buy shares from the market than from John. What if you decide not to honour the contract or agreement? it will be a loss for John. Similarly if the price rises you are at a risk if John doesn't honour the futures contract. So both of you decide that you will find a common friend and keep Rs. 25000 each with this friend in order to take care of price fluctuations. This money paid by both of you is called Margin paid for the futures contract.
Finally you decide that the futures contract will cash settled. Which means at the expirty date of the contract, instead of actually handing over 500 shares - John will pay you the money if the price rises, or if the price falls you will pay John the balance amount. For example at the end of the expiry date if you find out that the price of the share is Rs. 230, then the difference
Rs. 230 - Rs. 202 = Rs. 28
will be paid to you by John. You can then purchase the shares fromt he Stock Market at Rs. 230. Since you will get Rs. 28 per share from John, you will effectively be able to buy the shares at Rs. 202 , the agreed strike price of the futures contract. Similarly John can directly sell his 500 shares in the market at Rs. 230 and give you Rs 28 (per share) which means he effectively sold each share at Rs. 202, the agreed price.
Stock Futures trading - Commodity Futures trading - Index Futures trading
Just like the above example of Stock Futures you can have commodity futures where instead of dealing with stock you deal with commodities - for e.g. gold futures , crude oil futures, etc. You can also have futures on Index. For e.g. Nifty is a stock market index in India. If you buy 1 futures contract of Nifty then at the expiry date you will be gain or loose money accordingly as the index moves up or down. Index futures contracts are always cash settled as there is nothing to 'actually buy or sell' in case of an index. You simply pretend that you are buying the 'index' and cash settle it at the expiry date. Anyone can buy or sell a futures contract.
Futures Trading: some minor differences between Actual Futures contract and
the above example of futures contract
the above example of futures contract
In concept the above example illustrates all the basic notions of a futures trading. However in real life, while trading stock futures on stock market exchange or commodities futures on commodity exchange you have to keep in mind the following points.
1. You directly deal with the stock exchange or the commodity exchange when buying or selling a futures contract. The Margin money is kept with the stock exchange. The margin is calculated in real time and constantly updated. For e.g. if you buy a futures contract and the price of the stock / commodity goes down - you will be required to provide additional margin, etc.
2. The expiry date of the futures contract is decided by the Exchange. It is usually the last Thursday of every month except when there is a public holiday in which case it is the earliest
3. All futures contract are sold in multiple of a lot size which is decided by the Stock Market exchange or the commodity exchange. For e.g. if the lot size of Tata Steel is 500, then one futures contract is necessarily for 500 shares. You can however buy or sell multiple futures contracts and hence you will be able to deal with only multiples of the given lot size of the contract.
4. The exchange decides whether the futures contract is cash settled or settlement is delivery based. For e.g. all index futures are always cash settled because there is no concept of actual 'delivery' of the index. In india even all stock futures are currently cash settled.
5. You dont have to actually have the stock or commodity (or index) in order to sell a futures contract. For e.g. even if I have no gold with me, and I believe that the price of gold is going to go down, I can simply sell a futures contract and hope to benefit from my speculation. In case the futures contract is delivery settled, you can simply buy it again (called squaring your position) just before the expiry.
Advantages of Futures Trading: Why trade Futures?
There are several advantages of trading in futures. Here are some.
1. Futures trading allows you to trade in 'large amounts' with low cash. For e.g. if you want to buy a futures contract of 500 shares of Tata steel - Actually buying them would cost much more than the margin you have to pay for trading futures. Note however, leveraged position of futures can also be dangerous.
2. Trading in stock market Futures is usually less expensive than actually buying stocks. For e.g. if you realise that you have 500 stocks and want to sell them and again buy them when the price is low, it is much cheaper (brokerage charges etc.) to sell futures than actually selling stocks.
3. You can sell futures contract even if you dont have shares or the commodity. Thus if you have reasons to believe that the stock market is going down you can sell a particular stock future or index future and benefit from the price fall. This is possible only if you trade futures and not with physical stocks or commodity.
4. Trading futures can be used in several hedging strategies which will be discussed in a later post.
put option
Definition
An option contract that gives the holder the right to sell a certain quantity of an underlying security to the writer of the option, at a specified price (strike price) up to a specified date (expiration date); here also called put.
An options trader can be long a Put, in which case they have bought a Put contract, and have the right of exercise described above. Or a trader can be short a Put, in which case they have sold a Put contract, and may be required to buy the underlying commodity if they are chosen by the exchange (or options clearing system) to complete their contract obligations.
call option
Definition
An option contract that gives the holder the right to buy a certain quantity (usually 100 shares) of an underlying security from the writer of the option, at a specified price (the strike price) up to a specified date (the expiration date). also called call.
An options trader can be long a Call, in which case they have bought a Call contract, and have the right of exercise described above. Or a trader can be short a Call, in which case they have sold a Call contract, and may be required to sell the underlying commodity if they are chosen by the exchange (or options clearing system) to complete their contract obligations.
Trading in Futures Derivatives
Idea about futures derivatives
Future trading can be done on stocks as well as on Indices like IT index, Auto index, Pharma index etc
Stock future trading -
Let’s first understand what the meaning of futures trading is. In simple language one future contract is group of stocks (one lot) which has to be bought with certain expiry period and has to be sold (squared off) within that expiry period.
Suppose if you buy futures of Wipro of one month expiry then you have to sell it within that one month period.
Important - Future contract get expires at every last Thursday of every month.
If you buy October month expiry future contract then you have to sell it within last Thursday of October month. Likewise you can buy two months and three months expiry period future contract.
You can buy maximum of three month expiry period.
For example - suppose this is month of October then you have to buy till maximum month of December expiry and you have to sell it within last Thursday of December month. You can sell anytime between these periods.
Lot size (group of stocks in one future contract) varies from future to future contract.
For example Reliance Industries future lot size has 150 quantities of shares while a Tata Consultancy service has 250 shares.
In the same manner all futures have different lot sizes decided by SEBI (Securities Exchange Board of India).
The margin (in other words price of one lot size) varies on daily basis based on its stocks closing price.
Future trading can be done on selected stocks listed under Nifty and Jr. Nifty and not on all stocks.
The price of future contract is determined by its underlying stock.
Important - You can’t buy future contract of expiry period of not more than 3 months.
Idea about futures derivatives
Future trading can be done on stocks as well as on Indices like IT index, Auto index, Pharma index etc
Stock future trading -
Let’s first understand what the meaning of futures trading is. In simple language one future contract is group of stocks (one lot) which has to be bought with certain expiry period and has to be sold (squared off) within that expiry period.
Suppose if you buy futures of Wipro of one month expiry then you have to sell it within that one month period.
Important - Future contract get expires at every last Thursday of every month.
If you buy October month expiry future contract then you have to sell it within last Thursday of October month. Likewise you can buy two months and three months expiry period future contract.
You can buy maximum of three month expiry period.
For example - suppose this is month of October then you have to buy till maximum month of December expiry and you have to sell it within last Thursday of December month. You can sell anytime between these periods.
Lot size (group of stocks in one future contract) varies from future to future contract.
For example Reliance Industries future lot size has 150 quantities of shares while a Tata Consultancy service has 250 shares.
In the same manner all futures have different lot sizes decided by SEBI (Securities Exchange Board of India).
The margin (in other words price of one lot size) varies on daily basis based on its stocks closing price.
Future trading can be done on selected stocks listed under Nifty and Jr. Nifty and not on all stocks.
The price of future contract is determined by its underlying stock.
Important - You can’t buy future contract of expiry period of not more than 3 months.
Indices future trading
As you can do future trading on stocks likewise you can do trading on different indices like Nifty index, IT index, Auto index, Pharma index etc.Successful trading in futures
Future or derivative trading is the process of buying or selling stock future or index future for a certain period of time and squaring off before the expiry date.
Expiry period can be of one month, two month and three month and not more then of three month.
Its not compulsion that you have to square off your positions on the expiry date or wait till the expiry period but in fact you can square off at any time even, at the same day, or you can hold as long as you want but remember to square off before expiry date.
Most of the times on 3rd month expiry future you may see very less trading volumes.
Generally most of the traders/investors trade or invest on current month future or second month future contract and you may see very low volumes on last month means third month expiry .
But on Nifty index contract or on other index contract you may see good trading volumes even on 3rd month expiry future also.
You can also buy and sell or sell and buy future contract on the same day of any expiry month. This is called as day trading or intraday in futures.
Selling future contract before buying is called short selling. Short selling is allowed in futures trading.
As you can do future trading on stocks likewise you can do trading on different indices like Nifty index, IT index, Auto index, Pharma index etc.Successful trading in futures
Future or derivative trading is the process of buying or selling stock future or index future for a certain period of time and squaring off before the expiry date.
Expiry period can be of one month, two month and three month and not more then of three month.
Its not compulsion that you have to square off your positions on the expiry date or wait till the expiry period but in fact you can square off at any time even, at the same day, or you can hold as long as you want but remember to square off before expiry date.
Most of the times on 3rd month expiry future you may see very less trading volumes.
Generally most of the traders/investors trade or invest on current month future or second month future contract and you may see very low volumes on last month means third month expiry .
But on Nifty index contract or on other index contract you may see good trading volumes even on 3rd month expiry future also.
You can also buy and sell or sell and buy future contract on the same day of any expiry month. This is called as day trading or intraday in futures.
Selling future contract before buying is called short selling. Short selling is allowed in futures trading.
Major Advantages of Futures Trading over Stock Trading
1) Margin is available -
In future trading you get margin to buy (but can hold only up to maximum of 3 months), while in stock trading you
must have that much of amount in your account to buy.
For example - If you plan to buy stock XYZ at Rs. 100 and quantity 1000 shares then you have to pay 1 lakh
rupees (RS 100 x1000 qty). But if you plan to buy XYZ future contract and that contract lot size has 1000 quantity
of shares then instead of paying 1 lakh rupees you have to pay just 20% to 30% of whole amount which comes to
20 thousand to 30 thousand rupees.
In short in future trading you have to pay just 20% to 30% of the whole amount what you pay if you buy stock of
that price. But limitation for this is your expiry period. Means if you bought future of one month expiry then you
have to square off within that one month likewise you can buy maximum of three months expiry.
2) Possible to do short selling -
You can short sell futures- You can sell futures without buying them which is called short selling and later buy within
your expiry period, to cover up your positions.
This is not possible in stocks. You can’t sell stocks before buying them in delivery (you can do in intraday). You can
short sell futures and can cover off within your expiry period.
For example - If expiry period of your future contract is of 1 month then you have time frame of one month to cover off
your order like wise if your future expiry period is of two months then you have time frame of two months and this
continues till three months and not more then three months.
In short selling of futures also you get margin as you get in buying of futures.
3) Brokerages are low -
Brokerages offered for future trading are less as compared to stock delivery trading.
1) Margin is available -
In future trading you get margin to buy (but can hold only up to maximum of 3 months), while in stock trading you
must have that much of amount in your account to buy.
For example - If you plan to buy stock XYZ at Rs. 100 and quantity 1000 shares then you have to pay 1 lakh
rupees (RS 100 x1000 qty). But if you plan to buy XYZ future contract and that contract lot size has 1000 quantity
of shares then instead of paying 1 lakh rupees you have to pay just 20% to 30% of whole amount which comes to
20 thousand to 30 thousand rupees.
In short in future trading you have to pay just 20% to 30% of the whole amount what you pay if you buy stock of
that price. But limitation for this is your expiry period. Means if you bought future of one month expiry then you
have to square off within that one month likewise you can buy maximum of three months expiry.
2) Possible to do short selling -
You can short sell futures- You can sell futures without buying them which is called short selling and later buy within
your expiry period, to cover up your positions.
This is not possible in stocks. You can’t sell stocks before buying them in delivery (you can do in intraday). You can
short sell futures and can cover off within your expiry period.
For example - If expiry period of your future contract is of 1 month then you have time frame of one month to cover off
your order like wise if your future expiry period is of two months then you have time frame of two months and this
continues till three months and not more then three months.
In short selling of futures also you get margin as you get in buying of futures.
3) Brokerages are low -
Brokerages offered for future trading are less as compared to stock delivery trading.
Disadvantages of Future Trading over Stock Trading
1) Limitation on holding - If you buy or sell a future contract then you have limitation of time frame to square off your position before expiry
date.
For example - If you buy or sell future contract of one month expiry period then you have to square off your position
before your expiry date of that month, so in this example you got one month period. So likewise if you go for two
month expiry period then you get 2 months and if you go for three month expiry then you will get 3 month expiry
period to square off your position.
2) Level of Risk - Due to margin facility in future trading you may earn huge profit by investing fewer amounts but at the contrary side
if your trade goes wrong then you may have to suffer huge loss.
3) Limitation on stocks - You can’t do future trading on all stocks. You can only do on listed stocks on Nifty and Jr. Nifty.
1) Limitation on holding - If you buy or sell a future contract then you have limitation of time frame to square off your position before expiry
date.
For example - If you buy or sell future contract of one month expiry period then you have to square off your position
before your expiry date of that month, so in this example you got one month period. So likewise if you go for two
month expiry period then you get 2 months and if you go for three month expiry then you will get 3 month expiry
period to square off your position.
2) Level of Risk - Due to margin facility in future trading you may earn huge profit by investing fewer amounts but at the contrary side
if your trade goes wrong then you may have to suffer huge loss.
3) Limitation on stocks - You can’t do future trading on all stocks. You can only do on listed stocks on Nifty and Jr. Nifty.
Important points to Remember while doing future trading
1) First up all you have to decide whether you want to buy stock derivatives or index derivative. After this you have to
select the expiry period. Once you buy certain expiry period then you have to sell (cover off) your order before that
period.
Its no need to wait till the expiry period, you can even square off on the same day (if you are getting profit) or
anytime whenever you feel to book profit, no compulsion to cover off your order on the last day of expiry.
2) Check out for Futures current market price.
3) Futures Lot Size (number of shares in that particular Lot).
4) Futures Lot price (this is the amount you must have in your account to buy one lot of future) also called as margin
amount.
5) Selection of expiry period - you want to trade on expiry of one month, two month or last 3rd month.
6) No need to wait till expiry period can book profit wherever applicable.Method of Short Selling
Short selling (selling before buying in future trading)
In future trading you can do short selling and buy (cover) later when price comes down from your selling price you can short sell stock future as well as index future. But again same restriction will apply and that is of expiry period.
1) First up all you have to decide whether you want to buy stock derivatives or index derivative. After this you have to
select the expiry period. Once you buy certain expiry period then you have to sell (cover off) your order before that
period.
Its no need to wait till the expiry period, you can even square off on the same day (if you are getting profit) or
anytime whenever you feel to book profit, no compulsion to cover off your order on the last day of expiry.
2) Check out for Futures current market price.
3) Futures Lot Size (number of shares in that particular Lot).
4) Futures Lot price (this is the amount you must have in your account to buy one lot of future) also called as margin
amount.
5) Selection of expiry period - you want to trade on expiry of one month, two month or last 3rd month.
6) No need to wait till expiry period can book profit wherever applicable.Method of Short Selling
Short selling (selling before buying in future trading)
In future trading you can do short selling and buy (cover) later when price comes down from your selling price you can short sell stock future as well as index future. But again same restriction will apply and that is of expiry period.
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