Futures Trading – Basics & Benefits

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Futures contract is a derivative financial instrument within which an agreement is entered into between a buyer and a seller where the buyer agrees to purchase the underlying at a specified time in the future for a fixed price.

They are powerful derivative financial instruments made use of by hedgers and speculators alike depending on their individual financial interests.

To give clarity, let’s take an example. Suppose there are two traders, Aman and Nitin. Aman has a point of view that the value of a particular stock will rise from it’s present value in the future while Nitin believes that the value of that same stock will fall. So Aman and Nitin both get into a contract with Aman buying the shares of the stock from Nitin at the present price sometime in the future. If Aman’s prediction comes true where the value of the stock increases then he can buy the stock at a discounted price where is the price if the stock falls as predicted by Nitin, then Nitin can sell the stocks at a premium which is higher than the current price.

How does future trading work?

In futures trade, there is no actual exchange of assets that takes place like normal trading. They only take advantage of the price changes and buy and sell the contracts in short time and earn profits for themselves. Below is the process of how it works.

• It is available in both the BSE and NSE
• The trader can either place a buying order which means agreeing to buy it at a certain price or place a selling order which means selling it at a fixed price
• In this case the buyer takes a bullish approach while the seller takes a bearish approach
• Futures can only be bought in lots. Each lot size depends from company to company. Some may have a lot size of 250 shares or 500 shares or even 100 shares, it varies.
• Each future contract expires on the last Thursday of every month by which all payments are settled and new contracts are created.
• Once you buy a future contract, you can also end up selling it to others.
• A futures contract position, either on the buy or sell side can be held by paying a small amount called the margin. Say, if a trader wants to buy one contract of Nifty consisting of 50 units of Nifty he has to pay a margin as specified by the exchange. If Nifty is trading at 17500 the cost of buying a lot of Nifty would have been Rs 875,000 (17500 X 50). But in futures market one can hold a contract of Nifty by paying as little as Rs 120,000. 

Benefits of Future contracts

Some of the main benefits of trading in a futures market are as follows:

• Effective hedging mechanism

Futures are instruments that can be employed effectively to mitigate or hedge against systemic risks of movement in the underlying. One of the common ways in which a future is used as hedging tool is in the currency segment. Companies and even Governments use futures contracts to hedge against any potential currency fluctuations especially when they indulge in international trade. For example, Infosys expecting a dollar payment of 1 million dollars six months down the line for a software project could mitigate the risk of fluctuations in the USD INR market by entering into a currency futures trade. Airline companies wanting to hedge risk of rising fuel costs can enter into oil commodity futures to hedge and manage this risk. Likewise, even traders in the equity markets who hold positions in the Cash market often make use of the futures market to hedge the risk of volatile movements.  

• The power of Leverage trading

Yet another important benefit of trading futures is the power of leverage it offers making it a more attractive investment than a cash market trade.

Let us demonstrate how with an example. 

Assume that you decide to buy Reliance shares today since you feel that the price will go up in the next few days and you can profit from this transaction. Your capital is Rs.1.5 lakh and timeframe is going to be the end of December because you want money for your new year celebrations. You have two options.

Option-1

Buy Reliance shares in the Spot market

Reliance currently happens to be trading at Rs. 2,411.25 (The value of the underlying is the value of the share in the spot market if you remember. The spot market is nothing but the cash market or the equity market)

So, with Rs. 1 lakh, I can buy 1,50,000/ 2411.25 which is about 62 shares. On December 31st, if the share price grows to Rs.2,500 as you had predicted, you would make a profit of Rs. (2,500- 2,411 = Rs.89) per share. In total, your profit will be Rs. 5,518 when calculated for 62 shares and the return on your investment about 3.65%. Now let us evaluate option-2.

Option-2: Buy Reliance Futures

The December expiry Reliance future is trading at Rs.2,425 per share (Last price in the above snap) and the lot size is 250 shares as we had discussed before. So, the contract value would be Rs.2,425 * 250 = Rs.6,06,250. But wait, this is outside my investment limit, right? 

Now this is where the derivatives market offers leverage facility. To trade in Reliance futures, you need not pay the entire amount. It is sufficient if you pay what is known as margin amount, which is usually a percentage of the contract fixed by the Exchange. For Reliance, the margin happens to be 22%. Thus, you need to may about 22% of Rs.6,06,250 which is about Rs.1,33,375, which happens too be within your investment limit. 

Now, upon expiry, your profit per share would be Rs. (2,500-2,425= Rs.75 per share). When multiplied for 250 shares, your profit is Rs. 18,750 and your return on investment, about 12%. Impressive right! To be able to make about Rs. 13,000 more with the same capital does amount to something significant. 

In conclusion

In general, the futures market is a highly liquid market that offers a great mechanism to hedge risks and also the power of leverage trading to maximise your gains. It is a bet on the direction of the movement of the stock and buyer profits with a rise in price while a seller profits from a drop in the price.