Derivatives, such as futures, are a sort of derivative. What are derivatives and how do you use them? Derivatives are akin to nuclear weapons! These aren’t our words, by the way. These are the remarks of Mr Warren Buffett, the world’s finest investor.
We, on the other hand, would like to politely disagree. If you know how to trade futures, you can make a lot of money. And learning exactly what futures are and how a futures contract works is the first step in trading futures.
However, before we can grasp what futures are, we must first understand what derivatives are. After all, futures are a form of derivative.
Derivatives are financial contracts whose value is determined by the underlying asset’s value.
Consider the classic example of milk and curd. Milk is used to make curd. As a result, if the price of milk rises, so will the price of curd. This implies that curd has no intrinsic worth. Its value is determined by the value of the underlying asset’milk.’
- If the price of the underlying asset rises, so will the price of the derivative.
- If the price of the underlying asset falls, so will the price of the derivative.
There are 4 types of Derivatives Contracts in India
Everything about forward contracts and options has previously been discussed. We shall discuss what futures are and the fundamentals of a futures contract in India in this essay.
Now that you know what derivatives are, let’s look at another example to see what futures are.
Let’s say you’re planning a trip to Dubai in three months. Today’s flight costs Rs 35,000. We all know that making a reservation ahead of time is always preferable. So you book a flight with Emirates today to fly to Dubai in three months. This is similar to a futures contract between you and the airlines.
What are Futures? Example of Futures
Futures are standardized contracts that allow you to buy or sell an underlying asset at a pre-determined price on a specified date. A stock, currency, commodity, or index can be used as the underlying asset.
In the above example: You’ve already chosen to spend Rs 35,000 for a trip to Dubai. This is the price you’ve set for yourself. Even if the airfare rises to Rs 40,000 in three months, you will still only pay Rs 35,000. Similarly, your travel date has been determined in advance. This is the precise date for you. You and the airlines are both bound by a contract. You must pay them Rs 35,000 in order for them to hold a seat for you on a specified day.
It’s crucial to remember that the buyer and seller will have opposing viewpoints about the underlying asset. You bought the tickets in advance because you expect the ticket costs to rise in the case above. Because the airline expected ticket prices to fall, they sold the tickets ahead of time to minimize their loss.
Let’s look at this example to see what futures are in the stock market.
Assume you expect Reliance Industries’ stock price to rise in the future months. You too wish to profit from this chance. You have two choices:
Let’s have a look at the first possibility. Assume that one Reliance Industries share costs Rs 2,000 on the open market. You’d like to purchase 100 shares. A hundred shares will cost Rs 2 lakhs!
However, you only have Rs 1 lakh to work with. As a result, you purchase 50 shares. After three weeks, Reliance Industries’ stock price jumps to Rs 2,500, as planned. You profit Rs 25,000 by selling your 50 shares. In just three weeks, you made a 25% profit! You feel like you’re on top of the world! Could you, however, have made a bigger profit?
Yes, it is correct. If you had looked into choice two, investing in Reliance Futures, you could have made a lot more money. Let’s take a look at situation number two.
You have a sum of Rs 1 lakh to invest. Let’s pretend that one Reliance futures contract costs Rs 2,186. 250 shares are contained in a single Reliance futures contract. As a result, the contract’s total value is Rs 5,46,500. The good news is that buying a Reliance futures contract does not require you to pay the full Rs 5,46,500. You only need to pay a small deposit. Later on, we’ll learn more about this.
Assume the initial margin required to carry one Reliance futures contract is Rs 64,700 for the time being. Here’s where you can figure out how much margin you’ll need.
So you pay Rs 64,700 for one Reliance futures contract. In the spot market, Reliance Industries’ share price jumps from Rs 2,000 to Rs 2,500, as projected. Remember how I said that as the price of the underlying asset rises, so would the price of the derivative.
After three weeks, the price of your futures contract rises from Rs 2,186 to Rs 2,558. You’ve made the decision to sell your contract before it expires. The cost of your purchase is Rs 2,186, and the cost of your sale is Rs 2,558. So, each share, you made Rs 372? Your total profit is Rs 93,000, because one lot of Reliance Industries has 250 shares.
You don’t have to be a financial genius to see that a 144 percent increase is preferable to a 25% gain! So, instead of buying Reliance futures on the spot market, you got the following:
- Better volumes – You could only acquire 50 shares on the spot market. However, you purchased 250 shares in the futures contract!
- Lower Capital – You invested Rs 1 lakh in the spot market, but just Rs 64,700 in the futures market.
Before you get too enthusiastic and start trading futures, here are ten things you should know about futures.
Basics of Futures Contract in India
1. Lot Size: Buying milk at the market is equivalent to buying a lot size. There are regular parking spaces. Milk is available in 250 mL, 500 mL, and 1 litre containers. You can’t ask for half a glass of milk from the shopkeeper! Futures contracts, like stocks, have lot sizes.
2. Futures Price: This is the price per share at which you will purchase futures. The price of a futures contract is often higher than the price of the underlying asset (in our example, stocks). Consider the following scenario:
3. Contract Value: The contract value of your employment is the actual value of your job. It’s computed by dividing the lot size by the futures contract’s price.
- A single Reliance Futures contract is worth Rs 5,46,500 (Rs 2,186*250).
- 1 State Bank of India futures contract has a contract size of Rs 11,60,250 (Rs 386.75*3,000).
4. Expiration Date: Every futures contract has a set expiration date. On the last Thursday of each month, all futures contracts expire. The contract will expire on Wednesday if the last Thursday is a holiday.
There are three futures contracts available for trade at any given moment. In the image below –
5. The underlying asset’s price is called the underlying price. In the case of Reliance futures, the underlying asset is the cash market share price of Reliance. In an ideal world, futures prices would move in the same direction as underlying prices.
6. Buyer of a futures contract: A buyer of a futures contract is a person who purchases a futures contract. Buyers are optimistic about the stock. This indicates that the buyer anticipates an increase in the price in the future. As a result, he is purchasing it today at a reduced price. You are said to be long on a stock when you acquire a futures contract.
7. Seller of a futures contract: A seller of a futures contract is a person who sells futures contracts. He believes the stock is overvalued. His goal is to lock in the sell price today so that a future drop will not result in a loss. You are said to be short on a stock when you sell a futures contract.
8. Futures contract settlement: In India, the vast majority of futures contracts are settled in cash before they expire. What exactly does this imply? Every futures contract has an expiration date. As a result, you must resolve them. This means that if you purchased a futures contract, you must sell it before or on the expiration date. Similarly, if you sold a futures contract, you must buy it back at the expiration date.
Futures in India were cash-settled until October 2019. However, if you do not settle your position by the expiration date, you will have to physically settle your transaction. But, in futures, what does physical and cash settlement mean? With this example, let’s look at how a future contract works.
How Do Futures Work? Workings of a Futures Contract
Assume you purchase one lot of Reliance futures with an expiration date of March 25, 2021. Your cost price per lot is Rs 2,186. The total amount of your contract is Rs 5,46,500. As a buyer, you anticipate a growth in the share price of Reliance Industries. Because you are the buyer, you must have purchased the futures contract from a seller.
As a result, the seller’s position will be valued Rs 5,46,500 as well. To square-off (close) your position, you have until March 25, 2021. Your Reliance futures contract will grow in value from Rs 2,186 to Rs 2,500 on March 20, 2021.
So you’ve made a 93,000 rupee profit. The vendor loses money when you make a profit. As a result, the vendor loses Rs 93,000. Futures are known to be a zero-sum game because of this.
You have squared off or closed your buy position by selling your futures contract. The seller’s trading account will be debited by Rs 93,000, while your trading account will be credited with Rs 93,000. This is referred to as a cash settlement. Only the difference is charged or debited to the buyers’ and sellers’ trading accounts in this case. However, cash settlements are only possible if you square-off your positions before the expiration date.
Assume you didn’t sell your futures contract until March 25, 2021. In that instance, you will be required to accept delivery of 250 shares, and the seller will be required to deliver 250 shares. Physical settlement is the term for this. This only happens if you don’t square off your position before the expiration date.
9. Open Interest: The number of open contracts or positions on a given date is referred to as open interest, or OI. A large open interest indicates a high level of liquidity.
10. Change in Open Interest: This chart depicts the daily change in the futures contract. A rise in price and a rise in OI indicate that more contracts have been added and that people are going long (buying) on the futures contract.
Now that you know what futures are and how they function, your next question might be, “Are futures safe?”
What makes them “weapons of mass destruction”?
The Securities and Exchange Board of India regulates the futures market in India (SEBI). The Securities and Exchange Board of India (SEBI) strives to protect investors’ interests in the stock market. It has put in place strong processes to ensure that neither the buyer nor the vendor breaks their agreement. Keeping the exchange as the counterparty is one such measure. In a futures contract, either the buyer or the seller can back out of their commitment if the price goes in the opposite direction of their expectations.
In a futures contract, however, this is not possible. By acting as a counterparty, the exchange ensures that both the buyer and the seller honor their contracts. As a result, the buyer buys from the exchange and the seller sells to it. The exchange subsequently transfers funds from the buyer to the seller.
If a buyer fails to pay the required amount, the exchange will pay the seller instead of the buyer and retrieve the money. As a result, in the event of a futures contract, there is no risk of counterparty default.
Another key factor to remember is that India’s futures market is quite popular and has a lot of liquidity. The following graph depicts the evolution of India’s futures markets during the last two decades.
So, futures contracts are heavily regulated and have a lot of liquidity. The key advantage of a futures contract is that it allows you to earn higher profits. Remember how you got a 144 percent raise instead of a 25% raise?
While the potential for significant returns is one of the most appealing aspects of futures, it is not the only one. Let’s have a look at the best benefits of Futures.
Advantages of Futures
- One of the most significant advantages of a futures contract is leverage. You must pay the entire contract amount upfront when buying equity shares on the spot market. This is not the case with futures, as you may get into positions by merely paying the initial margin. With an initial capital of Rs 64,700, you may take positions worth Rs 5,46,500, as we saw in the preceding case. This allows traders with small cash to access large holdings.
- Larger Profits on Limited Capital: High leverage provides investors with the possibility to generate higher returns. Investors might earn bigger returns than on the spot market since they have access to higher positions. The profit in the cash market was 25%, while the profit in the futures market was a stunning 144 percent. As a result, the second largest advantage of futures is larger returns due to increased leverage.
- Risk Hedging: Futures aren’t just for speculators and arbitrageurs. Hedgers frequently use futures to hedge their spot market bets. Assume an investor has 250 Reliance Industries shares on the spot market. However, he is concerned that the stock will drop in the near future. He can protect himself by selling futures contracts on Reliance to hedge his spot market position.
- Short-Selling Opportunities: In the spot market, you must cover your short position within the same trading day. As a result, even if they are losing money, investors are forced to square-off. With futures, however, this is not the case. You do not have to square-off your position in futures on the same day. You have the option to keep your futures contract until it expires. As a result, investors have plenty of time to cover their short holdings.
The Art of Short Selling The Best Short-Selling Strategy in the Stock Market is a must-see.
However, as lucrative as futures may be, they are not without risk. Consider what would happen if Reliance Industries’ stock price dropped instead of growing. So, what happens next? There’s a good probability your 144 percent profit may become a 144 percent loss!
Don’t be discouraged, though. Futures trading can be a profitable investment strategy if you follow strong risk management principles, such as a hard stop-loss.
We’d even go so far as to say that “futures are weapons of mass wealth generation!” This weapon is also available for free to anyone. So, begin your futures trading career with Samco, India’s leading broker.
Open a FREE Samco Demat and trading account for high leverage, a superior trading platform, and a wealth of FREE futures trading ideas from experts.
Open a Samco Demat and Trading account for free right now! It takes only 5 minutes to open an account entirely online. So, employ the weapon of mass wealth generation to brighten your stock market future!
What is an example of future trading?
Commodity futures trading is very common. When someone buys a July crude oil futures contract (CL), they are promising to buy 1,000 barrels of oil at the agreed price when the contract expires in July, regardless of the market price at the time. Similarly, the seller agrees to sell the 1,000 barrels of oil at the agreed-upon price. The original seller will deliver 1,000 barrels of crude oil to the original buyer unless either party trades their contract to another buyer or seller by that date.
Is it legal to trade futures in India?
Futures trading is prohibited by SEBI. goods produced by agriculture Agricultural commodity futures trading. India’s Securities and Exchange Board.
In the Indian stock market, what are futures?
1. What are Stock Futures and How Do They Work? Stock futures are financial contracts with a particular stock as the underlying asset. A stock future contract is an agreement between the buyer and seller to buy or sell a certain quantity of underlying equity shares at a price agreed upon in the future.
Is trading in futures risky?
They are riskier than guaranteed fixed-income investments, much like equity investments. However, many people believe that trading futures is riskier than trading stocks because of the leverage inherent in futures trading.
Futures or options: which is better?
- Futures and options are common derivatives contracts used by hedgers and speculators on a wide range of underlying securities.
- Futures have various advantages over options, including being easier to comprehend and value, allowing for wider margin use, and being more liquid.
- Even so, futures are more complicated than the underlying assets they track. Before you trade futures, be sure you’re aware of all the hazards.
Is it possible to sell futures before they expire?
Purchasing and selling futures contracts is similar to purchasing and selling a number of units of a stock on the open market, but without the need to take immediate delivery.
The level of the index moves up and down in index futures as well, reflecting the movement of a stock price. As a result, you can trade index and stock contracts in the same way that you would trade stocks.
How to buy futures contracts
A trading account is one of the requirements for stock market trading, whether in the derivatives area or not.
Another obvious prerequisite is money. The derivatives market, on the other hand, has a slightly different criteria.
Unless you are a day trader using margin trading, you must pay the total value of the shares purchased while buying in the cash section.
You must pay the exchange or clearing house this money in advance.
‘Margin Money’ is the term for this upfront payment. It aids in the reduction of the exchange’s risk and the preservation of the market’s integrity.
You can buy a futures contract once you have these requirements. Simply make an order with your broker, indicating the contract’s characteristics such as theScrip, expiration month, contract size, and so on. After that, give the margin money to the broker, who will contact the exchange on your behalf.
If you’re a buyer, the exchange will find you a seller, and if you’re a selling, the exchange will find you a buyer.
How to settle futures contracts
You do not give or receive immediate delivery of the assets when you exchange futures contracts. This is referred to as contract settlement. This normally occurs on the contract’s expiration date. Many traders, on the other hand, prefer to settle before the contract expires.
In this situation, the futures contract (buy or sale) is settled at the underlying asset’s closing price on the contract’s expiration date.
For instance, suppose you bought a single futures contract of ABC Ltd. with 200 shares that expires in July. The ABC stake was worth Rs 1,000 at the time. If ABC Ltd. closes at Rs 1,050 in the cash market on the last Thursday of July, your futures contract will be settled at that price. You’ll make a profit of Rs 50 per share (the settlement price of Rs 1,050 minus your cost price of Rs 1,000), for a total profit of Rs 10,000. (Rs 50 x 200 shares). This figure is adjusted to reflect the margins you’ve kept in your account. If you make a profit, it will be added to the margins you’ve set aside. The amount of your loss will be removed from your margins if you make a loss.
A futures contract does not have to be held until its expiration date. Most traders, in practice, exit their contracts before they expire. Any profits or losses you’ve made are offset against the margins you’ve placed up until the day you opt to end your contract. You can either sell your contract or buy an opposing contract that will nullify the arrangement. Once you’ve squared off your position, your profits or losses will be refunded to you or collected from you, once they’ve been adjusted for the margins you’ve deposited.
Cash is used to settle index futures contracts. This can be done before or after the contract’s expiration date.
When closing a futures index contract on expiry, the price at which the contract is settled is the closing value of the index on the expiry date. You benefit if the index closes higher on the expiration date than when you acquired your contracts, and vice versa. Your gain or loss is adjusted against the margin money you’ve already put to arrive at a settlement.
For example, suppose you buy two Nifty futures contracts at 6560 on July 7. This contract will end on the 27th of July, which is the last Thursday of the contract series. If you leave India for a vacation and are unable to sell the future until the day of expiry, the exchange will settle your contract at the Nifty’s closing price on the day of expiry. So, if the Nifty is at 6550 on July 27, you will have lost Rs 1,000 (difference in index levels – 10 x2 lots x 50 unit lot size). Your broker will deduct the money from your margin account and submit it to the stock exchange. The exchange will then send it to the seller, who will profit from it. If the Nifty ends at 6570, though, you will have gained a Rs 1,000 profit. Your account will be updated as a result of this.
If you anticipate the market will rise before the end of your contract period and that you will get a higher price for it at a later date, you can choose to exit your index futures contract before it expires. This type of departure is totally dependent on your market judgment and investment horizons. The exchange will also settle this by comparing the index values at the time you acquired and when you exited the contract. Your margin account will be credited or debited depending on the profit or loss.
What are the payoffs and charges on Futures contracts
Individual individuals and the investing community as a whole benefit from a futures market in a variety of ways.
It does not, however, come for free. Margin payments are the primary source of profit for traders and investors in derivatives trading.
There are various types of margins. These are normally set as a percentage of the entire value of the derivative contracts by the exchange. You can’t purchase or sell in the futures market without margins.
How do you make money trading futures?
The value of futures and options is determined by the underlying, which might be a stock, index, bond, or commodity. For the time being, let’s concentrate on stock and index futures and options. The value of a stock future/option is derived from a stock such as RIL or Tata Steel. The value of an index future/option is derived from an underlying index such as the Nifty or the Bank Nifty. F&O volumes in India have increased dramatically in recent years, accounting for 90 percent of total volumes in the industry.
F&O, on the other hand, has its own set of myths and fallacies. Most novice traders consider F&O to be a less expensive way to trade stocks. Legendary investors like Warren Buffett, on the other hand, have referred to derivatives as “weapons of mass destruction.” The truth, of course, lies somewhere in the middle. It is feasible to benefit from online F&O trading if you master the fundamentals.
1. Use F&O as a hedge rather than a trade.
This is the fundamental principle of futures and options trading. F&O is a margin business, which is one of the reasons retail investors get excited about it. For example, you can buy Nifty worth Rs.10 lakhs for just Rs.3 lakhs if you pay a margin of Rs.3 lakhs. This allows you to double your money by three. However, this is a slightly risky approach to employ because, just as gains can expand, losses in futures might as well. You’ll also need enough cash to cover mark-to-market (MTM) margins if the market moves against you.
To hedge, take a closer look at futures and options. Let’s take a closer look at this. If you bought Reliance at Rs.1100 and the CMP is Rs.1300, you may sell the futures at Rs.1305 and lock in a profit of Rs.205 by selling the futures at Rs.1305 (futures generally price at a premium to spot). Now, regardless of how the price moves, you’ve locked in a profit of Rs.205. Similarly, if you own SBI at Rs.350 and are concerned about a potential fall, you can hedge by purchasing a Rs.340 put option at Rs.2. You are now insured for less than Rs.338. You record profits on the put option if the price of SBI falls to Rs.320, lowering the cost of owning the shares. By getting the philosophy correct, you can make F&O operate effectively!
2. Make sure the trade structure is correct, including strike, premium, expiration, and risk.
Another reason why traders make mistakes with their F&O deals is because the trade is poorly structured. What do we mean when we say a F&O trade is structured?
Check for dividends and see if the cost of carry is beneficial before buying or selling futures.
When it comes to trading futures and options, the expiration date is quite important. You can choose between near-month and far-month expiration dates. While long-term contracts can save you money, they are illiquid and difficult to exit.
In terms of possibilities, which strike should you choose? Options that are deep OTM (out of the money) may appear to be cheap, but they are usually worthless. Deep ITM (in the money) options are similar to futures in that they provide no additional value.
Get a handle on how to value alternatives. Based on the Black and Scholes model, your trading terminal includes an interface to determine if the option is undervalued or overvalued. Make careful you acquire low-cost options and sell high-cost options.
3. Pay attention to trade management, such as stop-loss and profit targets.
The last item to consider is how you handle the trade, which is very important when trading F&O. This is why:
The first step is to put a stop loss in place for all F&O deals. Keep in mind that this is a leveraged enterprise, thus a stop loss is essential. Stop losses should ideally be included into the trade rather than added later. Above all, Online Trading requires strict discipline.
Profit is defined as the amount of money you book in F&O; everything else is just book profits. Try to churn your money quickly since you can make more money in the F&O trading company if you churn your capital more aggressively.
Keep track of the greatest amount of money you’re willing to lose and adjust your strategy accordingly. Never put more money on the table than you can afford to lose. Above all, stay out of markets that are beyond your knowledge.
F&O is a fantastic online trading solution. To be lucrative in F&O, you only need to take care of the three building components.
To trade futures in India, how much money do you need?
To trade futures, how much money do I need? Margin is required when trading futures contracts. The amount of margin will be determined by the size of the stake. To place a trade, however, most brokers will require at least 10% advance margin.
How much capital will be required for future trading?
If you assume you’ll need to employ a four-tick stop loss (the stop loss is four ticks distant from the entry price), the minimum you should risk on a trade in this market is $50, or four times $12.50. The minimum account balance, according to the 1% rule, should be at least $5,000 and preferably higher. If you want to risk a larger sum on each trade or take more than one contract, you’ll need a bigger account. The recommended balance for trading two contracts with this method is $10,000.