What is Future Contract?

Futures Contract is a derivative product. As the name suggests, it’s value is “derived” from another financial entity called as “underlying asset”. In India, futures contract is available for select stocks, main indices, currency pairs and commodities.

Background

Though futures trading is commonly done in equity now, it has been in place in commodity (agriculture) since few centuries. Let’s understand this using an example.

A farmer has planted tomato saplings in his farmland. Current price is ₹15/kg. He will be able to get the tomatoes 3 months from now. However, he is sceptical on the price after 3 months as it is volatile. He will be in loss if he could not get ₹15/kg.

A tomato ketchup factory needs tomatoes. However, the factory owner is sceptical on price fluctuations and is worried that he will be in loss if he procures at higher price after 3 months. He has supply agreements for next 3 months already.

So there is a producer who fears on price going down (on more supply) and a buyer who fears on price going up (on rain damage or less supply). These two entities enter into a “contract” to exchange tomatoes at a “future date” for a price of say ₹17/kg, ₹2/kg premium from spot price.

Now there can be 3 different scenarios that happen by end of 3rd month.

Scenario1: Market price of tomato at ₹17/kg. Both farmer and factory owner happy as they anticipated the right market price and tomatoes were exchanged.

Scenario2: There were good supply at market as many farmers cultivated tomato. Due to this, price has dropped to ₹12/kg. Due to future contract, factory owner need to pay ₹17/kg and take delivery. Farmer stand to gain in this case due to him signing the future contract at ₹17/kg.

Scenario3: There were floods due to heavy rains and most of the cultivated plants got destroyed. So there was only less supply to market. Now price has gone up to 25rs/kg. Due to future contract, factory owner will pay only ₹17/kg and take delivery. Factory owner stand to gain in this case as him signing the future contract at ₹17/kg.

Points to note:

1) Future contract is signed between the buyer and seller who has opposite view of the price movement of underlying asset. In our earlier example, underlying asset was tomato.
2) Price is negotiated between buyer and seller. They agree on the price that both feel is appropriate for them



Regulations involved:

Future contracts are traded on secondary markets on stock exchanges like NSE, BSE and MCX. Trader need to just place order on the broker’s application at their desired price. Counter party risk is not there as brokers ensure sufficient margins are blocked up front before allowing any trade. To avoid liquidity issue at the end, profit/loss is settled on a daily basis. Due to these factors, one can trade in futures contract without worrying on these factor and just focus on being correct in speculating the price movement of the underlying asset.

Currently as per SEBI rule, stock futures are physically settled. So if a trader has a open position in future contract till expiry, then it get settled with stock. Long position need to take delivery of stock while short position need to give delivery of stock. So brokers require traders to have sufficient margin on expiry week.

Traders:

Futures are traded mostly by institutions who want to hedge their cash holdings by selling corresponding future contracts and by speculators who enter a trade with only intention of getting out with profit.

If one were to analyse the “Participant wise OI data” file provided by NSE (EOD), it will be evident that DII holds massive amount of stock future short positions. These are purely to hedge their massive stock holdings under various Mutual Funds.

When there is good exposure by Mutual Funds in a stock that is not part of F&O yet, it is more likely to get added soon, as this will allow Mutual Funds to hedge their positions in cash. Some investors track such stocks.
Advantages of Futures Trading:

There are various reasons why trading in futures is considered preferable for most. Here are some of the most important advantages of futures trading.

• High Leverage: A trader can buy a futures contract by paying only a small percentage of the contract’s value, as margin. If the market conditions are favourable, trader can enjoy a considerable profit.
• Positional Shorts: When one is bearish on a stock, one can sell a future contract, which can be carried forward until expiry. In cash segment, short positions need to be closed on same day.
• Liquidity: Due to the high number of futures trading occurring on a daily basis, the futures market is liquid in nature, unlike stock options where most contracts have big spread between bid/ask due to low liquidity.

Risks Involved:

Though it may seem straightforward to trade futures, there are risks involved. Without understanding the risks, it is not advisable to trade futures.
• There can be a good opposite move against the position which will wipe out good part of the capital. Trade with a stop loss always
• It is better to hedge the futures position either by stocks in demat or by taking contra position in options. Gap up or Gap down outside of stop loss, can result in bigger loss. Hedged position will have limited impact when price moves against the position
• Big gaps can result in account going into negative too as many traders don’t follow money management. Ex: If the trading balance is 7L and if the margin required for 1 lot is 3.25L, traders take 2 lots with only 50k left to cover for M2M. One good swing will result in margin pressure leading to closing of position in loss.
• Two historical examples where traders lost money
o SKS Micro Finance (renamed as Bharat Financial which got acquired by Indusind bank) gap down when RBI refused banking license
o Yes Bank gap down when CEO appointment is rejected by RBI
Conclusion:

As with all investments/trading, before venturing into futures trading, it is important to do your fair share of research. As someone trading in futures contracts, it is essential to work on developing the right trading strategies. This requires time, patience and proper mind-set to deal with open position. Many retail traders have lost big amount in futures trading without having proper trading strategy AND risk/money management. So do it only when you know what you are risking.