Home Contract Futures contract : all you need to know

Futures contract : all you need to know

April 30, 2022

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This article has been written by Nikunj Arora of Amity Law School, Noida. This article provides a detailed analysis of futures trading and futures contracts in India, along with a general overview of stock and index futures and legal provisions associated with them.

This article has been published by Sneha Mahawar.

Table of Contents

Introduction

On December 20, 2021, in a move believed to stem rising prices, the Securities & Exchange Board of India (SEBI) publi shed an order stating the banning of the futures and options trading in paddy, wheat, mustard seeds and derivatives of them, soybeans and derivatives of them, crude palm oil, and green gram.

Again, as part of the National Stock Exchange (NSE)’s, futures and options (F&O) segment, the NSE has banned the trading of three stocks, including PSU stocks Bharat Heavy Electricals Limited (BHEL), Punjab National Bank (PNB), and PSU metal stock Steel Authority of India (SAIL), from February 11, 2022, because they exceeded 95% (as per the NSE) of the market-wide position limit. Future trading has always been in the news due to some reason or the other. Thus, as a part of the ‘financial derivatives’, the futures market plays an essential role.

Generally, a futures contract is an agreement between two parties to buy or sell a certain asset at a specific price and quantity at a future date. The delivery date signifies the future date when the asset will be paid for and delivered. In futures contracts, the buyer is known as holding a long position. It is said that the seller of a futures contract has a short position. Commodities, stocks, currencies, interest rates, and bonds can all be underlying assets for a futures contract. Such contracts are traded on recognized exchanges. This exchange serves as a mediator and facilitator between the parties to the contract. The exchange requires that both parties put in advance a nominal margin as part of the contract.

Various exchanges offer rate, commodity, and currency derivatives. For example, when you purchase a futures contract of Tata Motors, the underlying asset will be the Tata shares. A similar scenario could emerge if you were to purchase a Nifty futures contract, with its underlying asset being the Nifty Index. There shall be a correlation between the two. Therefore, if the value of Nifty is going up, then the price of Nifty futures contracts is also considered to be moving in the same direction. As a result, if the index moves up by 100 points, we can also expect the price of the Nifty futures to move in a similar direction.

Overview of futures contract

What is a futures contract

A futures contract is a financial instrument in which a buyer (the one holding a long position) and a seller (holding a short position) agree on terms of the contract. Under such circumstances, the buyer agrees to acquire a derivative/index at a specific date in the future at a specific price.

When the contract’s price changes over time relative to the price at which it was traded, the trader gains or loses money. Respective stock exchanges monitor every contract they settle.

Futures contracts are derivatives in nature because their value is determined by an underlying asset. Individuals or institutions can buy commodities at today’s rates and receive them at a specified future date by trading these contracts. Keeping track of the market price of the traded commodity by delivery date allows investors to post profits.

Contracts for futures have an expiration date, but they need not be held until that date. Cancellation is allowed at any time during the tenure. Generally, futures contracts have two positions:

one short position which requires delivery on a predetermined date, and
the other long position which requires acceptance on that same date.

The expiration dates of contracts can also be specified. Taking an example of a situation where a trader trades gold futures, such trader may see contracts for gold futures for February, April, June, August, October and December. To mitigate inflation for the specified tenure while also making a profit, the trader can purchase a contract for delivery in October if the trader believes gold prices will increase in September or October.

Nature of a futures contract

In general, a futures contract exists for a finite period, after which it is either settled in cash or done through delivery. On the other hand, most of them (though not all), spot instruments that are used as the underlying base for futures contracts are perpetual. As underlying spot instruments, futures also serve several economic functions.

Futures contracts are standard forms, but specific details vary according to the type of commodity involved. They specify the quality and quantity of the asset concerned. Buying and selling commodities at a predetermined price are both binding on both the buyer and seller.

What is a derivative

You need to be familiar with derivatives trading before you can understand futures trading. As discussed above, a derivative is a financial contract between two or more parties as long as the underlying asset, index, or security is agreed upon. A common derivative is a futures contract, a forward contract, an option, a swap, and a warrant. The purpose of derivatives is either to mitigate risk or to assume risk and reap rewards.

The value of derivatives is determined solely by the value of the underlying principle of security. Derivative investments are typically considered advanced investments.

Locks and options are the 2 classifications of the derivative instruments. Contracts with lock terms (swaps, futures, or forwards) bind the parties to those terms for the duration of the contract. Stock options, for example, are a type of option product that allows a holder to buy or sell an underlying asset at a predetermined price at or before the option’s expiration date, but not the obligation to do so. Derivatives are based on assets, but owning one is not the same as owning that asset.

In India, the Reserve Bank of India (RBI), SEBI and Forward Markets Commission (FMC) have the authority to regulate and permit derivatives instruments.

A major responsibility of the RBI is to regulate the derivative instruments, including but not limited to interest rate derivatives, foreign exchange derivatives, and credit derivatives. Further, under the Reserve Bank of India Act, derivatives are defined for regulatory purposes.

What is futures trading

Futures trading is speculating on or protecting against, the future value of a wide range of assets, such as stocks, bonds, and commodities. There is a high potential for high returns when trading futures, but there is also a high risk attached with it.

Futures trading involves making speculations about whether a commodity’s price will increase or decrease in the future. Essentially, futures trading involves taking advantage of price fluctuations for profit, meaning that a commodity is bought at a low price and sold at a higher one. Unlike manufactured goods, commodities are traded in the primary sector of the economy.

There are two types of commodities: soft commodities (coffee, wheat, sugar) and hard commodities (gold, silver, oil).

From an investor’s perspective, investing in futures can provide some diversification to your portfolio, if you understand the way they work and how they might fit into your portfolio. The question here arises how futures trading differs from other financial instruments?

Futures are derivatives, so their value depends on that of another derivative. Thus, they have no intrinsic value. Unlike other financial instruments, the contract has an expiration date and lasts for a defined period.

In contrast to a futures contract, which has a fixed duration, a stock represents the equity in a company or an organisation and can be held for a comparatively longer duration. The direction of the market and timing is, therefore, crucial when it comes to trading futures. The most important difference by which futures trading differs most from other financial instruments is in terms of how ‘leverage’ is used.

Therefore, we understand that futures contracts are used to invest in derivatives. Typically, only a small amount is required in advance for an investor to initiate a contract of this kind. The initial margin required to begin the contract is a percentage of the total value. Exchanges set margin requirements and maintenance values for contracts. Futures markets are distinguished from other financial instruments by this factor.

How to buy and sell a futures contract

In essence, a futures contract works the same way as a cash market purchase or sale, except that the buyer does not take immediate delivery.

Index futures (explained below) also mimic the movement of a stock price by moving their level up or down. Indexes and stock contracts are quite similar to shares, so it’s quite similar to trading stocks.

Buying

Whether in the derivatives sector or the stock market, a trading account is a prerequisite, and another requirement is money. However, the derivatives market has its own set of requirements.

Unless you are a day trader using margin trading, you will have to pay the entire amount of the shares purchased in the cash segment. In other words, you have to pay the exchange or clearing house the full amount.

Margins money is the term for this upfront payment. In addition to reducing risk, it helps maintain the integrity of the market. A futures contract can be purchased once these requirements are met. Orders need only be placed with the broker, who will specify the details of the contract such as the expiry month, contract size, etc. To do so, you simply need to give the margin money to the broker. The broker will then contact the exchange on your behalf.

If you are a buyer, the exchange will connect you with a seller, and if you are a seller, it will connect you with a buyer.

The following points highlight the main provisions of how to buy a futures contract:

The first step is to get the trading account.
Secondly, the arrangement of the margin money.
Deposit the margin money with the respective broker, who then passes it to the exchange.
The next step is to place the buy/sell order with the trader.
The exchange shall then match the order if the buyer/seller is available at a given price.

The settlement

A futures contract does not offer immediate delivery of the assets. The contract is settled after settlement. The expiration of the contract is usually the date of settlement. Most traders, however, decide to settle the contract before it expires.

The following two methods of settlement are available for stock futures:

Expiration date (on expiry)

If the contract expires at the end of its term, the price of the contract is settled based on its closing price.

For example, A futures contract consisting of 200 shares of XYZ Ltd. (“Company”) has been purchased by you and expires in October, and the company’s shares were trading at Rs 1,000 at that time. Suppose the company closes in the cash market for Rs 1,050 on the last Wednesday of October. At that price, your futures position will be settled. If you settle your share at Rs 1,050 and you bought it for Rs 1,000, you shall receive a profit of Rs 50 per share, or Rs 10,000. Margin adjustments are made according to your account balance. Whenever you receive profit, it will be added to your margins deposited previously. On the other hand, losses are deducted from margins if they are substantial.

Before the expiration date

Futures contracts do not have to be held until their expiration date. Many traders gain access to the market before the expiration of contracts. If you have made any profits or losses, they will be adjusted against the margins you have deposited until you choose to terminate the arrangement.

Alternatively, you can purchase an opposing contract to nullify your contract. In this scenario, your profits or losses will be returned to you once your position has been squared off, adjusted for the margins that you have deposited.

The settlement of index futures contracts is cash-based. Alternatively, this can be done on or before the expiry date of the contract.

How to trade futures

The NSE and the Bombay Stock Exchange (“BSE”) are two Indian stock exchanges that provide trading in futures. Here are some instructions on trading futures in India;

Understanding the working

Unlike stocks and mutual funds, futures are complex financial instruments. A first-time investor in stocks can find trading futures a challenge. When you make your first trade in futures, you will need a thorough understanding of how futures work and the risks and costs involved.

Knowing the risk

In futures trading, one can also lose money while trying to make profits. The first step to investing in futures is knowing your risk appetite. Make sure you know how much money you can afford to lose and whether you will be able to maintain your current lifestyle without it.

Trading strategy

Choosing your trading strategy is critical. Understanding and researching futures can guide your decision. You can simulate the trading process on a simulated trading account, which is available online, once you have a basic understanding of futures trading.

The trading account

You need a trading account if you want to trade futures. Before you open an account, make sure you perform a thorough background check.

The margin money

Following this, the money needs to be paid to the broker, who will then deposit it with the exchange. It is held by the exchange throughout your contract. You will be required to pay extra margin if the margin money increases during that time frame.

The order

Your broker can then proceed with the order. As with buying stock, a broker places an order for you. To place a trade, you will need to provide the broker with certain information, including the size, the number of contracts you want, the strike price, and the maturity date.

Settlement

Future contracts must then be settled. They may be settled at expiration or before expiration. It is the delivery obligation associated with a futures contract that constitutes a settlement. When it comes to an equity index or interest rate futures, delivery is conducted based on cash received. When it comes to agricultural products, physical delivery might be done, but when it comes to equity indexes, delivery is done based on cash received.

Features and basics of a futures contract

In India, the Forward Markets Commission (FMC) regulates futures markets. As a governing body, this organization is responsible for matters such as granting or denying recognition to any commodity or market engaged in forward dealing.
A futures contract can be used for many different types of assets, such as commodities, currencies, and indices.
As opposed to forward contracts, a futures contract is standardized. For example, if one’s contract stipulates that it applies to 1000 barrels of oil, they will have to fix their price according to that unit. You would have to sell or purchase a hundred separate contracts to lock in a price. Buying or selling a thousand contracts of this type is the only way to lock in a million barrels of oil. Moreover, futures traders can calculate the price that a stock or its index will likely achieve in the future.
By analyzing their current future prices, future contracts can determine the future demand and supply of shares.
The margin trading mechanism of futures makes it possible for those with insufficient funds to trade and participate in trades. Instead of paying the entire physical value, a smaller margin can be used.
Both speculators and hedgers use futures contracts. Hedgers and producers are those who create or purchase underlying asset hedges. In addition to guaranteeing the price of the commodity, these individuals assure its sale or purchase. Additionally, speculators are those who wager on the price movements of the underlying asset by using futures.

Types of future traders in a futures contract

Participants in the futures contracts can be categorized into two types: Hedgers and Speculators.

Hedgers

As a general rule, hedgers use futures to reduce the effects of adverse price movements in the underlying commodity. To hedge, we rely on the fact that cash prices and futures values tend to move in tandem.

Business or individual hedgers often deal in cash commodities at one point or another. Consider an example where a food processor company that cans corn deals in cash commodities. If corn prices go up, the farmer or corn dealer must be compensated more. To protect against higher corn prices, the processor can take on corn futures contracts equal to the quantity of corn he anticipates buying to hedge his risk exposure. Due to their tendency to move together, cash and futures prices will be in sync if corn prices rise enough to offset losses in cash corn.

Speculators

Speculators make up the second-largest group of players in futures contracts. Traders and investors make up this group. They also are referred to as locals or independent floor traders. Individual floor brokers or brokerage firms carry out trades themselves.

In comparison to other investments, futures can offer the following important advantages to speculators:

Faster money: In general, futures prices tend to change more quickly than real estate or stock prices, so a trader who has good judgment can make more money faster in the futures market. In contrast, poor judgment in the futures market might lead to greater losses than would be the case in other types of investments.
Leverage: They involve a great deal of leverage. Usually, 10%-15% of the underlying contract’s value is put up as a margin, and the trader is allowed to ride the full value of the contract as it varies.

Performance bonds are not down payments on underlying contracts but are instead performance bonds. On those rare occasions when delivery is made, the actual value of the contract is exchanged. Unlike the stock investor, the commodity futures investor does not have to put up 50% of the full contract value as a margin. In addition, there is no interest due to the margin difference.

Smaller commissions: The investor pays commissions on futures trades after the position is liquidated, and they are small compared to other investments.
Quick trade: Many commodities are broadly traded and are liquid. By executing trades quickly between the moment a decision to trade is made and the moment that trade is executed, adverse market movements can be reduced.

Advantages and disadvantages of a futures contract

Advantages of a futures contract

The following are the advantages:

Easier than stocks

It is easier to short-sell futures than stocks. Additionally, more types of investments are available.

Pricing

A futures contract’s price is determined by using the current spot price and adjusting it for the risk-free return rate until expiration and the costs of storing the commodity until it is delivered to the buyer.

High Liquidity

Due to the high liquidity of futures markets, investors can easily switch positions without incurring high transaction costs.

Greater leverage

Unlike a typical brokerage account, futures trading can provide a greater amount of leverage.

Easy for hedging

An easy way to hedge positions. Business or investment portfolios can be protected from downside risks if they hold a strategic futures position.

Regulation

As with the stock market, futures are regulated by stock exchanges and clearing corporations.

Disadvantages of a futures contract

The following are the disadvantages and the risks attached:

Price fluctuations

You may be required to provide more cash to cover your broker’s maintenance margin if your position moves against you. Furthermore, underlying assets don’t have to move very far for you to be forced to put up more money when you use a lot of leverage. The trade can be turned into an average trade.

Future uncertainty

There is also the risk that futures traders cannot predict the future. A farmer, for example, might agree to sell corn in the fall, but if a natural disaster destroys his crop, he will need to buy an offset contract. A natural disaster might have wiped out your crop, and the corn price probably rose much higher, resulting in losing a huge amount of money. Furthermore, investors cannot predict all potential changes in demand and supply.

The expiry

A futures contract expires after a particular period. Although you may have been right in your speculation that gold prices will rise, you may wind up with a negative result if the contract expires before that time.

Stock futures and index futures

Stock futures

In stock futures, which is a financial contract, an individual stock is an underlying asset. In a stock futures contract, both parties agree on a price prior to the future date for buying or selling a specified quantity of shares. Standard specifications are standardized for each contract, such as market lot, expiration date, unit of quotation, tick size, and method of settlement.

As a result of adding the current spot price and carry costs, the theoretical price of a futures contract is calculated. Demand and supply of the underlying stock have a great deal of influence on the price of a futures contract. A futures contract will generally trade at a higher price than the spot price for its underlying stock.

Unless the dividend is not expected until the expiration of the futures contract, the cost of carrying is the interest cost of a similar position in the cash market. There are many ways in which stock futures can be used by investors. Stock futures can be used by investors for long-term positioning. They are highly leveraged. This allows them to take large positions with a small investment.

Index futures

Over some time, a stock index measures changes in the prices of a group of stocks. An industry or company size is chosen as the basis for selecting stocks. Indices represent a segment of the market or the entire market, allowing price movements to be tracked.

In the case of the BSE Sensex, the index comprises 30 liquid and fundamentally sound companies. In addition to being market leaders, these stocks are subject to any changes in the economy or industries through their prices on the BSE.

The indices also offer futures contracts. Futures contracts allow traders to profit if the indices do well.

Index futures have the following characteristics:

The lot size on these contracts is the same as on stock futures.
Due to the abstract nature of indices, transactions cannot be settled by actually purchasing or selling the underlying assets themselves. Stock futures are the only ones that can be settled physically. The settlement of an open position in index futures can thus be accomplished by conducting a transaction opposing it on or before the expiration date.

Legal provisions of futures contract

As with all contracts, futures contracts are governed by the Indian Contract Act of 1872, which compiled common law principles into one statutory document. The Act gives parties to a futures contract the opportunity to execute their rights and responsibilities.

Depending on the SEBI Act, 1992 not all commodities are appropriate for trading in futures. It is determined by the SEBI that a commodity can be traded as a futures contract only if demand and supply conditions are right

This means that there must be a large volume and marketable surplus. There should be no regulatory or other bodies that impose restrictions on the supply, distribution, or price of the commodity involved in futures contracts. According to the Act, commodities must also be volatile so that futures price risk can be hedged. Hedging facilities would be needed as a result.

A homogeneous commodity is also required, or, otherwise, its standard can be stipulated. It has already been established in this article that a futures exchange requires a standard since futures are standardized contracts. The SEBI Act requires that the commodity must be storable, otherwise, arbitrage is impossible, and the spot and futures markets cannot be connected.

Conclusion

The key to successful futures trading techniques is to increase profits, reduce losses, stay rational, keep emotional balance, and not lose your emotional equilibrium.

To achieve success in a futures trading career, you need to know how to think ahead and perceive market fluctuations before they occur. Being ahead of the curve means being able to predict future events.

All traders, speculative or otherwise, find futures trading attractive. Since futures markets are more mature, they are efficient and transparent. Short selling is easier due to high liquidity. Assets are rarely delivered in physical form. Dealing is easier due to low commission and execution costs. If you are inexperienced, however, you can incur a huge loss if you do not learn how to invest in the future.

Day trading futures is a great option for day traders, and it requires fewer capital resources than stock trading. Moreover, futures markets are not designed for day trading. In addition to diversifying your portfolio, futures contracts are a great way to invest in the future.

References

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