What Is a Futures Contract?
A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a pre-decided price at a specified time in the future. The buyer of a futures contract commits to buy and receive the underlying asset when the futures contract expires and the seller of the futures contract commits to sell/provide and deliver the underlying asset at the expiration date. The expiry date of the futures contract is the last date of the contract.
Why Is it Called a Futures Contract?
The buyer and seller of the contract are deciding to pay the price today for some asset or security that is to be delivered in the future.
In India, futures contracts can be traded on the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). While buying futures you should remember the following things:
Understand the working of futures and options
Futures are different from other tools such as stocks and mutual funds and are complex financial instruments. Trading in futures can be tough for a first-time investor.
Know the risk
Everyone wants to make profits in the markets, but the contrary is true that one can lose money in futures trading. Before you invest in futures, it is essential to know your risk-taking capability. You should know how much money you can afford to lose and if losing the amount will affect your lifestyle.
Practice with a simulated trading account
Once you get an idea of how to trade in futures, you can try and practice the same on a simulated trading account, which is available online. This will enable you to have first-hand practical experience on how futures markets work. This makes you better at trading in futures without making any actual investments.
Open a trading account
To start trading in futures, you need to open a trading account. You need to pay the required fees for this. While investing in futures, it is important to select the best trading account.
Arrange the margin money requirement
To start trading futures you will require to deposit some amount of margin money as a security, which can be between 5% to 10% of the contract size. Once you know how to buy futures, it is necessary to arrange for the margin money required. When you purchase futures in the cash segment, you have to pay the entire value of the shares purchased, unless you are a day trader.
Deposit the margin money
Pay the margin money that you have arranged to the broker who in turn will deposit it with the exchange. The exchange holds the money for the entire period you hold your contract. If the margin money goes up during that period, you will have to pay extra margin money.
Place buy/sell orders with the broker
You can then place your order with your broker. Placing an order with a broker is similar to buying a stock. You will have to let the broker know the size of the contract, the number of contracts you want, the strike price, and the expiry date. Brokers will provide you with the option to select from various contracts available, and you can choose from them.
Settle future contracts
This can be done on expiry or before the date of expiry.
Before Expiry: You can settle the futures contract before expiry. Most traders exit their futures contracts before expiry dates. Gains or losses you have made are settled by adjusting them against the margins you have deposited till the date you decide to exit your contract. You can do this by either selling your contract or purchasing an opposing contract that nullifies the agreement. Here, your profits will be returned to you or losses will be collected from you, after adjusting them for the margins that you have deposited once you square off your position.
On Expiry: When closing a futures contract on expiry, the closing value of the contract on the expiry date is the price at which the contract is settled. If on the date of expiry, the index closes higher than when you bought your contracts, you make a profit and vice versa. The settlement is made by adjusting your gain or loss against the margin money you’ve already deposited. Your margin account will be credited if you have made a profit or your account will be debited if you get a loss.
What are the payoffs and charges associated with futures contracts?
There are different types of margins prescribed by the exchange as a percentage of the total value of the derivative contracts.
Initial margin is defined as a percentage of your open position and is set for different positions by the exchange or clearinghouse. The average volatility of the stock in concern over a specified time and the interest cost decide the amount of initial margin ar. Depending on the market value of your open positions, the Initial margin amount fluctuates daily.
The exposure margin is set by the exchange to control volatility and excessive speculation in the futures markets. It is charged on the value of the contract that you buy or sell.
The difference between the cost of the contract and its closing price on the day the contract is purchased is called a Mark-to-Market margin. After purchase, mark to mark margin covers the daily differences in closing prices.
This is the amount given by the buyer to the seller for writing contracts. It is mentioned on a per-share basis. As a buyer, you pay a premium margin and if you are a seller, you receive a premium margin.
Margin payments help traders to get an opportunity to participate in the futures market and make profits by paying a small sum of money, instead of the total value of their contracts.