A futures contract is an agreement to buy or sell an asset at a future date at a predetermined price. These contracts are traded on an exchange where two parties are involved, namely, the buyer and the seller. The buyer of the futures contract is the party with the long position and the seller is the party with the short position. Read our blog on “What are future contracts?”
Let’s understand the entry of a futures trader into the market in a few simple steps.
Setting up an account:
As mentioned above, futures contracts are traded on an exchange, hence you need to set up a trading account with a broker that supports the markets you want to trade.
Determining Your Move:
Any trader who wants to trade in the future, may it be a long or short position, needs to first have a directional view of the price of the underlying asset. And if the expected direction is a rise in the price of the underlying asset, the trader would go long (buy) on its futures contracts or if you expect the price of the underlying asset to go down, you would go short instead. Further determining how long you want to hold your trade.
Determining Your Risk Tolerance:
Many beginners to futures trading miss out on this step. You need to determine how much of your fund you are willing to risk for that trade. Futures trading is a leveraged trading method, (where only a margin amount is deposited to trade), losses can accumulate very quickly which can empty all the money in an account in no time. Futures markets have an official daily settlement price set by the exchange hence the futures contracts are intolerant to losses. This risk tolerance is usually determined by percentage. Most futures day traders have a 1% or 2% risk tolerance. Once you know exactly how much you are willing to lose, you can now determine how many futures contracts to trade.
Determining Your Position Sizing:
This is a way of determining how many futures contracts to trade while trading in futures.
Determining Initial Margin Requirement:
When you have determined the number of futures contracts to trade and interpreted your tolerance to risk, the next step is to determine which futures contract to trade and calculate the amount of initial margin required to trade that amount of futures contracts. Initial margin is needed no matter if you take the long side or the short side while trading futures. If you fall short on the margin amount, you will have to cut off on the number of contracts you want to trade. Later, you can settle off the trade with the remaining cash to meet maintenance margin requirements if the trade move against your favor badly.
Entry and Stop Loss:
After completing the previous steps, it is time for you to make your entry. When trading futures, make sure you go long when speculating on the underlying asset going upwards and go short when speculating on the underlying asset going downwards. Once your futures position is on, you can gain the advantage of setting your stop-loss order if you incur loss beyond the tolerable risk. You must make sure you know what kind of orders your futures broker offers and plan your entry accordingly.
Once you have entered the market, you will need to take the next step to exit the market. No matter if you are taking profit or stopping loss in trading futures, you would need to perform an action called "Offset". Offsetting means carrying out an equal and opposite trade in order to neutralize your existing position in the same instrument, effectively closing it out.
Types of Futures Contract Settlement
Future contracts have two types of settlements, Mark-to-Market & final settlement.
Post-purchase, MTM margin covers the daily differences in closing prices. This type of settlement happens on a continuous basis at the end of each day. This means that the value of the contract is marked to its current market value. Mark-to-Market margin covers the difference between the cost of the contract and its closing price on the day the contract is purchased. The exchange, with the help of brokers and clearinghouse, pays this MTM margin from the loss suffering party to the profit-maker party.
MTM is calculated at the end of the day on all open positions as the difference between the:
The trade price or the previous day’s settlement price and the current day’s settlement price for contracts executed during the day and not squared off. (As the case may be) (Trade price/ Previous day’s settlement price -- Current day’s settlement price)
The buying price and the selling price for contracts executed during the day and squared up. (Buy Price – Sell Price)
You may understand better with the help of a practical example:
If an investor buys 1 lot of Futures on Stock that contains 100 shares on 10th September 2019, when the price is Rs.2000, the total value of trade would be 2000 x 100= 2,00,000.
Further, suppose the investor is liable to pay a margin of 15% of the lot value to buy this futures contract i.e. 15% of Rs.2,00,000 = Rs.30,000.
On 11th September, the next trading day, the Futures prices close on Rs.2060, then the investor has made a gain of Rs.6000 (Rs 60 x 100). This gain would be credited in his account and debited from the account of the seller on account of mark to market settlement. The position would start from Rs.2060 from the next day. When the contract expires, his margin account will be marked-to-market for P&L on the final day of the contract.
The Final settlement is the settlement that happens on the last trading day of the futures contract, i.e. after maturity of the futures contract. All the obligations of the parties are fulfilled by them as per the contract. The final settlement of the futures contract happens on a Final settlement date which may not be the same as the expiration date of the contract. The final settlement profit/loss is computed as. The difference between the trade price or the previous day's settlement price, as the case may be, and the final settlement price of the relevant futures contract. Final settlement loss/ profit amount is debited/ credited to the account on T+1 day (T= expiry day).
Most stocks and bonds settle within two business days after the transaction date. This two-day window is called the T+2. (Stock futures). Government bills, bonds, and options settle the next business day. (Interest rate futures). Spot foreign exchange transactions usually settle two business days after the execution date. (Currency futures) Can we buy and sell futures on the same day? Yes, Futures can be day traded. Day trading is the strategy of buying and selling a futures contract within the same day without holding the long (buy) or short (sell) positions overnight, the profits and losses are settled at the end of every single trading day in a process known as "Daily Settlement". In day trades, Futures contracts realize their gains and losses at the end of each trading day. Stock and Index Settlement: On Expiry The futures contract, no matter the position is long or short, is settled in cash at the closing price of the underlying asset as on the expiry date of the contract. Example: If you are holding a long position in a stock futures contract of Tata Motors Ltd., consisting of 100 shares in a lot and the contract month is August. At that time, the share’s price was Rs 1,000. Therefore, Cost price = Rs.1000
If on the last Thursday of August, ABC Ltd. closes at a price of Rs 1,050 in the cash market, your futures position will be settled at that price. You will receive a profit of Rs 50 per share (the settlement price of each share will be 50, Rs 1,050 minus cost price of Rs 1,000). This sums up to Rs.5,000 (Rs.50 x 100 shares). This amount is adjusted with the margins you have maintained in your account. If you make profits, it will be added to the margins that you have deposited. If you made a loss, the amount will be deducted from the margins.
Before Expiry Just as we know that there is no obligation to hold on to your position till its expiry date. Many traders exit their contracts before they expire. You can exit your position before the expiry of the futures contract by either selling your contract or neutralize the contract by purchasing an exact and equal contract that nullifies the agreement. The gains or losses that you make, are adjusted against the margins you have deposited till the date you decide to exit your contract. If the margin amount available, falls short the remaining amount will be collected from you and if the margin amount is in excess, the excess amount will be returned to you in form of profits. Index futures contracts Settlement: The Index futures contracts are settled in cash. This type of contract also does not oblige you to wait for the contract to expire to exit the position. Hence, there are two periods of expiry in index futures contracts. On Expiry While settling of index futures on expiry – The price at which the contract is settled in the closing value of the index. If on the date of expiry, the index closes higher than when you purchased your contracts, you make a profit. If On expiry, the index closes lower than when you purchased your contract, you will make a loss. And further, the profits and losses made are settled by adjusting it against the margin money you’ve already deposited and is available in your account.
Example: In case, as of August 7, you are holding 2 contracts (50 units per lot) of Nifty futures at 14600, expiring on July 27 (being the last Thursday of the contract duration). If you are not available to sell the future on the day of expiry due to some circumstances, the exchange will itself settle your contract at the closing price of the Nifty on the expiry day. So, if on July 27, there can be two cases:
If the closing price of Nifty falls by Rs. 100 i.e., Rs.14500, you will have made a loss of:
Difference in index price (Rs.100) x (2) lots x lot size of (50 units) = Rs 10,000. And just like in stock futures, the broker will adjust the amount from your margins deposited with him and make a margin call if the amount in the margin account falls short. This amount forwarded to the exchange, in turn, will forward it to the seller, who has made that profit. In the other case, where if the Nifty rises to 14700, you would have made a profit of Rs 10,000. This will be then added to your account as per the process mentioned above.
Before Expiry There is no obligation to hold a position and hence you have the freedom to exit your index futures contract before the date of expiry. If you believe that the price of the futures will rise before the expiry of your contract and you predict that you may get a better price. Then you can exit your position and further the transaction will be settled by the exchange by comparing the index levels when you bought and when you exit the contract. You may gain profit or loss, and accordingly, your margin account will be credited in case of profit or debited in case of loss. With futures market trading, you simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.