Futures, as a derivative instrument offers unique trading characteristics, and is totally different from trading stocks and shares. It is also different than trading the underlying asset itself, known as spot trading. Spot trading of the underlying asset is a simple matter of just buying at one price and selling at a better price. However, the margin trading system (leverage) used in futures trading is completely different and requires a lot more than just buying at one price and selling at a better price.
Derivatives allow investors to bet on the expected future price of an asset, which may be anything from among stocks, bonds, commodities, currencies, and interest rates. The futures market can be used by many kinds of financial players, including investors and speculators as well as companies that actually want to take physical delivery of the commodity or supply it.
Futures have great advantages that make them appealing for all kinds of investors — speculative or not. However, highly-leveraged positions and large contract sizes make the investor open to huge losses, even for small movements in the market
A futures contract is an agreement between the buyer and the seller to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. These agreements are basically traded on an exchange and not directly between the parties. Here, the buyer agrees to buy a given quantity of securities or a commodity, and take delivery on a certain date and the seller agrees to provide it as agreed upon between both parties.
The buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.
If a trader holds security that is trading at 1800 in the market and wants to sell at 2000 in near future. However, since the prices keep continuously fluctuating, the trader feels he may not be able to get the amount he wants. So, to hedge against price fluctuations, he enters into a futures contract to sell the stock or commodity at Rs 2,000 at a specified date. So in the meantime, the stock price falls to Rs 1,500. And at this time, the trader can avoid this loss by exercising his futures contract and get Rs. 2,000 for the stock/ commodity, thus gaining Rs.200 per share. The disadvantage is that if the stock prices go up to Rs 2,500, he will not enjoy the benefit of the price increase as he will still have to sell the stock at Rs 2,000. He will stand to lose Rs 500 per share.
Underlying assets may include anything ranging from physical commodities or other financial instruments.
PROs and CONs of Future Contracts
Futures have great advantages that make them appealing for all kinds of investors — speculative or not.
Opens the Markets to Investors - Futures contracts are useful for risk-tolerant investors. Investors get to participate in the markets with an initial margin and trade in securities without limitation
Stable Margin Requirements - Margin requirements for futures are standardized in the futures market. Thus, a trader knows how much margin he should put up in a contract. It's important to note that trading on margin allows the trader to trade for a much larger position than the amount he holds in the brokerage account. Margin investing can maximize gains, and on the contrary, it can also magnify losses. If the price of the contract goes against the direction you had bet upon and the balance in your broker account falls short to cover the losses, the broker would make a margin call asking for additional funds to be deposited to cover the market losses. Whereas, in case of profit, your broker account will be credited.
High Liquidity - Most of the futures markets offer high liquidity, especially in the case of currencies, indexes, and commonly traded commodities. This allows traders to enter and exit the market when they wish to.
Simple Pricing - Futures pricing is quite easy to understand. It's usually based on the cost-of-carry model, under which the futures price is determined by adding the cost of carrying to the spot price of the asset.
Protection against Price Fluctuations - Many people enter into forward contracts for better risk management. Forward contracts are used as a hedging tool in industries with a high level of price fluctuations.
Not dependent on Market Price - One can sell the stock or commodity at a fixed price on a future date even if the current market price on that date is less or high.
Speculation - Investors can use futures contracts to speculate on the direction in the price of an underlying asset.
No Control Over Future Events - One common drawback of investing in futures trading is that you don't have any control over future events. Natural disasters, unexpected weather conditions, political issues, etc. can influence the situation of the market.
Expiration Dates - Future contracts involve a certain expiration date. The contracted prices for the given assets can become less attractive as the expiration date comes nearer. Due to this, sometimes, a futures contract may even expire as a worthless investment.
Leverage - Investors have a risk that they can lose more than the initial margin amount since futures use leverage.
Limit Profits by Hedging - Investing in a futures contract might cause you to lose out on favorable price movements of the stock that you hedged.
Types of future contracts
The types of future contracts depend upon the underlying assets broadly categorized as Physical/commodity commodities and financial instruments. Hence there are many types of contracts based on the underlying assets, in both financial and physical segments. Some of the types of financial futures include stock, index, currency, and interest futures.
Difference between Financial Futures and Commodity Futures.
In Commodity futures, a particular commodity like food grains, metals, gold, etc. is the underlying asset. Whereas in financial futures, the underlying assets are financial instruments such as stocks, bonds, indices, currencies, etc.
Futures are available for other asset classes too. The different types are further explained below:
Stock Futures (dealing with shares)
Stock Futures are financial contracts where the underlying asset is an individual stock. A stock futures contract is a commitment to buy or sell a stock at a certain price and a specified time in the future, regardless of its market price at that moment. You can trade stock futures on stock exchanges like the BSE and NSE. However, they are available only for a specified list of stocks.
Like Options, in the futures also the buyer of a futures contract is not required to pay the full amount of the contract upfront. A percentage of the price called an initial margin is required to be paid. The main advantage of trading in stock futures is leverage.
If the initial margin is 10%, then to buy 50 lakhs worth of stock futures you will have to pay just Rs.5 lakh. The larger the volume of transactions, the higher your profit. But the risks are also significant.
Index Futures (dealing with Stock indices)
index futures can be used to speculate on the movements of indices, like the Sensex or Nifty, in the future. Let’s say you buy BSE Sensex futures at Rs 40,000 with an expiry date of the month. If the Sensex rises to 45,000, you stand to make a profit of Rs 5,000. If it goes down to Rs 30,000, your losses, in that case, would be Rs 5,000. Index futures are used by portfolio managers to hedge their equity positions should share prices fall. Some of the index futures in India include Sensex, Nifty 50, Nifty Bank, Nifty IT, etc.
Currency Futures (dealing with currency exchange)
Here the underlying asset is the currency exchange rate. Currency futures are also known as foreign exchange futures. In a futures contract, you can exchange one currency for another at a specified date in the future at a fixed exchange rate.
In forex, contracts are traded through currency brokers, but currency futures are exchange-traded that provide regulation in terms of centralized pricing and clearing.
Commodity Futures (dealing with gold, crude oil futures)
In Commodity futures, a particular commodity like food grains, metals, gold, petroleum, gas, etc. is the underlying asset. Commodity futures allow hedging against price changes in the future of various commodities, including agricultural products, gold, silver, petroleum, etc. Speculators also use them to bet on price movements. Since initial margins are low in commodities, players in commodity futures can take significant positions.
Interest rate futures (dealing with treasury bills, bonds)
An interest rate future is a financial derivative (a futures contract) with an interest-bearing instrument as the underlying asset.
Interest rate futures is one of the important financial futures in the world. It’s a contract to buy or sell a debt instrument at a specified price on a predetermined date. You can trade these on the NSE and the BSE.
The underlying assets are interest-bearing securities like Treasury bills, Bonds, Debentures.
Ways of future trading
Futures contracts allow players to secure a specific price and protect against the unexpected fluctuating prices (up or down) ahead. Not everyone in the futures market wants to exchange a product at the end of the contract, some players enter into a futures agreement to benefit financially. They are Hedgers and speculators who trade in futures to make money from price changes in the contract itself.
An Airline company would not want an unexpected rise in the price of Fuel (aviation turbine fuel) hence they can lock in the fuel price to avoid such situations by buying a futures contract (commodity futures). This allows them to buy a fixed amount of aviation fuel for delivery in the future at the price locked in by them.
On the other hand, the seller of that fuel would not want the prices to unexpectedly fall in the future. So he can sell a futures contract and protect against possible loss.
Both buyer and seller will agree on specific terms- Quantity of fuel, Price of fuel, and the Duration of the contract.
Moreover, Futures can be used for hedging or speculation. Speculators accept risk in the futures markets, trying to profit from price changes. Hedgers use the futures markets to avoid risk, protecting themselves against price changes.
A futures contract allows a trader to speculate on the direction of movement of a commodity's price. If a trader buys a futures contract and the price of the commodity increases and the commodity is trading above the original contract price at expiration, then he could have earned a profit. Before expiration, the trader will set off his buy trade by buying a sell trade for the same amount at the current price, effectively closing the long position.
The difference between the prices of the two contracts would be cash-settled in the investor's brokerage account, and no physical product will change hands.
Speculators can also take a short or sell speculative position if they predict the price of the underlying asset will fall. If the price does decline, the trader will take an offsetting position to close the contract. Again, the net difference would be settled at the expiration of the contract. An investor would realize a gain if the underlying asset's price was below the contract price and a loss if the current price was above the contract price.
It's important to note that trading on margin allows for a much larger position than the amount held by the brokerage account. As a result, margin investing can amplify gains, but it can also magnify losses. Imagine a trader who has a $5,000 broker account balance and is in a trade for a $50,000 position in crude oil. Should the price of oil move against their trade, they can incur losses that far exceed the account's $5,000 initial margin amount. In this case, the broker would make a margin call requiring additional funds to be deposited to cover the market losses.
Futures can be used to hedge the price movement of the underlying asset. Here, the goal is to prevent losses from potentially unfavorable price changes rather than to speculate. Many companies that enter hedges are using—or in many cases producing—the underlying asset.
For example, corn farmers can use futures to lock in a specific price for selling their corn crop. By doing so, they reduce their risk and get assured that they will receive a fixed price over a specific period of time. If the price of corn decreases, the farmer will gain on the hedge to offset losses from selling the corn at the market. With such a gain and loss offsetting each other, the hedging effectively locks in an acceptable market price.
My Experience with Future contracts
To speculate on the price of crude oil by entering into a futures contract in May with the expectation that the price will be higher by year-end. The December crude oil futures contract is trading at Rs.500 and the trader locks in the contract.
Since oil is traded in increments of 1,000 barrels, the investor now has a position worth Rs.500,000 of crude oil (1,000 x Rs.500 = Rs. 500,000).However, the trader will only need to pay a fraction of that amount up-front—the initial margin that they deposit with the broker.
From May to December, the price of oil fluctuates as does the value of the futures contract. If oil's price gets too volatile, the broker may ask for additional funds to be deposited into the margin account—a maintenance margin.
In December, the end date of the contract is approaching, which is on the third Friday of the month. The price of crude oil has risen to Rs.650, and the trader sells the original contract to exit the position. The net difference is cash-settled, and they earn Rs.15,000, less any fees and commissions from the broker (Rs.650 – Rs.500 = Rs.150 x 1000 = Rs.1,50,000).
However, if the price oil had fallen to Rs.400 instead, the investor would have lost Rs.1,00,000 (Rs.400 – Rs.500 = negative Rs.100 x 1000 = negative Rs.1,00,000).