What is Futures Trading
Futures and Options, abbreviated as F&O, are both a part of the derivatives trading segment. Derivatives – as the name suggests – is a financial contract that ‘derives’ its value from an underlying asset’s price movement. The assets could range from stocks and commodities to indices.
Both Futures and Options involve a financial contract. In this contract, the buyer and the seller agree to purchase a specific quantity of an asset, at a later date, and at a pre-determined price. Both parties aim to benefit from the price fluctuation of the asset. The Securities and Exchange Board of India (SEBI) regulates this segment.
Derivatives trading enables you to hedge and manage your risk, access otherwise inaccessible markets and in the process, earn higher returns.
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In this article, we will cover the following:
- Deep Dive: Futures Trading
- Difference Between Futures and Options
- Key Words to Know
- Benefits of Futures Trading
Deep Dive: Futures Trading
Futures Trading is a type of derivatives trading that is used as a hedge or to benefit from the price fluctuation of assets like stocks, commodities (like oil, agricultural, metal), currency and indices. For this, buyers and sellers determine the future price of an asset, and enter into a contract with a fixed execution date for the trade.
This is captured in what is known as the Futures Contract. The contracts have standardized specifications like market lot, expiry day, price, and method of settlement.
A Futures Contract can be of 1-month, 2-months or maximum 3-months period. In this period, the price of an asset changes based on several factors, including its demand and supply, inflation, and the overall health of the economy. So on the expiry date of the contract, one party makes gains while the other makes losses.
After the expiry – on the last Thursday of the month – a new contract is introduced on the following trading day. And so the cycle continues.
Typically, there are two types of participants in Futures Trading.
- Hedgers: Hedgers can be businesses or individuals who use Futures Trading as a protection against volatile price movements in the asset.
- Speculators: Speculators are usually independent traders and investors, who use Futures Trading to make money for themselves or their clients.
Each type has a buyer and a seller, who enter into a Futures Contract with each other. A buyer usually expects a price increase, whereas a seller usually expects a price drop, by the time of execution of the contract.
Let’s see how this works with a hypothetical example of a mango farmer and a company that makes mango juice.
Mango prices, like any other commodity, can fluctuate. In June, the ongoing price of mangoes in the open market is Rs 100 per kg.
The farmer wants to hedge against the fall in mango prices in a few months, while the company – for whom mango is an important raw material – wants to hedge against the rise in mango prices.
So the farmer (seller) and the company (buyer) both enter into a Mango Futures Contract. As per the contract, three months from now, the company will acquire mangoes from the farmer for Rs 100 per kg.
At the end of three months, if the price of the mangoes rises to Rs 150 per kg, that means the buyer has profited, because the farmer will still have to sell it to the company at Rs 100 per kg. However, if the price drops to Rs 75 per kg, then the seller i.e. the farmer would profit, as the company would still have to pay Rs 100 per kg.
This example illustrates the broad functioning of Futures Trading.
You can trade in Futures on the National Stock Exchange (NSE) and the BSE in India.
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Difference Between Futures and Options
The workings of Futures and Options may look similar, but they aren’t the same.
Right versus Obligation:
In Futures trading, the contract is obligatory. Options contract, meanwhile, gives the trader the right but not the obligation, to execute the contract. Thus, if the condition isn’t favourable, the trader can choose to not exercise his / her right to buy or sell.
In Futures trading, the trader doesn’t need to pay the full amount upfront. The trader only needs to keep a margin money (i.e. a certain percentage of the traded value). This margin is blocked, and cannot be used for any other trades. In Options trading, the buyer has to pay a “premium”, while an Options seller has to set aside margin money.
In Futures Trading, the contract cycle could be of one month (near month), two months (next month) and three months (far month). Whereas in Options trading, the contract cycle could be weekly, monthly, and for long-dated options contract, the expiry could be 9 months to even 3 years.
Key Words to Know
- Spot Price: This is the market price, for the immediate purchase or sale of an asset
- Futures Price: The price at which the futures contract trades in the market
- Lot Size: Minimum quantity of an asset that one needs to buy or sell
- Contract Value: Current price of the futures of a security, multiplied by the lot size gives you the contract value
- Expiry Date: The date on which the contracts are compulsorily settled. In India, the Expiry Date is the last Thursday of every month
- Open Contract: A contract that hasn’t expired
- Open Interest: The total number of Open Contracts of a particular security, stock or asset
- Margin: Percentage of contract value that needs to be paid when placing a trade
Benefits of Futures Trading
Futures Trading is gaining popularity in India because:
- It is an excellent tool to hedge risk
- It enables effective discovery of price of an asset
- It creates multiple pay off scenarios
- It has the potential to benefit from even a non-directional market
To get a better understanding of futures and options in the stock market, you can start investing in F&O with Prabhudas Lilladher, one of India’s most trusted and respected financial services organisation.
PL provides excellent and timely research reports and calls, which help you trade efficiently in F&O. PL also organises LIVE market webinars to teach derivatives trading.
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