What is Futures Trading in Derivatives?

What is Futures Trading in Derivatives?

Futures trading is a popular derivative instrument that occurs in the equity market, specifically in the F&O segment. It involves buying or selling an asset at a future date at a price determined today. Futures contracts, also known as futures market investing, are contracts that do not create assets. They are symmetric products, meaning the rights and obligations of buyers and sellers are symmetrical to each other. 

Futures trading is a short-term trading strategy, with stock index futures and individual stock futures available on four indices. Futures trading is not a form of investment, as these contracts do not create assets. Understanding futures trading as a product and how to execute it in the real live market is crucial for successful futures trading.

How do you trade a Futures Contract?

  • There are many different types of financial actors in the futures market. They could be traders, investors, or businesses looking to furnish the goods under the terms of a futures contract or physically receive its delivery.
  • Hedgers utilize futures contracts to lock in the price at which they will purchase or sell the underlying commodity on a given date.
  • Consider a jar of beans to see how futures trading operates. A large food processor that depends on beans to maintain its company will have to pay the farmer or the merchant more if the price of beans rises. The processor could choose to "hedge" his risk by purchasing contracts for futures on beans to insure against the unexpected price increase. If the price of beans increases, it will be advantageous for the buyer of the futures contract.
  • In a similar vein, stock futures allow investors to hedge stock prices in the stock market. It is now available for buying on stocks or an index. In a futures contract, the buyer is not required to pay the entire contract price upfront. With a future trading app, only the first margin needs to be paid.

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Table of Content

  1. How do you trade a Futures Contract?
  2. What are Futures Contracts?
  3. Types of Future Traders
  4. How does Futures Trading differ from other financial instruments? 
  5. Advantages & Disadvantages of Futures Trading
  6. Payment of Margins on Futures Contracts
  7. Contract Specifications for Exchange Traded Futures

What are Futures Contracts?

A futures contract is an agreement between two parties to buy or sell an underlying asset at a future date but at a price that is determined today. For every futures contract, there is a buyer and there is also a seller. The futures trade at the futures price, which is normally at a premium to the spot price since the futures pertain to future data and hence the interest cost of funds has to be factored in. The chart below offering details of a live Bank Nifty contract will give a much more in-depth idea of what a futures contract is all about.

Futures contracts expire on the last Thursday of every month and at any point in time, 3 contracts are trading that are near month, mid-month and far month. For example, December 2023 is the near-month contract, January 2024 is the mid-month contract and February 2024 is the far-month contract. On 30th December, the January contract becomes near month and february becomes mid-month. A new far-month contract for March 2024 will be introduced.

Types of Future Traders

Hedgers and Speculators are the two categories of futures trading.

Hedgers: Investors who buy derivative products to hedge against losses on their money are known as hedgers. For instance, a commodity producer may sell a futures derivative at the present price and purchase it back when the price drops if they believe that the value of their crop will decline in the future.

Speculators: Independent floor traders and investors who make money off of the rise and fall of derivative contracts are known as speculators. They purchase and sell futures and options based on the state of the market and the derivative's supply and demand dynamics. In actuality, the parameters of supply and demand control futures prices. A speculator is similar to an intraday share trader who makes purchases at a discount to the asset's value and sells it at a premium.

How does Futures Trading differ from other financial instruments? 

The primary distinction between other financial products and futures is:

  • The value of a futures contract is derived from the underlying asset; it does not have an inherent worth.
  • In stock markets, futures contracts are exchanged.
  • The last Thursday of each month is when futures contracts expire.
  • Lots of transactions include futures contracts.

Advantages & Disadvantages of Futures Trading

Here are the advantages and disadvantages of futures trading:

Advantages of Futures Trading

Disadvantages of Futures Trading

No risk of default due to the clearing corporation guarantee.Trading complexity surpasses stock trading.
Counter-guarantee by the clearing corporation minimizes default.Leveraged positions can amplify losses.
Allows larger contract positions with minimal initial margins.Daily mark-to-market adjustments require substantial capital, limiting smaller capital usage.

Payment of Margins on Futures Contracts

Futures are leveraged contracts, in the sense that traders are taking positions that are much larger than they would take in the cash segment. Being leveraged, the exchange has to collect margins as these trades are guaranteed by the clearing corporation. To partially offset this risk, the exchange charges margins on open futures contracts. Here are some important margins charged on futures contracts. The margins are the same for long futures and short futures positions.

  1. The initial Margin is paid when you initiate a futures buy or sell contract and has to be deposited upfront. This margin is based on the concept of Value at Risk (VAR), which calculates the maximum possible loss on a single day in over 99% of the cases.
  2. The second important margin, which is also collected upfront, is the volatility margin or the extreme loss margin (ELM). This is at a fixed rate and is collected over and above the initial margin. Till the year 2018, collecting ELMs was optional, but post-2018 SEBI has made it mandatory to collect ELMs, over and above the VAR margins.
  3. Finally, the mark-to-market (MTM) margins will take care of daily price movements. The initial margin only takes care of the starting risk. What happens if the stock price moves against you? That has to be paid to the exchange daily in the form of MTM margins. The exchange collects these MTM margins from the loss-making participants and pays to the gainers on a day-to-day basis.

Apart from the above, the exchange can impose special margins, additional special margins etc. if the volatility or speculative element in a stock demands.

Contract Specifications for Exchange Traded Futures

Under the SEBI approval list, there are currently 4 indices and a total of 194 stocks where trading in futures and options is permitted. Here are the contract highlights:

  • Out of the 4 index futures; Nifty 50 Index Futures, Nifty Bank Index Futures and Nifty Financial Services Index will have 3 consecutive months trading cycle i.e. Near-Month, Mid-Month and Far-Month.
  • The Nifty Midcap Select Index Futures will have 4 serial weekly cycles excluding the monthly expiries plus 3 consecutive months trading cycle i.e. Near-Month, Mid-Month and Far-Month.
  • In terms of F&O expiry, for Nifty 50 and Nifty Bank Index; the last Thursday of the expiry period will be the expiry. If the last Thursday is a trading holiday, then the contract will expire on the previous working day.
  • For the Nifty Financial Services Index and the Nifty Midcap Select Index, the expiry of the monthly contract will be on the last Tuesday of the expiry month. If the last Tuesday is a trading holiday, then the expiry day will be the previous trading day.
  • For the 194 individual securities in F&O, the last Thursday of the expiry month will be the default expiry date for the contract.   

Understanding futures trading nuances is pivotal. Engage in this dynamic market with informed decisions and strategic approaches using a robust stock market app. The integration of insights into market trends, coupled with risk management strategies, empowers traders to navigate the complexities of futures trading effectively, maximizing opportunities while mitigating potential downsides.

FAQs on Futures Trading in Derivatives

You can trade Intraday in futures during market hours if your broker's account is linked to your Futures trading activity.

The smallest quantity of underlying assets that a futures contract represents in futures trading is known as the lot size.

Hedgers use futures contracts to mitigate the risk of adverse price movements in the underlying asset, securing future prices. Speculators, on the other hand, aim to profit from price fluctuations by buying or selling futures contracts based on market expectations.

Futures contracts obligate both parties to fulfil the contract's terms upon expiration, involving buying or selling the underlying asset. Options contracts, however, provide the holder with the right but not the obligation to buy or sell the asset.

Futures trading carries risks such as market volatility, leveraged positions leading to magnified losses, and potential margin calls requiring additional funds. It's crucial to understand these risks and employ risk management strategies while engaging in futures trading.