What is Futures Trading in Derivatives

Trading in equity and index futures

One of the most popular derivatives instrument is futures. So what are futures and what is futures trading. Remember, that futures trading also happens on the equity market, but in the F&O segment. On the NSE, you have stock index futures as well as individual stock futures to trade. These share index futures are available on 4 indices and all of them are fairly liquid in the futures derivatives segment.

In this segment we shall understand the Futures Trading meaning with a fairly elaborate Futures contract example. As the name suggests, futures are contracts to buy or sell an asset at a future data at a price that is determined today. That is the futures contract meaning and while we may loosely call it as futures market investing, it is actually short term trading. You don’t invest in futures since these are contracts and do not create assets.

So we shall start with the futures stock meaning and then get down in some detail to the futures trading basics. The idea is to understand futures trading as a product and then look at how to do futures trading in the real live market. Unlike options, futures are symmetric products in that the rights and obligations of the buyers and sellers of the futures contract are symmetrical to each other.

WHAT ARE FUTURES CONTRACTS?

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 pertains to a 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 granular idea of what a futures contract is all about.

 
Chart source: NSE

Futures contracts expire on the last Thursday of every month and at any point of time there are 3 contracts trading viz. near month, mid-month and far month. In the above case, December 2022 is the near month contract, January 2023 is the mid-month contract and February 2023 is the far month contract. On 30th December, the January contract becomes near month and February becomes mid-month. A new far month contract of March 2023 will be introduced.

Key Concepts in Futures Trading

Futures Price

: is the price of the Bank Nifty futures contract. In the above case, December 2022 Bank Nifty futures closed at 41,735.45. Futures normally trade at a premium to spot.

Spot Price

: is the price at which the spot value of the Bank Nifty trades. In the above case, the spot Bank Nifty has closed at 41,668.05.  

 

Expiration Day

: The day on which a derivative contract ceases to exist. Trades can either square off the contract or exercise the contract or just leave it to expire. In the above case, the expiration day is 29th December 2022; the last Thursday of the month.

Market Lot

: is the minimum size of the contract that can be traded in futures. In the above case, Bank Nifty has a minimum lot size of 25 units. At the spot value of 41,668.05, the notional value of one lot of Bank Nifty futures would approximately be worth Rs10.42 lakhs.

Bid and Ask Price

: Bid price is the price that buyer is willing to pay and ask price is the price the seller is willing to offer. Buy orders are executed at the best ask price and sell orders at the best bid price. The order book above captures bid and ask prices and specific volumes.

Contract Size and Contract Value

: contract size is the lot size which is 75 in the above case. When the futures price is multiplied by the lot size or the contract size you get the actual contract value. Contract lots help to standardize the futures contracts.

Basis

: is the difference between the spot price and the futures price. If futures price is greater than spot price, basis for the asset is negative. Similarly, if spot price is greater than futures price, basis for the asset is positive. In the above case, the Bank Nifty futures price of 41,735.45 is greater than the spot price of 41,668.05; so basis is negative.

Cost of Carry

: Here cost of carry has been mentioned at 11.4%, but what does that mean. Cost of carry is the relationship between futures prices and spot prices. In commodity futures, the futures includes storage cost, insurance plus the interest cost. In case of equity and index futures, the cost of carry only has interest cost and dividends earned. If the futures are trading at a premium of Rs.7 and Rs. 3 is to be received as dividend per share then the net cost of carry would be Rs.4. Cost of carry is presented on annualized % basis.

Open Interest and Volumes Traded

: what does open interest of 82.176 contracts mean here? Open interest is the total number of contracts outstanding (not settled) for any underlying asset. Total number of long futures will always be equal to total number of short futures and so only one side of contracts is considered while calculating open interest. Analysts and traders normally look at increase / decrease in the open interest and correlate with the price movements to infer whether the stock / index is seeing accumulation, short covering or unwinding. Volumes are the actual trades executed and can be looked at in terms of number of contracts or value of contracts executed.

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, 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 for short futures positions.

1. 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 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 ELM 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 of the stock price moves against you. That has to be paid to the exchange on a daily basis in the form of MTM margins. The exchange collects these MTM margins from the loss-making participants and pays to the gainers on 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 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 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 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.