What are Futures Trading? Meaning and its types
- 24 Jun 2024
- By: BlinkX Research Team
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Any trader with zero experience or with good experience seeks to look out for different market opportunities. Investing in the share market opens a portal for different trading opportunities in India. Some of the opportunities can be the Futures and options trade, commodity trading, ETFs etc. Let's discover what is futures trading in stock market
Futures Trading Meaning
Futures trading meaning reflects the buying and selling of futures contracts. A futures contract is an agreement to buy or sell an underlying asset at a predetermined price on a specified future date. Here are some key points about futures trading:
The underlying asset can be a commodity like oil, gold or agricultural goods, a financial instrument like a stock index or government bond, or a currency pair.
Futures contracts have standardised terms that specify the quantity and quality of the underlying asset, the delivery location and date. This standardisation makes it easy to trade on futures exchanges.
Table of Content
- Futures Trading Meaning
- How does Futures Trading work?
- How to Start Future Trading?
- Types of Future Trading
- How Futures Trading Differs from Other Financial Instruments?
- Conclusion
How does Futures Trading work?
Futures trading is used for both speculation and hedging. Speculators in the stock market aim to profit from anticipated price movements in the underlying asset. Hedgers use futures to manage risk by locking in prices for future buying/selling of the actual asset.
Futures prices are influenced by several factors, including supply and demand, weather conditions, and geopolitical events that affect the underlying commodity or asset. The prices of futures contracts are closely linked to the spot prices of their underlying assets.
- Futures trades are settled on a daily basis, based on the daily movements of prices. Most futures positions are closed out before expiration through offsetting trades.
- Futures trading involves leverage, which means that only a small initial margin deposit is required to open a position. This allows traders to gain bigger exposure with less upfront capital. However, the leverage in trade can also magnify potential losses.
- Futures trading involves substantial risks and is considered a complex domain suited for active, sophisticated traders. Proper risk management principles are essential for trading futures.
- Buyers and sellers enter into long or short positions by putting up margin and posting trades through brokers during trading hours.
- All contracts are marked-to-market daily, which means that profits and losses are settled in cash based on the end-of-day settlement price determined by the exchange. Most futures positions are closed out before expiration by taking an offsetting trade. Open positions at expiry must take physical delivery of the underlying asset per contract terms.
- Traders book profit or loss based on the difference between their entry and exit prices. Profitable trades earn back the initial margin plus gains, while losers must cover margin shortfalls.
- Brokers hold margin collateral to cover potential losses. If margin falls below the maintenance level due to losses, brokers issue margin calls requiring deposit of more funds. Traders employ strategies like going long or short, spreads, and arbitrage to profit from both rising and falling prices based on market analysis.
Overall, futures offer traders leveraged exposure to underlying markets in a transparent and regulated environment with the potential for big, but risky rewards.
How to Start Future Trading?
To start your future trading, you need to follow some of the below steps:
Here are some key steps to start futures trading:
1. Educate yourself: Develop an understanding of how futures contracts work, different trading strategies, technical and fundamental analysis, risk management principles etc. Read books, take training courses to learn before trading.
2. Choose a broker: Open a futures trading account with a reputed, regulated broker. Important factors are commissions, margin rates, trading platforms and tools provided. Many brokers allow paper trading accounts for practice.
3. Pick markets to trade: Select futures markets based on your analysis of trading opportunities, risk appetite and capital. Common choices are equity index, commodity, currency and bond futures. Understand seasonality and events impacting each market.
4. Develop a trading plan: Outline your risk tolerance, capital allocation, strategies (long/short/spread), position sizing, entry and exit rules. Define trading guidelines to maintain discipline.
5. Employ stop losses: Use stop market/limit orders to exit losing trades at predefined levels. This will limit downside in volatile futures markets.
6. Start with small position sizes: Trade only a few contracts when starting out. Gain experience before increasing position sizes.
7. Review performance: Analyse results periodically to improve trading plans. Track detailed trading records, performance metrics, mistakes to refine strategy.
8. Manage risks: Control overall portfolio risks through prudent position sizing, diversification and managing market exposure. Use defensive strategies if required.
Types of Future Trading
In futures trading, there are different types of futures contracts. Know about different future contract in the mentioned below:
Index Futures: Based on major stock market indices like Nifty 50, Sensex, Bank Nifty. Allow trading view on overall market direction.
Stock Futures: Futures on individual stocks are available for over 100 major stocks like Reliance, Infosys, HDFC Bank etc. Provide exposure to specific stocks.
Commodity Futures: It includes bullion (gold, silver), energy (crude oil, natural gas), agricultural (wheat, cotton, pepper), metal (copper, zinc, nickel) commodities. Traded on MCX.
Currency Futures: Rupee denominated futures on USD/INR, EUR/INR, GBP/INR, JPY/INR currency pairs. Traded on NSE, BSE, MCX-SX.
Interest Rate Futures: Used for managing interest rate risk. Includes futures on 10-year Government bonds, T-bills, repo rate.
Sectoral Index Futures: Index futures tracking specific sectors like IT, Banking, Auto, Metal etc. Allows sector specific exposure.
CPO Futures: Refined soy oil futures contracts, widely traded agricultural commodities.
These futures contracts have standardised lot sizes, expiration cycles and settlement processes as defined by the respective exchanges. They provide extensive tools for speculation and hedging.
How Futures Trading Differs from Other Financial Instruments?
Futures trading has some key differences compared to other common financial instruments like stocks, options and forex:
Futures contracts are standardised derivative instruments that obligate the buyer and seller to transact in the underlying asset at a predetermined price on a specified future expiry date. The standardised terms allow futures to be easily traded on exchanges. In contrast, stocks represent ownership in a company, while options and forex are structured differently.
The primary use of futures is for hedging and speculation on the future price of commodities, currencies or financial assets. Futures utilise leverage, allowing traders to gain large market exposure with relatively little upfront capital through margins. Profits or losses are settled daily based on the mark-to-market mechanism. On expiry, contracts are settled by physical delivery of assets. This is different from stocks where investors have a longer term view based on company performance. Options give the right but not the obligation to buy or sell, while forex involves simultaneous buying and selling of currency pairs.
Therefore, this unique standardised structure, derivatives nature, leverage use and mandatory expiry settlement make futures trading distinctly different from other financial market instruments. Futures offer unique advantages but also pose higher risks compared to stocks, options and currencies.
Conclusion
Trading in futures offers opportunities for both speculators and hedgers to gain exposure and manage risks in commodity, currency, and financial markets. The standardised structure of futures contracts allows for efficient trading on centralised exchanges with complete transparency. However, it is important to note that the leverage involved requires careful risk management. You can manage your future contract, add stop-loss & explore differently by downloading stock trading apps from play store or app store.