Derivatives are financial instruments which do not have any inherent value. Instead, they derive their value from their underlying assets. The underlying assets can be stocks, bonds, commodities, indices, currencies, etc. Any change in the price of underlying assets reflects in the value of derivatives. There are popularly four types of derivatives: forwards, futures, options and swaps.
What are Futures?
Futures contracts are standardised legal agreements used to buy or sell a particular asset or financial security at a predetermined price and on a particular date in the future. Such contracts are standardised in terms of the quantity and quality of the underlying asset.
The buyer and sellers of futures contracts have obligations to exercise the contract. Simply put, buyers have to buy, and the sellers have to sell the underlying asset on a predetermined maturity date.
Types of Futures
Here are various types of futures.
- Stock Futures: A stock futures contract is an agreement to buy or sell a particular quantity of shares at a specific point of time in the future at a predetermined price. Stock futures involve standardised specifications such as market lot, a unit of price quotation, tick size, settlement method, expiry day, etc.
- Index Futures: Index futures are agreements allowing the trader to buy or sell indices, the settlement of which takes place later. In index futures, traders speculate the future price movements of indices such as Nifty, Sensex, etc.
- Currency Futures: These are contracts where two parties agree to exchange a particular currency at a predetermined price on a specific date. They may be settled or reversed before the maturity date. If not, the currency may be delivered at expiry.
- Commodity Futures: Commodity futures contracts are agreements to buy or sell commodities at a specific point of time in future and predetermined price. For example such as food, oil, metals, petroleum, etc.
Uses of Futures
Trading futures can be profitable since some commodity prices tend to move in predictable patterns. Traders and fund managers use future contracts to speculate the underlying asset’s price.
For instance, a trader might purchase gold futures if he expects the gold price to increase before delivery. If the gold price rises, he may earn greatly. However, if the gold price falls, he may lose significantly.
Hedging refers to taking a position in a security or investments to reduce the risk of unfavourable price movement for an existing position. Businesses seeking to lock in the price to buy or sell a commodity/good may use futures contracts for hedging.
A corporation may take a long position in a futures contract if it needs to buy a particular raw material or another item in the future. A long position means buying a currency, commodity or stock, assuming its price will rise in the future.
To buy a particular item at a better price, which it assumes to decline in the future, a corporation may enter into a short position. A short position means selling a currency, commodity or stock, assuming its price will decline.
How Does Futures Trading Work?
Investors need a trading account to trade in futures. For trading in futures, the investor needs to put a margin amount with the broker. The margin amount can be 5-10% of the contract size.
Then, inform the broker of desired contract size, strike price, and expiration date to place a buy or sell order. The investor can settle the futures contract on or before expiry.
For instance, a trader entered into a crude futures contract in June, speculating that the price would go up by December. The December crude oil futures contract was trading at ₹1,000, and the trader bought the contract.
Since oil was traded in a lot of 100 barrels, the trader had a position worth of ₹1,00,000 (100 barrels*₹1,000). However, the trader had to deposit only ₹5,000 as the initial margin.
On the third Friday of December, when the expiry date of the contract was approaching, the crude oil price reached ₹1,200 per barrel. Therefore, the trader sold the contract and exited the position. The trader earned ₹20,000 [(₹1,200 – ₹1,000)*100 barrels) minus the fees and commission to the broker.
However, if the crude oil price had fallen to ₹700 per barrel, the trader would have incurred a loss of ₹30,000 [(₹1,000 – ₹700)*100 barrels).
Advantages and Risk of Futures
- High Leverage: Leverage means the opportunity to manage a significant contract value with a relatively lesser amount of money. In futures trading, the investor has to put a small fraction of the total contract value with a broker, known as a margin, while exposing himself to the significant value of stocks.
- High Liquidity: Futures are highly liquid since traders trade futures contracts in a massive volume daily. Therefore, it may be easier to take a position in future contracts. Additionally, the prices of futures contracts may not significantly move even if they are near maturity.
- Protection Against Price Movements: Futures contracts intend to protect the trader against losses from unfavourable price movements. Traders can remove uncertainty related to costs by fixing a price they can buy or sell the item.
- Price Risk: One of the common risks associated with futures trading is price risk. Though traders can benefit significantly if the price moves in the expected direction, the potential loss can be greater if that doesn’t happen.
- Leverage Risk: When leverage is a key benefit of futures trading, it is also a considerable risk since the losses can also occur multiple times the margin.
Frequently Asked Questions
If holding a futures contract until expiry, one needs to close the contract on the expiry date. You may do it by buying another futures contract that cancels out the previous one. Or by paying the cash settlement.
Futures derive their value from the underlying asset, unlike stocks and bonds. Unlike other financial instruments, futures contracts promise the physical delivery of the goods on a specific date.
Additionally, Futures contracts have an expiry date which doesn’t allow you to hold it as long as the trader wants.
Yes, it is possible to exit the futures contracts before the expiry. The gains or losses in such cases settle by adjusting against the margins you have deposited.
Futures contracts offer several benefits, such as higher leverage and liquidity, lower commission or execution costs, protection against price volatility, hedging against risks, etc.
However, futures trading requires experience and knowledge. Moreover, the potential losses by unfavourable price movements can be greater.