Future Trading

What is Futures Trading?

The goal of this post is to explain the basic idea underlying a futures trading or futures
contract by means of an example. Market derivatives like Stock Market futures and Options
have the reputation of being 'hard to understand' although the underlying idea of futures
trading is not that hard as it seem and is best understood by studying an example.

1. Stock Futures Contract.

2. Index Futures Contract (like Dow Futures, Nifty Futures, Sensex Futures, etc.)

3. Commodity Futures (like Gold Futures, Crude Oil Futures, etc.)

Although it looks like '3 types' the underlying principles and ideas behind trading any of the
above futures contract is the same. Let me try to explain futures trading with the help of an
example.

Futures Trading: Example of a Futures Contract:

Suppose the current price of Tata Steel is Rs. 200 per stock. You are interested in buying 500
shares of Tata Steel. You find someone, say John, who has 500 shares you tell John that you
will buy 500 shares at Rs. 200, but not now, at a later point of time, say on the last thursday
of this month. This agreed date will be called the expiry date of your agreement or contract.
John more or less agrees but the following points come up in your agreement.

1. John will have to go through the hassle of keeping the shares with him until the end
of this month. Moreover, the economy is doing well, so it is likely that the price of
the stock at the end of the month will be not Rs. 200, but something more. So he
says lets strike a deal not at the current price of Rs 200 but Rs. 202/-. The agreed
price of the deal will be called the Strike price of the futures contract. He says you
can think of the Rs. 2 per share as his charge for keeping the shares for you until the
expiry date. This difference between the strike price and the current price is also
called as Cost of Carry.

2. The total contract size is now Rs. 202 for 500 shares, which means Rs 101000.
However both you and John realise that each of you is taking a risk. For e.g. if

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 tomorrow the price of the stock falls from Rs. 200 to Rs. 190, in that case it is much
more profitable for you buy shares from the market than from John. What if you
decide not to honour the contract or agreement? it will be a loss for John. Similarly if
the price rises you are at a risk if John doesn't honour the futures contract. So both
of you decide that you will find a common friend and keep Rs. 25000 each with this
friend in order to take care of price fluctuations. This money paid by both of you is
called Margin paid for the futures contract.

Finally you decide that the futures contract will cash settled. Which means at the expirty
date of the contract, instead of actually handing over 500 shares - John will pay you the
money if the price rises, or if the price falls you will pay John the balance amount. For
example at the end of the expiry date if you find out that the price of the share is Rs. 230,
then the difference

Rs. 230 - Rs. 202 = Rs. 28

will be paid to you by John. You can then purchase the shares fromt he Stock Market at Rs.
230. Since you will get Rs. 28 per share from John, you will effectively be able to buy the
shares at Rs. 202 , the agreed strike price of the futures contract. Similarly John can directly
sell his 500 shares in the market at Rs. 230 and give you Rs 28 (per share) which means he
effectively sold each share at Rs. 202, the agreed price.

Stock Futures trading - Commodity Futures trading - Index Futures trading

Just like the above example of Stock Futures you can have commodity futures where instead
of dealing with stock you deal with commodities - for e.g. gold futures , crude oil futures,
etc. You can also have futures on Index. For e.g. Nifty is a stock market index in India. If you
buy 1 futures contract of Nifty then at the expiry date you will be gain or loose money
accordingly as the index moves up or down. Index futures contracts are always cash settled
as there is nothing to 'actually buy or sell' in case of an index. You simply pretend that you
are buying the 'index' and cash settle it at the expiry date. Anyone can buy or sell a futures
contract.

Futures Trading: some minor differences between Actual Futures contract and
the above example of futures contract

In concept the above example illustrates all the basic notions of a futures trading. However
in real life, while trading stock futures on stock market exchange or commodities futures on
commodity exchange you have to keep in mind the following points.

1. You directly deal with the stock exchange or the commodity exchange when buying
or selling a futures contract. The Margin money is kept with the stock exchange. The
margin is calculated in real time and constantly updated. For e.g. if you buy a futures

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 contract and the price of the stock / commodity goes down - you will be required to
provide additional margin, etc.

2. The expiry date of the futures contract is decided by the Exchange. It is usually the
last Thursday of every month except when there is a public holiday in which case it is
the earliest

3. All futures contract are sold in multiple of a lot size which is decided by the Stock
Market exchange or the commodity exchange. For e.g. if the lot size of Tata Steel is
500, then one futures contract is necessarily for 500 shares. You can however buy or
sell multiple futures contracts and hence you will be able to deal with only multiples
of the given lot size of the contract.

4. The exchange decides whether the futures contract is cash settled or settlement is
delivery based. For e.g. all index futures are always cash settled because there is no
concept of actual 'delivery' of the index. In india even all stock futures are currently
cash settled.

5. You dont have to actually have the stock or commodity (or index) in order to sell a
futures contract. For e.g. even if I have no gold with me, and I believe that the price
of gold is going to go down, I can simply sell a futures contract and hope to benefit
from my speculation. In case the futures contract is delivery settled, you can simply
buy it again (called squaring your position) just before the expiry.

Advantages of Futures Trading: Why trade Futures?

There are several advantages of trading in futures. Here are some.

1. Futures trading allows you to trade in 'large amounts' with low cash. For e.g. if you
want to buy a futures contract of 500 shares of Tata steel - Actually buying them
would cost much more than the margin you have to pay for trading futures. Note
however, leveraged position of futures can also be dangerous.

2. Trading in stock market Futures is usually less expensive than actually buying stocks.
For e.g. if you realise that you have 500 stocks and want to sell them and again buy
them when the price is low, it is much cheaper (brokerage charges etc.) to sell
futures than actually selling stocks.

3. You can sell futures contract even if you dont have shares or the commodity. Thus
if you have reasons to believe that the stock market is going down you can sell a
particular stock future or index future and benefit from the price fall. This is possible
only if you trade futures and not with physical stocks or commodity.

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 4. Trading futures can be used in several hedging strategies which will be discussed in a
later post.

F&0 Futures Trading on FONSE

For Futures trading on NSE remember the meaning of the following abbreviations:
FUTIDX = Futures Index
FUTSTK = Futures Stock

Thus before trading futures, you will be asked to select the type of financial instrument. There are
four types of financial instruments you can select on FONSE- Index Futures (FUTIDX), Stock Futures
(FUTSTK), Index Options (OPIDX), Stock Options (OPSTK). Then choose buy/sell depending on
whether you want to buy or sell the futures contract. In futures trading selling futures contract is
also sometimes referred to as 'writing futures contract'. Select the number of shares/index to be
traded (this has to be multiple of the lot size fixed by FONSE). Then select the correct expiry date of
the contract. On FONSE there are three types of expiry date available:

Futures Contract for Near Month: expiry date is on the last thursday of the current month.
Futures Contract for Middle Month: expiry date is on the last thursday of the next month.
Futures contract for the Far Month: Expiry date is last thursday of the month after the next.

Thank you

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