How to trade futures ? & what is futures trading ?.

Chapter 2

What are Futures?

Chapter 2

What are Futures?

Futures are financial derivative contracts that are standardised and traded on an exchange; a contract to buy or sell an underlying asset, at a future pre-determined date and pre-determined price. In futures markets, unlike in forward markets, faces no counterparty risk, due to 

exchange clearing and settlement mechanism. Futures could be used for trading or hedging.  There are futures contracts for trading/speculating on the price of indices like Nifty and Bank Nifty; while futures contracts are available for different Indian equities too. It is a speculative bet on the price of the underlying asset.

The buyer of a futures contract stands to benefit (profit) when the prices of the underlying asset rise and the seller of a futures contract benefit during price drop.

A buyer of the futures contract is said to be bullish on the underlying, while the seller is assumed to be bearish on the underlying. But the core reason that encourages traders to participate in futures is leverage.

Features of Futures Contract

In futures market, exchange decides all the contract terms of the contract, also known as contract specifications. The features of futures contract are discussed ahead

    1. The contract is traded on an exchange regulated by SEBI (India).
    2. Margins are paid by both the buyer and seller of the contract.
    3. Quality is specified in the futures contract specification (in case of commodities like gold etc.)
    4. Lot size of the underlying is pre-defined in the contract specification by the exchange.
    5. Futures are accounted for by the number of contracts open also known as Open Interest. We would be discussing open interest, again, in detail.


What are futures in trading? 

Futures are a financial derivative contract that obligates both parties to buy or sell the underlying, which may be a stock or an index, like Nifty, at a predetermined future date and price.

What is the benefit of futures trading?

Futures are leveraged financial contracts, as traders need to pay up only initial margin which is a smaller percentage of the contract value, to trade in futures. Traders can expose themselves to a much greater value of stocks than they could when buying the original stocks in the cash market.

How to calculate future value of stock?

The futures value of a stock is determined by cost of carry model.
Futures contract value = Spot*(1+r) ^time to expiry
Cost of carry refers to expenses incurred as a result of a position, including interest, storage, and opportunity costs. We will be learning about pricing in a separate chapter.

What are the key advantages and disadvantages of trading futures?

Futures contract involves financial leverage as compared to trading shares directly, where financial leverage is the purchase of F&O stocks or indices like Nifty by paying a small portion of the overall contract value called initial margin. The key disadvantage of futures trading is that, if markets move adversely to the trader’s established position it can result in steep losses. So financial leverage is a double-edged sword.