What are futures?

In the past, if someone said futures contract, you’d probably have drawn a blank look. That’s not the case any longer, especially since these were introduced in stocks and indices in the year 2000. Since then, `futures’ – as these contracts are known in stocks – are becoming increasingly popular among retail investors.

Of course, these aren’t restricted to stocks alone. They are used in multiple markets like agricultural commodities, currency and minerals, including wheat, oilseeds, cotton, gold, silver, petroleum, natural gas, shares, and so on.

What is a futures contract, and how does it work? Before we get to know what are futures, we must understand the concept of derivatives. A derivative is a contract based on the ‘derived value’ of an underlying asset.

Definition of a futures contract

A futures contract gives the buyer (or seller) the right to buy (or sell) a specific commodity at a specific price at a predetermined date in the future.

Let’s illustrate this with an example. Let’s say you work in a company making baked goods and want to purchase large amounts of wheat at frequent intervals. You will need 100 quintals a month down the line. However, wheat prices are volatile, and to protect yourself; you enter into this type of contract to purchase 100 quintals of wheat at Rs 2,000 a quintal a month down the line. In the meantime, wheat prices go up to Rs 2,500 a quintal. However, you will still be able to buy it at Rs 2,000. Thus, you would have saved Rs 50,000 because of this type of contract! However, if wheat prices fall to Rs 1,500, you would have lost Rs 50,000.

This is an example of someone who wants to hedge against an increase in prices. This is a prevalent form of hedging and is undertaken by large and small organisations as well as by governments. For example, a country that imports large amounts of petroleum will hedge against price rise by going in for oil futures. Similarly, a large chocolate maker will hedge against an increase in the prices of cocoa by going for cocoa futures. 

Futures trading

However, futures contracts aren’t restricted to them alone. Speculators too are enthusiastic participants in the futures market. They can reap the benefit of movements of asset prices without having to purchase the underlying asset through futures trading.

If you want to make money by betting on wheat futures, you don’t have to take delivery of large quantities of the commodity. You don’t have to spend large amounts either since you don’t have to deal in the underlying asset.

Futures contracts enable you to trade large quantities. This is because to trade, all you need is to deposit an initial margin with the broker. For example, if the margin is 10 percent, if you want to buy and sell futures worth Rs 20 lakh, all you need to deposit is Rs 2 lakh.

Generally, margins in commodities are low so that traders can deal in massive amounts. This is called leverage and can be a double-edged sword. The opportunities for profits are enormous because of the large numbers involved. However, if you don’t get it right, the losses can be considerable indeed. When you make losses, you may get margin calls from brokers to meet the minimum requirement. If you don’t meet it, the broker can sell the underlying asset at a lower price to recover it, and you could end up with more losses.

It’s essential to understand what are futures before venturing into them. Commodity markets are especially risky since price movements are volatile and can be unpredictable. The high leverage also adds to the risk. Generally, the commodities markets are dominated by large institutional players who can deal with risk better.

Futures trading in the stock market

What are futures in the stock market? Like many other assets, you can also trade in futures contracts on the stock exchange. Derivatives made their debut in the Indian stock market a couple of decades ago, and since then have become popular with investors. You can get these contracts for specified securities as well as indices like Nifty 50 etc.

Prices of stock futures contracts depend on demand and supply of the underlying. Usually, stock futures prices are higher than that in the spot market for shares.

Here are some of the features of a futures contract in stocks:

  • Leverage: There is considerable scope for advantage. If the initial margin is 20 percent and you want to trade in Rs 50 lakh worth of futures, you need to pay only Rs 5 lakh. You can get exposure to a significant position with little capital. This increases your chances of making profits. However, your risks will also be higher.
  • Market lots: Futures contracts in shares are not sold for single shares but in market lots. For example, the value of these on individual stocks should not be less than Rs 5 lakh at the time of introduction for the first time at any exchange. Markets lots vary from stock to stock.
  • Contract period: You canget these types of contracts for one, two and three months.
  • Squaring up: You can square up your position till the expiry of the contract.
  • Expiry: All futures and options contracts expire on the last Thursday of the month. A three-month contract will then become one for two months, and a two-month contract turns into a single-month contract.

Trading in stock and index futures contract can be rewarding since you don’t need much capital as on the spot market. However, there is a danger of extending leverage too far and biting off more than you can chew. If you can stay within bounds, you can steer clear of the risks. 

Conclusion

To conclude, futures contracts are an excellent way of hedging against future price increases in an asset. They are also useful for speculators since they can trade in large volumes without digging deep into their capital.

Frequently Asked Questions

How does a futures contract work?

Futures contracts work as a hedge against future market volatility as underlying prices go up or down. The buyer and seller entering the contract are obligated to follow the terms of the futures, irrespective of the actual market trends.

How long does a futures contract last?

Futures contracts are divided into different expiration dates, decided by the exchange. The futures contract remains active for the time period mentioned in the contract, after that it expires worthless. For example, CNX NIFTY future contracts expire on the Thursday of the expiration month. In case the expiration Thursday is a holiday, the contract expires the day before.

What happens when a futures contract matures?

In most cases, futures contracts are traded/exited before their expiration date. If you are only speculating, you trade the contract before it expires when it is profitable. But if a future contract is trading on the expiration date, then the deal will take place according to the terms mentioned in it. The trade can be cash settlement or delivery of the physical asset. However, most brokers will not insist on the physical settlement of the underlying; rather, they will allow you to settle against the payment of a nominal fee.

Do you have to take delivery of a futures contract?

If you know what futures are, then you must also know that at expiration a futures contract needs to be settled. Now, many traders may not want the physical delivery of the item mentioned in the contract, so they opt for cash-settled contracts.
In cash settlement, the participating parties accounts are simply debited or credited to adjust for the difference between entry price and final settlement. In case the trader wants to continue his long position beyond the expiration date, he needs to roll the position before expiration.

Can we sell futures contract before expiry?

Yes, among the many unique features of a futures contract, it allows you to trade (sell) a futures contract before expiry. In fact, most traders enter the market as speculators to profit from futures trading, exit their position before expiry. However, to trade in futures, you need a futures trading strategy.

What is the difference between a forward contract and a futures contract?

Both forward and futures contracts are the same in their fundamental functionalities. Both allow traders to buy or sell a specific asset at a future date at a pre-decided price. But there are quite a few dissimilarities between the two.
Forward contracts are customised contracts between the parties. It requires no initial payment and used as a hedge against price fluctuations. As against, futures contracts are standardised contracts and require payment of initial margin.
Future contracts are traded through the brokers and regulated by the market. Terms of the forward contracts are based on direct negotiation between the buyer and seller, not regulated by the market.
As compared to the forward contracts, risks associated with futures contracts are low and carry a guarantee of settlement.
In futures contracts, the stock exchange functions as the counterparty for both buyer and seller, and the price differences get adjusted daily based on market rates. For forward contracts, there is no such mechanism, and hence the risk is higher.