What are Futures/ Futures Contracts?

By Bajaj Broking Team

March 18, 2024

5 mins read

Futures and options

Futures contracts sound simple but may take a while to register. Let us understand with a simple everyday example. Assume you plan to travel to the U.S. on January 01, approximately two months from now. You have set aside an entire budget for the trip including the flight fare. You have decided to pay Rs. 40,000 for the flight ticket. You assume that the fares will increase as you near your travel date and wish to lock in the price of Rs. 40,000 with the airlines. The airlines happily enter a contract requiring you to pay Rs. 40,000 as the airfare. The airlines do so because they believed the airfares would take a dip and want to profit from an agreement with you.

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Profit/loss for different scenarios

Scenario I	Scenario II	Scenario III
Airfares increase to Rs. 50,000	Airfares remain stable at Rs. 40,000	Airfares drop to Rs. 30,000
Since you are bound by an agreement to pay Rs. 40,000, you end up saving Rs. 10,000. On the other hand, the airlines suffer a loss by entering into a contract with you.	Fares remain the same. Therefore, this becomes a case of no profit or loss for you or the airlines.	You regret entering the contract since you could have paid less for the tickets. You incur a loss of Rs. 10,000, while the airlines enjoy an extra Rs. 10,000 in profits.

Each futures contract comprises the following elements:

Pre-determined price
- The agreed-upon price at the time of signing the contract. In this case, the predetermined price was Rs. 40,000.
Predetermined date
- The date which is fixed in advance. In this case, the predetermined date was January 01.
Two parties, i.e., buyer and seller
- In this case, the two parties that entered the contract were you and the airlines. The buyer and seller typically have opposing views, which leads them to enter a futures contract. In the above case, you or the buyer assumed the fares would increase, whereas the airlines or the seller believed the fares would drop.

Definition of a futures contract

What are futures? A futures contract is an understanding between two entities to conduct a transaction at a locked-in price at a predetermined date in the future. Futures contracts can work across exchanges, indices, currencies, and commodities. Traders who want to hedge risks of fluctuating prices or take advantage of price movements may enter such contracts.

Futures Trading

Futures trading comprises of two types of participants, i.e., Hedgers and speculators. Hedgers enter a futures contract to minimise risk against rapid price movements. Speculators enter futures contracts with the sole purpose of making profits. The interaction between hedgers and speculators makes the futures markets efficient. Moreover, when a futures contract is initiated, the buyer is not obligated to pay the contract’s complete amount upfront. Instead, the trader pays only a small initial outlay. The exchanges decide the margin and maintenance amounts that need to be paid.

Futures Trading in the stock market

What are stock futures? Suppose you have purchased a futures contract based on an underlying stock that consists of 100 shares. The expiration date of the contract is January 01 for Rs. 100 per share. You pay the necessary margin amount and place the order. Let us assume on January 01; the stock is trading at Rs. 120. Since the stock is trading at a higher value, here is a chance for you to make a profit. You exercise your stock market futures contract, which entitles you to purchase 100 shares for Rs. 100 each. You then sell these shares at their current price, i.e., Rs. 120 and instantly make a profit of Rs. 20/share (minus the margin money paid). Your profit gets credited to your account after making necessary deductions in the form of commissions and associated brokerage fees. Suppose you incur a loss as the share prices drop to Rs. 90. In such cases, the amount gets deducted from your cash balance in the trading account.

Let us understand the primary features of futures contracts.

Lot Size
- Futures are fixed in standard lot sizes. One lot may consider a pre-defined number of shares.
Futures Price
- The futures price is essentially your purchase price per share.
Contract Value
- The contract value determines your investment’s total value. It is determined by taking the price of the futures contract and multiplying it with the lot size.
Expiry Date
- The last Thursday of the month is when all futures contracts are set to expire. If the markets are closed that Thursday, the contracts expire the day before, i.e., Wednesday.
Settlement of the futures contract
- All futures contracts must be settled. Traders who have taken a long position on futures sell it off, and those with a short position buy it back. If you wish to leave the contract to expire on its own, the net profit/loss automatically gets revised into your Trading account.
Open Interest
- The number of open contracts at a given time is denoted by open interest. An unusually high open interest may indicate an over-leveraged market.

Conclusion

What are futures in stock market? A futures contract is an understanding between two parties based on a specific underlying asset that comprises fixed constraints such as a pre-set price that is to be executed at a specified time in the future. These financial instruments have gained popularity primarily due to low-margin requirements. However, trading in futures can be risky. Investors must thoroughly understand what is a futures contract, how it works and what is the futures market before trading futures.

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