What is Futures Trading?
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.
What are Stock Futures?
Stock futures are derivative contracts that allow traders to buy or sell a specific stock at a predetermined price on a future date. These contracts are legally binding agreements between buyers and sellers, ensuring the trade happens at the agreed price, regardless of market fluctuations. Stock futures have standardised terms, including lot size, expiry date, price quotation, tick size, and settlement method.
They are commonly used for hedging against price volatility or for speculative trading. Investors use stock futures to lock in prices, manage risk, or take advantage of potential price movements in the underlying stock
What is the futures market and types of futures?
The futures market is a financial marketplace where buyers and sellers enter into contracts to buy or sell an asset at a predetermined price on a specified future date. It is commonly used for hedging risks and speculating on price movements. Futures are standardised contracts traded on regulated exchanges and can be based on commodities, currencies, or financial instruments. The main types of futures include commodities like grains and metals, financial instruments like indices and bonds, and other sectors like energy and livestock.
Grain futures
Grain futures are contracts to buy or sell agricultural products like wheat, corn, and soybeans. These are essential for farmers and producers to hedge against price fluctuations due to unpredictable weather or changing demand.
Currency futures
Currency futures involve contracts to exchange one currency for another at a set price on a future date. They are widely used by importers, exporters, and forex traders to manage foreign exchange risk.
Livestock futures
Livestock futures cover commodities like live cattle, lean hogs, and feeder cattle. These contracts allow farmers and meat processors to lock in prices, helping them manage costs and revenues more predictably.
Financial futures
Financial futures are based on assets such as stock indices, interest rates, and Treasury bonds. They are popular among institutional investors to hedge against market movements or speculate on macroeconomic trends.
Metal futures
Metal futures include contracts for trading base and precious metals like gold, silver, copper, and aluminium. These are used by manufacturers and investors to hedge against price changes or gain exposure to the metals market.
Food and fibre futures
These futures deal with commodities such as coffee, cocoa, sugar, cotton, and orange juice. Traders use them to manage supply chain risks, while investors use them to speculate on seasonal and global demand patterns.
Energy futures
Energy futures include contracts for oil, natural gas, gasoline, and heating oil. They are widely used by refineries, transportation firms, and traders to protect against volatile energy prices caused by global supply-demand shifts.
How does Futures Trading work?
The futures market attracts a variety of financial players, including investors, speculators, and companies. These participants may seek to physically accept the delivery of the commodity or supply it based on the terms of a futures contract.
Futures contracts are often used by hedgers to fix the buy or sell price of an underlying commodity on a specific date. This helps protect against potential price fluctuations and ensures stability in transactions.
To illustrate how futures trading works, let’s consider a jar of beans. If the price of beans rises, a major food processor reliant on beans for their business would need to pay the farmer or dealer more. To hedge against this risk of price increase, the processor might buy beans futures contracts to cover their exposure to price changes. This proves advantageous for the buyer if the price of beans goes up.
Similarly, in the stock market, individuals can hedge stock prices using stock futures. Futures contracts can be purchased for individual stocks or indices to mitigate the risk of market volatility.
Notably, the buyer of a futures contract does not need to pay the full contract value upfront. Instead, only an initial margin is required, which can be managed conveniently using a futures trading app.
Futures contract is used by Hedgers to fix the buy or sell price of the underlying commodity on a specific date.
To illustrate how futures trading works, let’s consider a jar of beans. In the event of the price of beans going up, a major food processor who is dependent on beans to run the business will have to pay the farmer or the dealer more. For protection against this sudden rise in the price of beans, the processor may want to “hedge” his risk by buying beans futures contracts to cover the risk of price changes. It will prove beneficial for the futures contract buyer in case the price of beans goes up.
Similarly, in the stock market too, people can hedge stock prices through stock futures. It can be purchased now on stocks or on an index. The buyer of a futures contract does not have to pay the full amount of the contract beforehand. Only initial margin is to be paid using a future trading app.
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How to Start Future Trading?
Starting with futures trading involves a step-by-step approach to understand the market dynamics and mitigate risks. Beginners should first educate themselves on the functioning of the futures market, the associated terms, and the risks involved.
- Learn the Basics: Familiarise yourself with key concepts such as margins, leverage, contract specifications, and expiration dates. Platforms like NSE and MCX offer detailed guides on futures contracts available for trading. Start with a demo account to gain practical exposure without risking real capital.
- Choose a Broker: Select a broker offering access to the futures market with reasonable margin requirements and a user-friendly trading platform. In India, several brokers provide online futures trading services with tools for research and analysis.
- Develop a Strategy: Before entering the market, design a plan that aligns with your risk tolerance and financial goals. Focus on futures trading strategies like hedging, speculation, or spread trading. These approaches help manage volatility and maximise returns.
- Begin Trading: After completing the prerequisites, start trading with a small initial capital. Monitor your positions closely and maintain discipline to avoid emotional decision-making. Leverage tools like stop-loss orders to manage risks effectively.
Understanding futures trading hours is crucial, as different assets have varying trading sessions. For instance, commodities like gold trade until late evening on the MCX, while stock futures adhere to NSE timings.
Start with Futures Trading Strategy
A robust futures trading strategy is essential for success in the futures market. Beginners can consider strategies like trend following, where traders enter positions based on the prevailing market trend, or range trading, which focuses on buying at support and selling at resistance levels.
Another approach involves hedging, where traders use futures contracts to mitigate the risks of adverse price movements in their portfolios. For instance, if you own shares of a company and expect short-term volatility, selling futures contracts for the same stock can offset potential losses.
The flexibility offered by futures trading hours allows traders to implement strategies that align with their availability. For instance, evening trading hours on the MCX enable working professionals to trade commodities like crude oil or natural gas after traditional market hours.
Always backtest and refine your futures trading strategies using historical data before applying them in live markets. This helps identify potential risks and optimise for better results.
Types of Futures Traders
There are two types of Futures traders - Hedgers and Speculators:
Hedgers: Hedgers are investors who buy derivative instruments to safeguard their capital from losses. They use futures trading to lock in prices and protect against adverse price movements. For example, a jewellery manufacturer may purchase gold futures to hedge against rising gold prices, ensuring stable production costs despite fluctuations in the futures market.
Speculators: Speculators aim to profit from the rise and fall of derivative contract prices. Their buying and selling decisions are driven by market conditions and the demand-supply scenario of the derivative. Speculators rely on futures trading strategies to anticipate price movements and maximise profits, often leveraging the extended futures trading hours for flexibility.
Other prominent types of traders include Arbitrageurs and Day Traders. Arbitrageurs exploit price differences between the futures market and the spot market, earning risk-free profits by simultaneously buying and selling assets in both markets. Their success depends on precise timing and a deep understanding of futures trading meaning.
Day Traders focus on intraday price movements, entering and exiting positions within the same trading session. By leveraging high liquidity and long futures trading hours, they can execute quick trades. Understanding the type of trader you aspire to be is crucial for designing effective futures trading strategies aligned with your financial goals.
How Futures Trading Differs from Other Financial Instruments?
The key difference between Futures and other financial instruments is:
- Futures contract does not have intrinsic value, its value is derived from that of the underlying asset
- Futures contract is traded in stock market
- Futures contract has an expiry date which is the last Thursday of the month
- Futures contract is transacted in lots
Advantages of Futures Trading
One of the biggest advantages of Futures Trading is that there’s no risk of default. The clearing corporation on the stock exchange gives a counter-guarantee for every trade of futures in the stock market. This ensures that sufficient margin is maintained by the respective counterparties in the contract to avoid the risk of default. Trading in futures lets you take position in larger contract size by just paying the margin amount.
Disadvantages of Futures Trading
- More complex than trading in stocks
- Leveraged positions can lead to magnified losses as well
- Daily Mark to Market adjustment requires the trader to have enough capital available to keep the position intact. So, it’s not possible to maintain a futures contract with smaller capital.
Pros and Cons of Futures Trading in Table
Pros
| Cons
|
High leverage for increased profit potential
| High risk due to leverage magnifying losses
|
Useful for hedging price volatility
| Requires careful monitoring and expertise
|
Flexible futures trading hours for global assets
| Risk of margin calls in volatile markets
|
Standardised contracts ensure transparency
| Losses can exceed initial investment
|
Difference between options and futures
While both options and futures are derivatives, they differ significantly in terms of rights, obligations, and risk exposure. Futures are binding contracts where both parties must fulfil the agreement at expiry. In contrast, options give the buyer the right—but not the obligation—to buy or sell an asset.
Futures require a margin deposit and can lead to unlimited losses or gains, depending on price movements. Options, however, limit losses to the premium paid. Futures are more suited for hedgers and institutional traders, whereas options are popular among retail investors for their flexibility.
Comparison: Futures vs. Options
Feature
| Futures
| Options
|
Contract Type
| Obligation to buy/sell
| Right, not obligation
|
Risk Exposure
| Unlimited loss/gain potential
| Limited to premium paid
|
Premium Payment
| No premium; margin required
| Premium paid upfront
|
Ideal For
| Hedgers, institutions
| Retail traders, short-term strategies
|
Settlement
| Must settle at expiry
| Can expire worthless or be exercised
|
Few Things to Keep in Mind While Trading Futures
- Clear concept of leverage – Understanding the working of leverage is very important while trading in futures. One of the biggest benefits of a futures market is that you needn’t pay the full price of futures contract’s value to take a long or short position. They just need to pay a portion of the price known as margin. Having said that, traders need to be very cautious in the usage of leverage. A slight deviation in the direction of prices can either bring them profits or result in major losses.
- Use of stop Loss orders – Traders should operate skilfully and know when to get in and out of a trade. Proper planning is of utmost importance and that’s where stop Loss orders play a significant role. Stop Loss orders are orders to buy or sell at a definite price to limit losses in a trade.
Futures are used by traders and investors to form an opinion on the price movements of the underlying asset.