What is Futures Trading?

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In order to have a comprehensive understanding of futures trading, one must have a thorough knowledge of derivatives first. Derivatives are financial contracts that derive their value from the price movement of some other financial instrument.

So, futures are nothing but a type of derivative contract for the purchase or sale of an asset on a future date at a predetermined price. That asset can be shares of a company, a commodity, coffee, silver, gold, etc. In a futures contract, one party is a buyer (the one having a long position) and a seller (the one having a short position), where the buyer of Futures agrees to buy a certain quantity of a commodity or securities and the seller agrees to provide it. Futures contracts are traded on the Exchange. As time goes by, the contract’s price tends to change based on the price of the underlying asset. This frequent change in the price of the contract also creates profit or loss for the trader. Futures trading is an obligatory agreement between a buyer and seller for trading of derivatives according to the agreement. Here both buyers and sellers are obligated to honor the contract in futures trading.

How does Futures Trading work?

The futures market is thronged by multiple kinds of financial players. They could be investors, speculators or companies either wanting to physically accept the delivery of the commodity or supply it through the terms of futures contract.

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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Types of Futures Traders

There are two types of Futures traders - Hedgers and Speculators:

Hedgers: Hedgers are investors who buy derivative instruments for the purpose of safeguarding their capital from losses

Speculators: They make profits from the rise and fall of the derivative contract price. Their entire buying and selling of Futures and Options are dependent upon the market situation and the demand-supply scenario of the derivative.

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.

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.
 

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Yes, you can open multiple demat accounts but only under the below conditions:

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