Understanding Futures Trading 1

Understanding Futures Trading

Futures make one of the two segments in Derivatives Trading,other being the Option Trading.Futures are quite popular among a section of traders who like to play the financial markets with cash leverage.Futures Trading is not available for all the stocks listed on a stock exchange.It is for the stock exchange to decide the stocks eligible for Futures Trading.Usually stock with higher liquidity are put into Futures Trading.

Futures :- Futures is a contract between a buyer and seller to buy or sell an underlying security at predefined time at a predefined price.These contracts are monthly contracts which expire at the fourth Thursday of every month.If there happens a holiday on the fourth Thursday,the contract expires on previous day (Wednesday) to the usual expiry day.

The Futures contracts are in the form of a group of shares of a particular company known as a ‘Lot’. The Lot size may be composed of 125,250,375,500,1000,1250,4000 or even more number of shares depending upon the market price of the share price.Lot size is bigger for low price stocks and smaller for high price stocks.Stock exchanges define the Lot sizes for the contracts.

Futures Trading,Reliance Futures

Glimpse of Reliance Futures-Showing Spot (cash) Price,Date & Month of Contract Expiry,Lot Size,Last Traded Price for each month Futures. [ courtesy – www.icicidirect.com ]

You may find Futures contracts whose expiry is one month or two months or three months away.It depends upon the liquidity in the Futures contracts and stock exchanges decide the availability of these contracts.It is obligatory for the buyer or seller to close his/her position at expiry.If you need to keep your position in that particular stock as you expect your target to be achieved in next contract,you may simultaneously create position in next month contract while closing position in expiring contract.This is called as Rollover of position.This is in contrast to Option trading where you have no such obligation and you may leave the contract to expire without closing your position.

Advantages of Futures Trading

There are reasons which make Futures a popular trading tool among traders.

1. Futures offer cash leverage to traders.In other words,you can create bigger position in markets with small sums of cash.

2. Futures allow you play the markets both ways.Like buying at lower prices and selling at higher prices in rising markets,you can sell at higher levels and buy back later on lower prices in falling markets.In cash trading,you can play for upside only.

3. Investors with heavy portfolios can use Futures to hedge their position in case they are anticipating significant downside in the markets to cope up with portfolio erosion.

4. Brokerages are less for Futures trade compared to cash trading.

Trading in Futures :- If you find a potential trade for short period of time,say for few days or weeks,you can create position in that stock by trading in Futures instead of Cash segment.By Futures,you would be able to take position in large number of shares by paying comparatively small cash.This is like Margin Trading in cash markets.

Futures Trading

Let’s take an example for understanding purpose only.You may want to trade in Reliance stock which is trading at market price of 900.You expect it to hit 950 in coming 3-4 weeks.You have 50,000 as cash for trading.You can either buy stocks in cash segment with the available cash.So you will get 50,000/900 = 55 shares.If the stock hits 950 in expected time,your profit is 55 X 50 = 2750.

Alternatively you may opt for Futures. The Lot size for Reliance Futures Contract is 250.Total trade value for the 250 shares in cash segment shall be 250 X 900 = 2,25,000. To create a position in Futures,you need to pay only some part of this total trade value,known as Margin amount.Later is fixed by the stock exchanges,depending upon the volatility in the stock price.It can be 14-20%.Suppose for Reliance Futures,requirement is 20 %. So you can create position in Reliance Futures with 20/100 X 2,25,000 = 45,000 only. So actually you have 250 shares with 45000 which is 5000 less than your available cash.When you create the position in Futures, 45000 shall be blocked in your account which you will not be able to utilise as long as you keep your position.

In this case if the stock hits 950,your profit is 250 X 50 = 12500 as compared to 2750 in case of cash segment trading.( we are assuming that Futures are also trading at 900 like in cash segment )

The settlement in case of Futures trading is based on T +1 day system.In case your position is in profit ,you get the profit amount credited to your account next working day.If you incur loss,that amount shall be debited from your account on same day.

To keep your position in market,you need to maintain certain amount in your account,known as Minimum Margin.You get the notification regarding that via email from your broker.If you don’t maintain Minimum Margin,your position shall get closed automatically and the blocked margin amount shall be released to your account.

Futures at Premium

Practically there is always some difference in market price of the stock in cash segment and its Futures price.When the Futures price is more than the stock price,we say Futures are at Premium.The Premium indicates that the traders are bullish on the stock and expect higher prices in coming days.

Futures at Discount

Contrary to premium,when the Futures price is lower than the cash prices for a stock,we call it as Futures at Discount.This indicates that the traders are bearish on the stock and expect prices to go lower in coming days.

On the day of expiry for a contract this difference between cash and Futures converges, leaving Zero difference.Premium and Discount is the basis for the Arbitrage Strategies which some traders like to play to make riskless profit.

Risks associated with Futures Trading

High Risk – Cash leverage is a double edged sword.If it enables you earn bigger profit,the risk of loss is also big.You may loose your cash more quickly before you realise.This is even more important when you carry forward your position overnight.If there is any adverse news for the stock,it can be lethal for your cash on the next market opening day.

It is very important to use strict stop losses for your trades while trading in Futures Trading.This helps to minimize losses in case of adverse stock price moves.

To overcome this shortcoming of Futures,you can go for Option Trading.In Option Trading,you risk only the amount you pay as Premium to buy an Option.

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