Understanding Futures

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What is a future?

It is a contract between a buyer and a seller to BUY/SELL a certain quantity of an asset in future at a price agreed upon today. The contract expires on a pre-specified date.

Terminologies used in Futures segment:

1. Contract size (Lot size): The number of units of the underlying asset for which the contract is made. It refers to the total number of stocks you would hold under the contract. Contracts are spoken in terms of Market lots. Assuming a market lot has 100 shares, it means that every contract would be to BUY/SELL 100 shares.

2. Contract month: It is the month in which a futures contract will be settled. Example: February 2013. The contract can be settled either by delivery or expiration. The contract month is also referred to as delivery month.

3. Contract expiry: A pre-defined period when the contract will expire. This predefined period is last Thursday of every month for Indian stock markets. You can settle the contract even before this period. If you don’t explicitly settle the contract, the exchange does it implicitly for you on this predefined period.

4. Volume: It is the total number of contracts that were traded. Volumes reflect the market sentiments. Volumes always indicate the sentiments of investors and the overall health of the market.

5. Open interest: It is the total number of F&O contracts that have still not been settled or delivered. Note that open interest is not the same as volumes. Technically it is reflection of the buy orders.

6. Spot: It is the price of the stock (underlying asset) in the cash market.

7. Margin: It is the amount that one needs to pay to enter into a F&O contract. Example: The Future’s Buying price is 100 and lot size is 500. Suppose %Margin needed is 10. So the amount needed to enter into a contract would be 10% of 50,000 which is 5000. Note that different stocks have different margin requirements.

8. Going LONG and SHORT: You go LONG (Buy) in a future when you are bullish on it. On the contrary you go SHORT (Sell) in a future when you are bearish on it.

9. Risk and Rewards: Risk and Rewards are unlimited for both the future buyer and seller. Let’s understand with a case study.

Case Study: Buying a Future

Case: Mr. Rakesh wants to BUY Future of ABC company.
View: Bullish
Price in futures: INR 100
%Margin: 10%
Lot Size: One lot (1000 shares) of ABC
Contract Month: February 2013.
Total Investment made for one lot: 10% Margin of (Price * lot size) = 10% (100*1000) = INR 10000.

The below simulation shows how the futures work:

1st FEB:

Future closes 10 Rs higher compared to previous close i.e 110.

Future buying rate: INR 100

Future closing rate: INR 110

Total Profit (Credit) = (110-100) * lot size = 10 * 1000 = +10000 (A)

Note: The profit amount of 10,000 is credited to your account the same day. This concept is called MTM (Mark to market).

2nd FEB:

Future closes 5 Rs lower compared to previous close i.e 105

Future buying rate: INR 110 (This is brought forward rate from the previous close and now becomes your buying rate for today)

Future closing rate: INR 105

Total Loss (Debit) = (110-105) * lot size = 5 * 1000 = -5000 (-B)

Note: The loss amount of 5000 is debited from your account the same day due to the concept of MTM.

3rd FEB:

Future closes 5 Rs higher compared to previous close i.e 110

Future buying rate: INR 105

Future closing rate: INR 110

Total Profit (Credit) = (110-105) * lot size = 5 * 1000 = +5000 (C)

Position squared off today on 3rd FEB

Total Profit made:

= A – B + C

= 10000 – 5000 + 5000

= 10000 (Profit credited same day due to MTM)

Points to Remember:

  • The Risk and Rewards both are unlimited here.
  • The MTM concept requires you to maintain a cash balance in your account for daily settlement. You must monitor your position daily.
  • The future price is more or less the same as the price of the stock in cash market.
  • The future prices are mere shadow images of the stock price in the cash market. As the stock price moves in the cash market, the future price also moves. Hence stop loss for futures also should always be followed in the cash segment only. If stop loss is triggered in cash segment, exit your future position also.
  • When you go LONG or Buy a future, the stock needs to move up for you to make money (You Buy low, Sell high). Conversely when you go SHORT or SELL a future, the stock needs to move down for you to make money (You Sell high, Buy low).
  • The above case study can also be simulated when you SELL (SHORT) a future. In that case you would make money by selling at a higher price and buying at a lower price. The Selling – Buying difference is your profit. Note that to make money in this case, the stock should fall.