Futures contracts are unlimited gain or loss instruments and, hence, risky. Being short-term instruments, they are subject to volatility and one must be aware of the risk-return trade-off before trading in them.
By definition, a futures contract is a type of derivative instrument to buy or sell a certain underlying asset at a specified price and date in the future.
A look at the basic aspects of a futures contract that the novice trader needs to be aware of.
Types of futures
Futures can be divided into index futures and stock futures. The former bases its value on a particular index (that is, the underlying asset is an index). For example, you can trade in the index futures of Nifty and the CNX IT. Stock futures, on the other hand, relate to trading in the futures contract of a particular scrip.
For example, you can take positions in the stock futures of Infosys, ITC or Ranbaxy; their value would depend on that of the underlying stock. Thus, if on the one hand, trading in index futures gives you an exposure to the market as a whole, stock futures restrict it to particular stocks.
Unlike cash market trading, futures trade happens in specific lot sizes, that is, a set quantity for buying or selling. For instance, Nifty futures come in lot sizes of 100, which means that if you want to trade in Nifty futures, you will have to transact in multiples of 100. The lot sizes of various stock futures vary and trading in these counters happens only in those sizes or their multiples.
There are three futures contracts current month, near month and far month (for example, the three contracts available now will be February, March and April). However, each contract expires on the last Thursday of the respective month (expiry day) when a new month contract gets added for trading. This means that the futures contracts have to be fulfilled or squared-off (closing of positions) before its expiry period.
Consider this. You want to take exposure in the stock futures of the State Bank of India, which trades at Rs 1,200. Since the lot size for the stock is 500, the total value of the transaction will be Rs 6 lakh (Rs 1200x500). However, to take a position in the futures market, you need to pay only the margin amount. Let us assume the margin amount is about 20 per cent. This means that to buy or sell SBI futures, you need to pay only Rs 120,000. This amount, which must be paid when the contract is entered into, is termed margin money.
At the end of each trading day, the margin account is adjusted to reflect your loss or gain
vis-a-visthe futures position you hold. This is calculated by marking each transaction in the contract you hold against its closing price at the end of trading. For example, you buy one lot of ITC current month futures at Rs 170. If by the end of a week the futures price drops to Rs 165, the notional loss of Rs 5,625 (lot size 1,125x5) will be deducted from the margin account. Similarly, in case the price rises to Rs 175, the balance in the margin account would increase by Rs 5,625.
However, note that the marking-to-market is not merely an arrangement between the broker and the client. When there is a decrease in the futures price, the decrease in the margin amount (in this case Rs 5,625) has to be paid to the exchange by the broker. The exchange, on the other hand, passes it on the broker and its clients with contrasting positions on the market (that is, with short positions in ITC futures).
Unlimited gain and loss instruments
Futures contracts are unlimited gain or loss instruments and, hence, considered risky. Being short-term instruments, they are subject to volatility in the stock market and one must be aware of the risk-return trade-off before trading in them.
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