Planning for ‘futures'

If you are an avid business news follower, you may have come across articles and discussions on futures and options across newspapers and business news channels. While those in the know would highly appreciate the intricacies and nuances of such discussions, here are some brass tacks on ‘futures' for the so-far uninitiated.

What are futures?

Though futures exchange markets were first set up in Japan in the 1730s, trade for standardised contracts started in 1864 when the Chicago Board of Trades (CBOT) listed standardised forward contracts. These were initially offered for grains. Nevertheless, they started a trend, which saw many other commodities and financial instruments being offered by various exchanges across the world over a period of time.

‘Futures' is a contract between two parties, traded through an exchange to buy or sell a specified quantity of an asset at a future date and at a pre-determined price. The asset can be a commodity such as gold, oil, wheat etc or financial instruments such as stocks or currency. An underlying asset can also be intangible such as an index or interest rate.

Obligation to buy or sell

When you buy a futures contract, you have an obligation to buy the underlying asset at a pre-determined price on the day when the contract matures (also called the expiry date).

Futures are exchange-traded instruments. In India, where trading is electronic, the Stock Exchange does the matching of bid and ask prices placed by the buyers and sellers and ensures that the transactions take place. Clearing and settlement of the trades is guaranteed by the exchange. Futures were traditionally settled by actually delivering or buying the underlying but now they can be cash settled. Futures traded in India are cash settled, which means on the date of expiry you just pay or receive the difference between the spot price and the contract price.

Futures are offered by NSE (National Stock Exchange) for financial instruments such as index, stocks, currency and interest rates. Commodities futures and currency futures are traded through MCX and NCDEX exchanges. To trade in these futures, you will need to open a trading account with brokers who are members of these exchanges.

Of futures, margin calls and risks

Futures come with higher risks as they give you a high leverage. While you can gain significantly more, know that you can also lose money very rapidly. Here's how. When you buy or sell futures you will first need to provide a margin to the broker called ‘initial margin'. When you buy one lot of futures contract, you will not be required to pay the full amount. Instead you will pay only a part of it as initial margin. This will range from 15-20 per cent for most stocks and about 10-15 per cent for Nifty futures (index). Margin requirement is fixed by the exchange and can vary every day. The margins can be in the form of cash. It can also be stocks that serve as collaterals.

Futures contracts on NSE are available for three maturity dates at any point in time – current month, near month and far month. Each of these contracts expire on the last Thursday of the respective months. When you buy a contract you need to choose the month of expiry. Like any other security, the price at which the future contract is available is determined by market forces and keeps changing constantly.

Every day, you will receive a debit or credit in your account depending upon whether price of the contract moves up or down. Hence, you make money when prices move up if you have bought a futures contract, and if you have sold a contract you make money when the futures price moves down. This daily debit or credit implies your contract is settled on a daily basis and you can square off your position anytime by exiting the position. In case you get a large debit due to adverse price movement or increase in margin requirement by exchange, your broker will ask you to bring in more margin.

Should you opt for futures?

One of the main advantages of trading in futures is that unlike stocks you don't need to square up position intra-day if you have short-sold. Hence, you can gain from a falling market much better. You also get very high leverage. Unlike when you buy stocks on delivery, your brokerage in futures is very low. If you intend to trade regularly this can lead to significant cost saving.

However, thanks to its high leverage, it also comes with some associated risks. If you are on the wrong side of the market, you can lose money very rapidly. It can even erode your capital in no time if the market moves sharply.

That said, if you take care of a few basics you can also benefit from futures.

Keep a stop loss on positions: This means you should know and give clear instructions to your broker to square off your positions when your losses hit a certain level. This will ensure you will limit your losses when your directional calls go wrong.

Use it to hedge your portfolio: If you feel markets may go down and erode the value of your portfolio, you can go short on index futures. And if the markets do correct, the profit on your short position would, to a large extent, hedge the losses in your stocks' portfolio.

Use only a part of your investible surplus for trading in futures: Depending on your risk appetite, allocate only a portion of your funds to trade in futures. While it can definitely boost your portfolio's earnings, do keep in mind that it comes with some risks. So, remember to always keep tabs on your futures position.

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