A Brief Introduction to Futures

Futures and Options are also called derivatives because their prices depend on some underlying entity. In case of the NSE Futures and Options, the underlying entity is usually the stock or index. This post is a beginner guide for those who are trading in equities but want to venture into Futures.

As per the Wikipedia definition, a futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed today (the futures price or strike price) with delivery and payment occurring at a specified future date, the delivery date. The contracts are negotiated at a futures exchange (National Stock Exchange in case of NSE futures), which acts as an intermediary between the two parties. The party agreeing to buy the underlying asset in the future, the “buyer” of the contract, is said to be “long”, and the party agreeing to sell the asset in the future, the “seller” of the contract, is said to be “short”. The terminology reflects the expectations of the parties—the buyer hopes or expects that the asset price is going to increase, while the seller hopes or expects that it will decrease in near future.

In India, futures are traded on stocks (NSE), commodities (MCX, NCDEX) and currencies(NSE,MCX-SX and USX). When trading in futures, it is important to understand the concept of margin. Although the futures contract specifies a trade taking place in the future, the futures exchange acts as an intermediary to minimize the risk of default by either party. Thus the exchange requires both parties to put up an initial amount of cash, the margin. Additionally, since the futures price will generally change daily, the difference in the prior agreed-upon price and the daily futures price is settled daily also (variation margin). The exchange will draw money out of one party’s margin account and put it into the other’s so that each party has the appropriate daily loss or profit. If the margin account goes below a certain value, then a margin call is made and the account owner must replenish the margin account.

Futures were first introduced for hedging purposes. To understand that, take the case of a gold jeweler who has to deliver some gold jewelry to a customer at a certain date in the future. To ensure that he is protected against any gold price increases, he would be long the gold future contract. Now if the gold price went up, so would the gold future and hence he would be protected against any price increases.

Lets see how it works with an example of a Stock Future. Suppose you are bullish on Bharti Airtel (BHARTIAIRTL) which is trading say at Rs 300 and you expect it to go to Rs 350 in a month. You can buy 1000 shares of BHARTIARTL at Rs 350 and if the stock indeed went up by Rs 50, you would have a gain of approximately 14% (50/350 x 100). Now if you were trading BHARTIARTL futures, you can control 1000 shares of BHARTIARTL by buying one contract and maintaining say a 20% margin, ie, your effective cost is 20% of Rs 300 or Rs 60. Now for the same Rs 50 gain, you will get almost an 83% gain (50/60 x 100). The important thing to remember though is that just as your potential gain is more when you trade futures, your potential loss can also be high if the stock goes in the opposite direction. That is why using Technical Analysis for timing becomes even more important for a futures trader.

Generally the stock or index future prices move in tandem with the stocks or index price movements. The only difference is in the premium which the future carries over the spot prices. One can do Technical Analysis on the Future or the Stock chart as long as you understand this difference. Many traders prefer to perform Technical Analysis on the future chart itself. We will see in a later post about options, that in case of options it is generally not a good idea to perform technical analysis of options.