Chapter 7: Futures Terminologies
6.1 Spot Price
The current market price (CMP) at which an asset or a commodity is traded in the cash markets is called the Spot Price.
For example, the price of Reliance Industries is closed at 2,377.35 which is the spot price of Reliance as of 26th September 2022.
6.2 Future Price
Future price applies to an asset or a commodity which needs to be delivered at a future date. Since the transaction is done at a future date, costs for storage, finance, etc will be borne by the seller to store the asset or commodity and carry them until delivery.
Thus, the pricing of a futures contract is usually at a premium to the spot prices since it is based on the spot price of an underlying asset plus the cost of carrying that asset until the delivery date.
As you can see, the spot price of RIL is trading at INR 2,377.35 as of 26th Sept 2022. The September futures, which is the current month’s futures contract, is trading at INR 2,380.05.
The October contract is trading at INR 2,492.20 and the far month November contract is trading at INR 2,406.20.
If you notice all the monthly contracts are trading at a premium, that is because the pricing of futures is based on various factors and they can trade at a premium or discount to the spot.
6.3 Cost of Carry
The cost of carry is the relationship between spot and futures prices. Cost of carry refers to the cost incurred to hold an asset or a commodity until the expiry of the futures contract.
In the case of commodities, these costs include storage costs, plus financing costs i.e. the interest paid to finance or carry the asset till the delivery date minus any income earned on that asset during the holding period.
In the case of shares, the cost of carry refers to the interest paid to finance the purchase less any income like dividends earned during the holding period.
6.4 Contract Cycle
The contract Cycle refers to the monthly cycle in which the futures contract are traded.
Futures contracts have a maximum 3-month trading cycle:
- The near month (one)
- The next month (two)
- The far month (three)
New future contracts are launched on the trading day following the expiry of the near-month contracts. The new contracts are introduced for a three-month duration.
As you can see, there three months contracts of Reliance Futures available
- The Near month – September Series
- The Mid month – October Series
- The Far Month – November Series
Similarly, Nifty 50 Index Futures, Nifty Financial Services Index and Nifty Midcap Select Index will have 7 weekly expiration contracts (excluding monthly contracts) and 3 monthly expiration contracts.
At a given time Nifty Bank index will have 4 weekly expiration contracts. This excludes the monthly contracts. In total , 3 monthly expiration contracts are available for Bank Nifty Index.
Additionally, Nifty 50 Index options and Nifty Bank Index options will have Three quarterly expiries (Q1 March, Q2 June, Q3 Sept, and Q4 Dec cycle).
Nifty 50 index will also have long-term index option contracts i.e. after the three quarterly expires, next 8 half-yearly expiries (Jun, Dec cycle) will be available for trading.
6.5 Contract Expiry
To overcome the issue of lack of standardisation of forward contracts, futures contracts have an expiry date, on which the futures contract compulsory settlement either in cash or physical delivery has to be done.
In the Indian share market, the expiry of futures contracts are as follows.
For Individual Securities, expiry is on the Last Thursday of the month. If last Thursday of the expiry period is a trading holiday, then the expiry day is the previous trading day.
The Nifty 50 and Nifty Bank indexes have an expiry on the last Thursday of the expiry period. These indexes also have a weekly expiry which is on a Thursday of the trading week.
If the last Thursday is a trading holiday, then the expiry day is the previous trading day in both cases.
For the Nifty financial services index (Finnifty) and Nifty Midcap Select Index, the expiry is on the Last Tuesday of the expiry period.
The Nifty financial services index (Finnifty) also has a weekly expiry period. If last Tuesday of the expiry period is a trading holiday, then the expiry day is the previous trading day.
6.6 Contract Specifications
Contract specifications specify the exact parameters on which future contracts are traded.
Details such as what is the underlying asset, the permitted lot sizes, tick size, trading cycles, expiry date of the contracts, settlement types, etc are mentioned by the exchange and may change from time to time.
6.7 Tick Size/Price Steps
A tick in financial markets refers to the minimum difference between the bid and ask price. Tick sizes are set by the exchange and are mentioned in the contract specifications.
The minimum movement of a futures contract has to be as per the tick size only which means if the tick size is 10 paise, the price minimum price movement of a futures contract can be 10 paise.
6.8 Contract Size and Contract Value
A lot size in F&O trading refers to the minimum number of shares that you can trade in the F&O markets. When trading F&O markets, you can only buy and sell contracts in a minimum of one lot or multiples of the lot size.
For example, the lot size of Nifty is 50 units so you can only trade Nifty in multiples of 50.
The lot size is determined by the exchange on which the futures contracts are traded and may be revised by them from time to time based on their contract value, volatility and various other criteria set by the exchanges.
In F&O markets Contract Value (CV) refers to the contract size multiplied by the current market price:
CV = lot size * Current Market Price (CMP)
6.9 Margin
The account where margins are deposited act as a collateral against the open position in a futures contract.
Margin requirements can range from 10% to 20% based on the asset. Along with the margin, brokers will require daily MTM settlement for profits and losses at the market prices during a day’s close.
Types Of Margins
Margins are a great tool for exchanges for their risk management as they provide a cover against the viable risk of adverse price movements.
Onto the next one…
In Indian F&O markets also known as the SPAN Margin is basically a VaRmargin that is set via a system which calculates an array of risk factors to ascertain the potential gains and losses for a contract under varied conditions.
6.10 Mark to Market ( MTM )
Mark-to-market is a great accounting tool used to record the value of an asset with respect to its current market price. What it simply means that the value of the asset is determined at its closing price of the day.
In India, futures contracts are marked to market on a daily basis at closing prices. This makes it easy for the exchanges to track margin requirements for every trader.
The exchange credits the trader’s margin account if he makes profits and debits the losses. That said, MTM settlement is a notional adjustment.
The final settlement happens only after the expiry of the contract. Exchanges make sure that at all times, traders maintain their margin requirements and MTM settlement is their way to curb the risk of defaults.
6.11 Margin Call
As we discussed before, margins are collateral deposits demanded by stock exchanges to hedge against default risk that may occur if any party fails to honor their obligations.
A margin call is a demand for more money as collateral incase the deposits deplete on account of MTM Losses.
Let’s get back to Mr Nivesh’s example in chapter 2 where he had Rs. 4,00,000 as margin money to buy Reliance futures.
Just when futures price of the stock dropped by 15%, returns on his investments dropped to zero. In such a case, Mr Nivesh has 2 choices.
6.12 Open Interest
Open interest (OI) is a measure of the flow of money into a F&O market. An open interest is the total number of contracts that are Open Positions, meaning they are yet to be settled.
Increasing open interest indicates new or additional money coming into the market while decreasing open interest indicates outflow of money from the markets.
In the futures market, for every long future contract there has to be a short future contract, that’s the only way exchanges can standardised futures contract and guarantee settlement.
By understanding the Open Interest data along with price action in a particular stock, a trader might be able to interpret whether a stock is on an uptrend or downtrend or a possible reversal in price.
6.13 Price Band
Price bands determine the range within which price of a security can move. Price bands are set by exchanges, to prevent erroneous order entry by market participants.
To illustrate, a 10% price band implies that the security can move +/- 10% of its previous day close price.
The downward revision in the price bands is a daily process whereas upward revision happens bi-monthly and is subject to certain conditions and can only be revised when certain criteria are met.
There are no day minimum/maximum price ranges applicable in the derivatives segment where future contracts are traded.
However, in order to prevent erroneous order entry, operating ranges and day minimum/maximum ranges are kept as below:
- For Index Futures: at 10% of the base price
- For Futures on Individual Securities: at 10% of the base price
- For Index & Stock Options: A contract specific price range based on its delta value is computed and updated on a daily basis
In view of this, orders placed at prices which are beyond the operating ranges would reach the exchange as a price freeze.
6.14 Long Position
Long Position is a buy position. When a buyer expects price to rise in future , he would go long or the buyer is said to have a long position in that asset meaning he buys the asset at current market price and sells when the price increases.
6.15 Short Position
As opposed to a long position (bullish position), a short position is the exact opposite. A short position is referred to as a sell position.
A trader who wants to hedge his price risk against a probable drop in price in the underlying asset can create a sell position in the futures of the same underlying and if the price falls, he would buy it again at a lower price.
Thus, the trader is said to have a short position in that asset. A short position indicates a bearish view and is widely used in futures trading since it allows traders having a bearish bias , to sell the underlying asset first and make money if the value of the contract decreases.
6.16 Open Position
In futures trading, a buyer or a seller speculates their view on the price of the futures contract. Based on their conclusions they develop a bullish or a bearish view.
Once this is developed, traders execute their long or short positions. This is referred to as an Opening of a Position in the markets.
For example, a trader can have the following positions:
- Long: 1 lot Reliance Futures Contract
- Short: 2 lots TCS Futures Contract
- Long: 2 lots ICICI Bank Futures Contract
6.17 Closing a Position
Closing a position refers to setting off or squaring off an open position. While closing a position a trader has to take a contra trade to his original position.
For example, if a trader is long on HDFC Bank Futures Contract, then he has to take a short position in the same HDFC Bank October Futures contract to close his open position. The reverse can be true as well.
| Open Positions | Closing Positons |
|---|---|
|
1 Long HDFC Bank October Futures |
1 Short HDFC Bank October Futures |
|
1 Short Reliance October Futures |
1 Long Reliance October Futures |
In futures trading, a trader can either close an open positon anytime during the contract period or else by default, the position is netted/nullified at expiry by the broker or the exchange.
This is because exchanges have to make sure that for evey buyer there has to be a seller assigned.
6.18 Pay Off Charts
This is a graphical representation of probable profit and loss depending on the settlement price of the futures contract.
A pay off graph can display all the possible outcomes of profit or loss at a given settlement price, breakeven price, etc in one graph.
6.19 LTP
Last Traded Price (LTP) is the price at which the last trade was concluded. LTP , as the name suggests, is the most recent trade between a buyer and seller that has executed. In futures trading, LTP is used by the buyers and the sellers for price discovery and to speculate and place bids.