Chapter 3: How Futures Contracts Work
Future contracts are almost the same as forwards. The significant difference between them is that futures are exchange-traded. The deal is made through a regulated exchange which acts as a centralized platform, often known as an intermediary between the buyers and the sellers).
Where are Futures Traded?
In India, equity futures contracts are traded on the National Stock exchange (NSE) and the Bombay Stock Exchange (BSE) Unlike forwards, futures can be bought or sold in lots. A ‘lot’ is a bunch of securities clubbed together under one contract.
In fact, futures contracts are traded in lot sizes only. In the case of stocks, the exchanges decide on the number of shares to be traded (known as the F&O lot size). Similarly, commodity and currency lot sizes are defined by the respective exchanges.
Here comes the most exciting part about futures! Futures trading involves leverage. To buy a futures contract, the buyer does not pay the full contract value. Instead, the buyer needs to deposit margin money to the broker or exchange.
This margin acts as collateral, to cover the credit risk that the broker or the exchanges may face in case the buyer does not honor the contract. Similarly, a seller also has to pay a deposit to the broker or exchange, so that the buyer can be compensated if the seller fails to meet the obligations to the contracts.
There’s one more difference. Futures contracts have an expiry and after the expiry date of the futures contract after which either the contracts have been settled in cash or physical delivery. Any of the two options is compulsory, unlike forwards which are customized contracts for requirements specifications.
2.1 Why Trade Futures?
Why do some of the most successful traders or companies in the world remain profitable consistently? They are good at managing their risk consistently. Risk management is the foundation of the trading futures contract.
In fact, futures contracts evolved primarily to help traders manage risk. Why? Because the price of assets is never linear. Over time, prices are influenced by macro economic changes like increase or decrease in demand and supply or geopolitical tensions. Sometimes, this even includes wars or natural calamities.
That’s why traders or large companies have to deal with so many fluctuations. Hence futures contracts are a great tool for risk management. However, uncertainty leads to volatility, which means there’s sharp price movements in the spot prices of the assets.
This welcomed a new genre of market participants known as the speculators or short term traders. They had no interest in taking physical delivery of the assets. Instead, they wanted to benefit from price movements and make gains by forecasting market trends and analysing price movements.
So to answer the question, why futures? The objective is clear:
- Risk management
- Speculation
Opportunity to satisfy biases in the markets are the two main reasons traders choose to enter into the world of Futures Market.
2.2 Who Trades Future Contracts?
Now you know why traders, groups of individuals running medium and small enterprises, or large corporations use futures contracts. They need to manage risks and uncertainties to become successful.
Some people who aren’t running their businesses are speculating in an asset by trading futures in the short term. They all are basically Market Participants of the Futures Market and can be categorised into 3 types depending on their rationale.
1. Hedgers
Individuals or companies hedge against various market variables or any other uncertainty pertaining to demand supply mismatch, price fluctuations of the assets they use for production. They enter into a futures contract to reduce their exposure and hedge against volatility.
2. Speculators
These are traders who buy and sell futures contracts before its expiry. It is easier for a trader to create a speculative position using futures contracts than by actually trading the underlying asset or commodity.
Instead of buying and storing the underlying asset and selling it later, a trader can hold a long position by paying margins and sell when the price goes up.
3. Arbitrageurs
An arbitrage is a deal that produces risk free profits by exploiting a mismatch in market pricing. Arbitrageurs are traders who purchase an asset at a cheaper price from one place and sell the same asset at another place where the prices are higher.
2.3 Example of Futures Contracts
We saw how forwards work with our example of Mr Nivesh and Mr Kisaan. We also established that futures contracts are similar to forwards. Now, let’s see how a future contract works with a practical example.
Assume Mr Nivesh started trading in the stock market. Mr Nivesh is bullish on the company Reliance Ltd and wants to go “long”, which simply means he wants to buy and hold the stock for a period of time.
Since he has been a successful businessman and understands how to trade in forwards, he seems fairly confident that he can speculate his views on the stock. His sole intention is to maximize returns by speculating in the market.
The current market price (CMP) in cash markets also known as the Spot Price of Reliance is let’s say Rs. 2000 on September 1st. Mr Nivesh has a capital of Rs. 4,00,000 with which he wants to invest in Reliance shares and hold for a period of 1 month. He has 2 choices.
At the expiry of the contract, he has to make the balance payment to the exchange and the exchange will ensure that Mr. Nivesh gets 1250 shares credited in his demat account.
Mr. Nivesh now has to decide which choice will give him maximum returns, given the fact that he understands all the risks that are involved in trading and is willing to speculate in the futures market.
Both the choices have their pros and cons, but which one do you think is more profitable for him? Take a minute to think about it.
Done? Let’s analyse.
Either option would have made him profits if his view was right or else he would book losses at the end of the month or expiry of the futures, depending on which instrument he chooses take his position.
Choice 1 Vs Choice 2
| Choice 1 | Choice 2 |
|---|---|
|
Reliance in cash markets |
Reliance September Futures |
|
Holding Period - Month End |
Holding Period - until expiry |
|
TOTAL INVESTMENT =
Paid in cash |
TOTAL INVESTMENT =
Margin Money Paid to Broker |
|
200 shares * 2000 cost price
= 400000 full amount paid to Broker |
1 lot (250 shares) 5*250*2100*15%
= 393750 |
|
Selling Price = 2500 |
Selling Price = 2500 |
|
Profit = Selling Price - Cost
= 2500 - 2000
= 500 rs per share * 200 shares held Total Profit = 100000 |
Profit = Selling Price - Cost
= 2500 - 2100
= 400 rs per share*1250 shares held Total Profit = 500000 |
In both choices, similar capital was used to fund the investment. Since futures contracts allow leverage, Mr Nivesh got exposure to larger contract value by deploying the same capital that he had planned to. As a result Mr Nivesh’s ROI was higher on the futures contract vs the cash market returns.
| Choice 1 | Choice 2 |
|---|---|
|
Reliance in cash markets |
Reliance September Futures |
|
TOTAL INVESTMENT = 400000 |
TOTAL INVESTMENT = 393750 |
|
ROI = Net income / Cost of investment x 100 |
ROI = Net income / Cost of investment x 100 |
|
ROI = 100000/400000*100
= 25% |
ROI = 500000/393750*100
= 126% 10x more than Choice 1 |
Clearly Choice 2 is more profitable than Choice 1. But what if the price goes down?
2.4 The Power of Leverage
We assume that an exchange has a mandatory 20% margin requirement from both parties to enter into the contract. They will need to deposit INR 2,00,000 (20%*10 lacs) as the initial margin.
A futures contract allows them to take INR 10,00,000 worth of exposure just by paying INR 2,00,000 with essentially a leverage of 5x (Leverage = Contract Value/Margin amount ).
That’s the beauty of futures contracts, as they allow you to execute trades at a future date just by paying an upfront margin money, which is a small fraction of the total contract value.
Let’s get back to Mr Nivesh’s example. A ~20% increase in the price of Reliance Industries helped him get 126% returns on his investments. Compared to the cash market position where he deployed his entire capital and even a 5% extra movement in prices, he could manage to get only 25% returns on his investment.
As they say, with great power comes greater responsibility – trading in futures comes with a disclaimer. High risk, high returns. Returns on investments indeed can be compounded exponentially. But what if the trade goes against you? That’s the risk that needs consideration and caution.
Let us consider another example , an extension to the previous one which would express the caution which we referred in our disclaimer above.
What If Mr Nivesh had the same options, but this time he choose to increase his position sizing to 5 lots, by deploying his entire capital in his margin account and the price goes down by 15%. What happens now ? Here’s how leverage works.
| Choice 1 | Choice 2 |
|---|---|
|
Reliance in cash markets (Holding Period - Month End) |
Reliance September Futures (Holding Period - until expiry) |
|
TOTAL INVESTMENT =
200 shares * 2000 cost price = 400000 full amount paid to Broker |
TOTAL INVESTMENT = 1 lot (250 shares) 5*250*2100*15% = = 393750 paid to Broker as Margin |
|
Selling Price = 1800 |
Selling Price = 1800 |
|
Loss = Selling Price - Cost Price |
Loss = Selling Price - Cost Price |
|
= 2000 - 1700 = = 300 rs per share * 200 shares held |
= 2100 - 1785 = = 315 rs per share*1250 shares held |
|
Total Loss = 60,000 |
Total Loss = 3,93,750 |
As you can see, a 15% down move could have easily wiped out Mr Niveshs’ capital due to a higher leveraged position.
Although leverage does increase the ROIs, if there is no risk management system in place, the risk of going All In could be an expensive bet. In the next chapter we shall discuss the various types of futures contracts traded in India.