Derivative Trading is the trading mechanism in which the traders enter into an agreement to trade at a future date or at a certain price, after understanding what the future value of the underlying asset of the derivative is expected to be. Derivatives at the financial contracts that derive their value from the underlying assets.
Of the derivative trading types, one is Futures Trading.
Futures Trading involves a legal agreement to buy or sell a derivative at a predetermined price at a predetermined time in the future. The underlying asset of the derivative can be a commodity or a financial instrument. A very important point to be considered is that in futures trading, the buyer and seller have an obligation to fulfil the contract at the predetermined price and time.
The predetermined price is called the futures price and the predetermined time is called the delivery date.
Futures Trading – Characteristics
Before we understand the mechanism of futures trading, the following are some key characteristics of a futures contract:
Price of the futures contract depends on the price of the underlying asset: If the price of the underlying asset goes up in the future, the price of the futures contract goes up too, and vice versa.
Transferable and tradable: Future contracts are transferable and therefore tradable. If one party changes the mind during the contract, it can be transferred to someone else and that party can move out.
Highly regulated: As futures trading involves risks of both the parties not fulfilling their obligation, the futures market is highly regulated by regulatory authorities like SEBI in India. SEBI overlooks the smooth functioning of the futures trading market and highly reduces the chances of default.
Standardised: Future contracts are always standardised and they cannot be customised according to individual requirements and the conditions are non-negotiable.
Settlement: Futures contracts are settled in cash, so the physical movement of the underlying assets is not required. Only the difference in cash values is paid by one party to the other.
Thus, before even thinking of moving into futures trading, make sure you understand the above-mentioned characteristics (in a sense, rules) otherwise, it can lead to unnecessary financial losses and/or hassles.
Futures Trading – Mechanism
This is how the whole concept of futures trading works in the simplest form possible:
We begin with understanding the mechanism and working of stock futures.
For instance, a trader anticipates that the share price of IBM is about to go up in the near future, due to certain annual report disclosures.
The trader will check for the spot price and future price of IBM stock (available at NSE website), and both prices will be related to each other.
He then buys the stock futures of IBM at the underlying price.
The trader buys 100 shares at ₹155 each. So, the lot size is 100 and the contract value is ₹15,500 and the expiry date is April 30, 2018. This also means that the minimum number of IBM shares that can be bought is 100.
As soon as the margin money is found to be sufficient in the margin account of the buyer and the counterparty is found, the trade is entered into.
Now, by the expiry date of April 30, if the price of IBM shares goes up to ₹170, the buyer’s prediction of price increase comes true and he can now buy the IBM shares at ₹155 which is ₹15 less than the market price. So, the total profit is ₹(100*15)= ₹1500. The seller of the futures contract will incur a loss of ₹1500 as he is obligated to sell the shares at ₹155 when the current market price is ₹170.
If the price of IBM shares goes down instead to ₹145, the buyer will incur a loss of ₹(100*10)= ₹1000 because he will have to buy the shares at ₹155 which are currently being traded at ₹145. The seller makes a profit in this case.
In the scenario when the price of the shares rises just after a couple of days, the buyer would not want to wait till the expiry because by then the prices may go down again, so he can still exit the trade by transferring the futures contract to another party and close his position with the profit.
The results of the squaring off of the transaction are directly debited from or credited to the parties’ margin accounts and no physical settlement is required.
Futures Trading – Advantages
Here are some of the benefits of using futures trading as part of your overall investment plan:
Leverage due to the provision of margin trading: Using the margin account, positions can be taken in the futures market by paying only a fraction of the total contract value. If the market moves in the expected direction then the return on investment becomes very high; although so do the losses if the market does not go in the right direction.
Liquidity: The number of futures contracts traded every day is quite high, so the futures market is very liquid. It is easy to enter and exit the market at any point. This also brings the effect that the market does not move drastically.
Low brokerage costs and commissions: The brokerage and fee charged on the futures contract are quite low, so the trader does not have to pay a huge amount in commission.
Hedging: Futures trading is a very important mechanism for hedging or diversification of portfolio and risks. Especially, in the foreign exchange market and the interest rate market, futures trading helps a lot to hedge risk due to price fluctuations. It is widely used by importers and exporters to hedge their risks due to foreign exchange price variations at the time of order and the time of delivery.
Short selling: There are many restraints on the short selling of stocks individually, but the short-selling of futures contracts is legal and the trader is able to sell a futures contract to get short exposures to a stock.
Fair and easy to understand: Futures trading is simple and easy and not as complicated as options trading. The futures market is also strictly monitored and regulated by the regulatory authorities like SEBI making it very fair to both the parties.
As a bottom line, futures trading is a very efficient way of making money due to leverage and provisions of hedging, but at the same time, the traders need to be very cautious while trading in the futures market as they are equally prone to risks due to high leverage and high contract values.
Futures Trading – Challenges
It’s not all rosy and sunny. Since the profit potential in this kind of trading style is high, thus, the challenges are going to be much tougher as compared to the ones in other conventional forms of trading.
Some of the challenges in futures trading you may face are:
Staying Objective: As soon as your emotions start making the trade decisions for you, you can assume your profit downfall is about to get started. You need to remain 100% objective throughout your trading choices especially when you are into futures.
Getting Distracted: Futures trading in general, DEMANDS focus and attention. Thus, as long as you are involving yourself into future trades, make sure you are completely immersed in your research and analysis.
Shutting Yourself: If you think you know everything about trading, be it any kind, well then it is going to be really difficult for you to make money consistently in the stock market. You need to be open about the new concepts emerging in the market since the stock market in itself is very dynamic in nature.
As long as you are able to tackle these and other related challanges, futures trading is certainly one of trading that can bring you reasonable returns on a consistent basis.
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