In financial terms, a futures contract is an agreement between two parties who decide to buy or sell a particular asset at a decided price and time in the future.
Before we start, let me give you a heads up on Futures Trading that it is not going to be a piece of cake. Yes, I’d quote in the words of the famous spoken English teacher from the movie “Phas Gaye Re Obama,” “Futures Trading not a children play, Future Trading like an undertaker play, Taj Mahal create!”
But, jokes apart, Futures trading is no rocket science either; it’s just a contract between 2 parties with certain terms and conditions. And in this article, we will be trying to give you an idea of what is futures trading in the stock market with the below-mentioned sub-topics.
Content:
- Futures Contract
- Features of a Futures Contract
- Lot Size
- Contract Value
- Margin
- Expiry
- How to Trade Futures?
- Why is Futures Trading Better?
- Disadvantages of Futures Trading
- Quick Summary
Futures Contract
In financial terms, a futures contract is an agreement between two parties who decide to buy or sell a particular asset at a decided price and time in the future. Later, at the time of maturity of the contract, it doesn’t matter what the market price of the asset is; both parties are obligated to follow the contract. One can be in a profit-making situation, while the other can be making losses. Note that the asset here can be stocks, bonds, commodities, etc.
Sounds similar to Options Trading? But, it is not. Read our blog on Options Trading to find the difference.
If you have ever been in a contract or agreement upon buying or selling anything, there is a good chance that you might have executed a futures contract unknowingly. Let me explain how.
Suppose you visit a Jewelry showroom and decide to buy a Gold chain. But instead of buying the display piece, you decide that you need some changes in the design and the jewelry maker agrees to your suggestions. The only condition here is that the gold chain will be delivered after a month.
Now, the jewelry maker proposes an agreement in which you can either make a partial payment and lock in the current gold price until the time of delivery, or you can pay at the time of delivery based on the gold rate one month later.
As you know, gold prices fluctuate, which you could not precisely predict, and one month is enough time to make a difference in the pricing. So you decide to stick to the first outcome and decide to lock in the current gold price for your jewelry.
Now, whatever may be the gold price one month later, you are obligated to pay for the jewelry at today’s rate. Similarly, the jewelry maker will be obligated to comply with the agreement. This is what a futures contract looks like.
Features of a Futures Contract
Diving deeper into the futures contract, let’s understand what are the important features and terms involved in it!
Lot Size
When trading in a Futures contract, you cannot buy one or two shares individually; instead, there are a number of shares decided per lot for different stocks and contracts. For example, if you are buying futures of Reliance, you will have to buy a minimum of 250 shares; as one lot of Reliance consists of 250 Shares, you may increase the number of shares, but only in the multiples of 250.
Contract Value
This is a very basic calculation. A contract value can be determined by the product of the total number of shares included in the contract with the current market price of the share.
Contract Value = Total shares X Current Market Price
For example, let’s take Reliance as a reference here. Say you are buying futures of 10 lots, i.e., 10 X 250 Shares = 2500 Shares. Now the CMP of Reliance is ₹ 2800, then the contract value of this future will be:
Contract Value = 2500 X 2800 = ₹70,00,000
Margin
Margin is nothing but the minimum amount required to be in your trading account to enter a futures contract. Earlier, the stockbrokers would provide up to 10X margin, but as per the latest guidelines from the SEBI, an Investor or Trader has to bear 100% of the amount required to enter a futures contract.
Expiry
The Expiry or the Expiration Date in a Futures Contract is the last date on which the agreement expires. In some cases, it is also referred to as the maturity date.
How to Trade Futures?
The first and foremost thing you need for trading futures contracts is a Demat account and a trading account. And this can be done in minutes while reading this article; all you have to do is follow these simple steps mentioned below.
To understand the difference between a demat and trading account, click on this link.
Step 1: Click here to fill in your Name, Email, Mobile Number, and State and click on Open an Account.
Step 2: Upload account opening documents.
Step 3: Provide an IPV (In-person verification) by showing your PAN towards the camera along with your face.
Step 4: E-sign the documents by verifying your Aadhaar with your Mobile Number.
Your account will be activated within 24 hours.
To understand the actual process of how you could trade in futures, let’s take an example.
Now, you may see that this is a Nifty May Futures Contract.
- The Lot Size here is 50 Shares/Lot, i.e., you can buy shares in the multiple of 50.
- The total margin required to enter this trade is ₹1,05,539.10.
Why is Futures Trading Better?
So, one of the main reasons why futures trading is better is that you get to hedge your positions in the market. Hedging is nothing but a risk management approach that is used to balance investment losses by acquiring an opposite position in a similar asset.
- Futures contracts can be used to hedge against systemic risks associated with an investment in a single stock or a portfolio of equities.
- Futures contracts also provide diversification to your portfolio, and these can be traded in stocks, currencies, commodities, ETFs, etc.
One of the most important advantages that derivative trading offers is Hedging. Click here to learn about what is hedging in the stock market.
Disadvantages of Futures Trading
Well, everything has its set of disadvantages. All you can do is understand them so that you are not in these situations.
- Futures can be more complicated than buying or selling stocks.
- If not understood clearly, you are very likely to make losses.
- Hedging can be a disadvantage as well; sometimes, you might miss out on a stock’s favorable run in the market.
Why don’t you click on this link to know the difference between Futures and Options?
We hope that you are clear about the topic. But there is more to learn and explore when it comes to the stock market, and hence we bring you the important topics and areas that you should know:
Quick Summary
- In financial terms, a futures contract is an agreement between two parties who decides to buy or sell a particular asset at a decided price and time in the future. Note that the asset here can be stocks, bonds, commodities, etc.
- Futures contracts can be used to hedge against systemic risks associated with an investment in a single stock or a portfolio of equities.
- Futures contracts also diversify your portfolio, and these can be traded in stocks, currencies, commodities, ETFs, etc.
- Futures can be more complicated than buying or selling stocks. If not understood clearly, you are very likely to make losses.
