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Forward Market

Forward Market

• Forwards market
• Futures contract
• Future trades
• Leverage & payoff
• Margin & M2M
• Margin calculator
• Open interest

• How to short
• Nifty futures
• Nifty futures
• Futures pricing
• Hedging with futures
• Notes

Future Trades

Before the Trade

We learned a variety of futures market-related ideas in the previous chapter. Keep in mind that any trader who enters into a futures agreement is doing so with the intention of earning money. The trader needs to be able to predict the direction of the underlying asset’s price. 

Perhaps it’s time to use a real-world futures deal as an example to show how this is . Let’s look at an example with stocks as we depart from the gold example.

Today (15th Dec 2014), Tata Consultancy Services (TCS) management, a leading Indian Software Company, had investors meet, wherein the TCS management announced that they are cautious about the revenue growth for the December Quarter.  The markets do not like such cautious statements, especially from the company’s management. 

After the statement, the markets reacted to it, and as we can see from the TCS’s spot market quote, the stock went down by over 3.6%. In the snapshot below, the price per share is  in blue. Ignore the red highlight; we will discuss it shortly.

As a trader, I believe that the TCS stock price reaction to the management’s statement is . 

Here is my rational – If you follow TCS or any Indian IT sector company in general, you will know that December is usually a lacklustre month for the Indian IT companies. December is the financial year-end in the US (the biggest market for the Indian IT companies) and the holiday season; hence the business moves quite slowly for such companies. This furlough has a significant impact on the IT sector revenues. 

This information is already known and factored in by the market. Hence, I believe the stock sinking by 3.6% is unwarranted.  I also feel this could be an opportunity to buy TCS, as I believe the stock price will eventually go up. Hence I would be a buyer in TCS after such an announcement.

Notice, based on my thoughts (which I perceive as rational), I have developed a ‘directional view’ on the asset’s price (TCS). I believe the TCS (underlying asset) stock price will increase in due course of time from my analysis. In other words, I am bullish about TCS at the current market price.

I choose to purchase TCS Futures rather than TCS Shares on the Spot Market (for reasons I will discuss in the next chapter). I only need to look at the price at which the TCS Futures are trading after deciding to purchase futures. On the NSE website, the contract information are easily accessible. In reality, the spot market quotes have a link to access specifics for a TCS futures contract. In the picture above, I’ve  the same thing in red.

Remember that the futures price ought to constantly mirror the spot price, thus if the spot price has decreased, the futures price ought to decrease as well. Here is a screenshot of the TCS Futures price from the NSE website.

Because the futures price has, as anticipated, followed the spot price, the TCS Futures are likewise down 3.77 percent. Now, you might have two inquiries:

  1. TCS is down 3.61 percent in the spot market. TCS futures, however, are down 3.77 percent. Why the distinction?
  2. TCS spot price is at Rs.2362.35, but Futures price is at Rs.2374.90? Why the difference?

Both of these are legitimate questions at present moment, and the answers to them depend on the “Futures Pricing Formula,” a subject we shall cover later. But the most crucial thing to remember at this time is that the spot price and the futures price have moved in lockstep and are both down for the day.

 Let’s take another look at the futures contract and analyse a few crucial components before moving on. I’ll re-post the futures contract with a few key points .

The box indicated in red at the top contains three crucial details, beginning at the top:

  1. Instrument Type: Keep in mind that the underlying asset is a company’s stock, and that we are in the future contract for the asset. As a result, the type of instrument in this case is “stock futures.”
  2. Symbol – This draws attention to the stock’s name, in this case TCS.
  3. Expiry Date – This is the date on which the contract ceases to exist. As we can see, the TCS futures contract specifies 24th Dec 2014 as the expiry. You may be to know that all derivative contracts in India expire on the last Thursday of the month. We will discuss more what happens on the expiry date at a later point.

The blue box, which just displays the future price, is something we had briefly examined earlier.

Finally, the black box draws attention to two crucial variables: the market lot and the underlying value.

  1. The price at which the underlying is on the spot market is as the underlying value. TCS was reportedly trading at Rs. 2362.35 a share when I took the above picture, but it had since dropped by a few more points. Consequently, the share price we see here is Rs. 2359.90.
  2. Remember that a futures contract is a standardised contract with a market lot (lot size). It prefixes the parameters. The minimum number of shares we must buy or sell in order to reach an agreement is as the lot size. The TCS futures’ minimum lot size is 125 shares, hence in order to trade TCS futures, a minimum of 125 shares (or a multiple of 125 shares) must be.

Recall that the “contract value,” which is equal to the “Lot size” times the “futures price,” was  in the previous chapter. Now, we can determine the contract value for TCS futures using the formulas below.

Lot size times futures price equals contract value.

=150x 2500.00

=3,75,000

Let’s quickly look at another “Futures Contract” to cement our understanding before moving on to the TCS futures deal. Here is a screenshot of the “State Bank of India (SBI)” futures contract.

You might be able to provide answers to the following queries using the above snapshot:

  1. What kind of instrument is it?
  2. What is the futures price for SBI?
  3. How does the future price of SBI compare to the current pricing?
  4. What is the expiry date of the Futures contract?
  5. What are the lot size and the contract value of SBI futures?

The Futures Trade

Returning to the TCS futures trade, the plan is to purchase a futures contract because I anticipate an increase in the stock price of TCS. I would purchase TCS Futures at a cost of Rs. 2374.9 per share. Keep in mind that I must purchase a minimum of 125 shares. A more common term for the bare minimum of shares is “one lot.”

How do we purchase the “Futures Contract” then? It’s really easy to do; we can either phone our broker and ask him to purchase 1 lot of TCS futures at a cost of Rs. 2374.99 or we can do it ourselves using the trading platform.

I like using the trading terminal to place my own transactions. I advise reading the chapter on the Trading terminal if you are unfamiliar with it. The only thing I have to do to buy the contract is press F1 once TCS Futures has loaded on my market watch.

Several things take place in the background as soon as I press the F1 key on my trading terminal to indicate my want to purchase TCS futures.

1. Margin Validation- Keep in mind that we must always deposit a margin amount (sort of a token advance) when we engage into a futures agreement. This amount is merely a percentage of the contract value. Margin will be  shortly. If the margin is insufficient, we cannot concur. Therefore, the risk management system or software of the broker verifies as the first step that I have enough funds in my trading account to satisfy the margin requirement to engage into a futures agreement.

2. The counterparty search- Following margin validation, the system looks for a suitable counterparty match. It is necessary to match the seller of TCS futures with me as the buyer of TCS futures. Keep in mind that the stock market is a “financial supermarket” with a wide range of players who have different opinions on how much an asset should be worth. The seller of TCS futures clearly believes that the price of TCS futures will continue to decline. The seller has a similar justification for his directional perspective as I have for my prediction that the price of TCS stock would increase. Thus, he desires to work as a seller.

3. The signoff – The buyer and seller digitally sign the futures agreement after Steps 1 and 2, which involve validating the margin and identifying the counterparty, are complete. The majority of this process is symbolic. By deciding to purchase (or sell) the futures agreement, each party authorises the other to abide by the terms of the contract.

4. The margin block –The necessary margin is  in our trading account after signoff is complete. The  margin cannot be  for any other purpose. As long as we continue to hold the futures contract, the money will be .

I now hold 1 lot of TCS Futures Contract after completing these 4 procedures. You might be  to learn that all of the aforementioned procedures take place consecutively in the real markets in a matter of seconds!

What does it imply when it says, “I now possess 1 lot of TCS Futures Contract,” exactly? Simply put, it means that by acquiring TCS futures on December 15th, 2014, I have digitally negotiated with a specific counterparty to acquire 125 TCS shares from me (the counterparty) at Rs. 2374.9/- each share. The counterparty and I have a futures contract that expires on December 24, 2014.

The 3 possible scenarios post the agreement

After agreeing, 3 possible scenarios can pan out by 24th Dec 2014. We know what these scenarios are (we studied them in chapter 1) – the price of TCS can go up, the price of TCS can come down, or the price of TCS could stay the same. Let us arbitrarily take up a few possible price situations and see the price’s impact on both the parties involved.

Scenerio 1- TCS stock price goes up by 24th Dec.

In this instance, my prediction about the trajectory of TCS shares was correct. I therefore stand to gain from this.

Consider that on December 24, 2014, TCS’s stock price increased from Rs. 2374.9 to Rs. 2450 per share. As a result of the increase in the spot price, the futures price would likewise rise. 

This indicates that I am  to purchase TCS shares at Rs. 2374.9/- per share, which is significantly less than the going market rate. (Rs. 2450 – Rs. 2374.9) My profit per share will be Rs. 75.1. Since there are 125 shares involved in the transaction, my entire profit will be Rs. 9387.5 (Rs. 75.1 * 125).

The seller plainly loses money since he is  to sell TCS shares at Rs. 2374.9 per share rather than at the substantially higher price of Rs. 2450 per share on the open market. Without a doubt, the vendor loses out to the buyer.

Scenario 2: The TCS stock price declines by December 24.

This is an instance where my analysis of the direction of TCS stock was incorrect. I would therefore stand to lose.

Assume that on December 24th, 2014, TCS’s stock price drops from Rs. 2374.9/- to Rs. 2300/- per share; as a result, the futures price will likewise drop to a level that is roughly equivalent. 

As a result, I am  to purchase TCS shares at Rs. 2374.9/- a share, which is significantly more expensive than the market price. My loss will be Rs. 75 (Rs. 2374.9 – Rs. 2300) per share. Since there are 125 shares involved in the deal, my overall loss will be Rs. 9375 (Rs. 75 * 125).

As I am  to purchase Tata shares for Rs. 2374.9 per share rather than purchasing them on the free market for a far lower price of Rs. 2300 per share, I will undoubtedly suffer a loss. It is obvious that the seller’s benefit is the buyer’s loss.

Situation 3: The Tata stock price stays the same.

In such a case, neither the buyer nor the seller gain, hence no party is financially impacted.

Utilising a trading chance

Following agreement, three potential outcomes could occur by December 24th, 2014. These possible outcomes are known to us because we studied them in chapter 1; the price of TCS may increase, decrease, or remain unchanged. Let’s arbitrarily choose a few different price scenarios and examine how the prices affect the two sides.

 

Scenario 1: Tata stock price increases by December 24.

In this instance, my prediction about the trajectory of TCS shares was correct. I therefore stand to gain from this.

Consider that on December 24, 2014, TCS’s stock price increased from Rs. 2374.9 to Rs. 2450 per share. 

As a result of the increase in the spot price, the futures price would likewise rise. This indicates that I am  to purchase TCS shares at Rs. 2374.9/- per share, which is significantly less than the going market rate. (Rs. 2450 – Rs. 2374.9) My profit per share will be Rs. 75.1. Since there are 125 shares involved in the transaction, my entire profit will be Rs. 9387.5 (Rs. 75.1 * 125).

The seller plainly loses money since he is  to sell TCS shares at Rs. 2374.9 per share rather than at the substantially higher price of Rs. 2450 per share on the open market. Without a doubt, the vendor loses out to the buyer.

Scenario 2: The Tata stock price declines by December 24.

This is an instance where my analysis of the direction of TCS stock was incorrect. I would therefore stand to lose.

Assume that on December 24th, 2014, TCS’s stock price drops from Rs. 2374.9/- to Rs. 2300/- per share; as a result, the futures price will likewise drop to a level that is roughly equivalent. As a result, I am  to purchase TCS shares at Rs. 2374.9/- a share, which is significantly more expensive than the market price. My loss will be Rs. 75 (Rs. 2374.9 – Rs. 2300) per share. Since there are 125 shares involved in the deal, my overall loss will be Rs. 9375 (Rs. 75 * 125).

I will undoubtedly lose money since I am  to purchase TCS shares for Rs. 2374.9 instead of doing it on the open market for Rs. 2300. The seller’s gain is unquestionably the buyer’s loss.

Situation 3: The Tata stock price stays the same.

In such a case, neither the buyer nor the seller gain, hence no party is financially impacted.

Exploiting a trading opportunity

So let’s look at the situation: after purchasing TCS futures on December 15 for Rs. 2374.9/-, the price of TCS increased the following day, on December 16. It is currently trading at Rs. 2460. What shall I do? Clearly, I stand to gain a lot from the price hike. I am currently sitting at a profit of Rs. 85.1 per share, or Rs. 10,637.5 (Rs. 85.1 * 125) as an overall profit, at the time the picture was .

Suppose I am happy with the money that I have made overnight. Can I close out the agreement? Or rather, at Rs.2460 per share, what if my view changes? What if I no longer feel bullish about TCS at Rs.2460? Do I really need to hold on to the agreement until the contract expiry date, i.e. 24th Dec 2014, by which time if the price goes down, it could lead to a loss?

Well, the futures agreement is tradeable, as I had already mentioned in the previous chapter. By transferring the futures agreement to another party, I can easily exit the agreement at any time after entering it. As a result, I am able to close my open TCS futures position and make a profit of Rs. 10,637.5. Not bad for a day’s work, huh?

“Squaring off” refers to the closing of an existing futures position. I offset an existing open position by squaring off. I initially purchased 1 lot of TCS futures in the TCS example, and when we square off, I must sell 1 lot of TCS futures (so that my initial buy position is offset). The idea of square off is  in the following table in general:

When I want to square off a position, I may either use the trading terminal to do it myself or phone my broker and ask him to do it. In the illustration, we are long TCS futures with an open trade (1 lot). The square off position would be to “sell 1 lot of TCS futures” in order to balance this open position. When I choose to square off the TCS position, the following things take place:

  1. The broker searches for a counterparty prepared to purchase my futures position via the trading terminal. To put it another way, “my current purchase position will just be to someone else.” By purchasing the contract from me, that “someone else” now assumes the risk of the Tata price fluctuation. As a result, this is known as the “Risk Transfer.”
  2. Keep in mind that the transfer will occur at the market’s current futures price, or $2460 per share.
  3. After the trade is, my position is regarded as offset (or squared off).
  4. The margins that were previously barred would be after the trade is. I can use this money for other purchases.
  5. The transaction’s profit or loss will be or debited to my trading account that very same evening.

The futures trade is now likely to be  with this.

Note that I might keep holding the stock futures if, at Rs. 2460, I start to believe that the price will go considerably higher. In fact, I can keep the futures until the contract’s expiration, which is December 24th, 2014. I will continue to be exposed to the risk of TCS price volatility as long as I keep the futures. In actuality, the TCS futures snapshot shown here was obtained on December 23, 2014, one day before the contract’s expiration. Since TCS futures are currently trading at Rs. 2519.25 per share, my returns would have been significantly larger had I chosen to hold the futures until December 23rd.

In truth, “someone else” purchased the TCS futures from me on December 16, 2014, when I decided to book profits at Rs. 2460. In other words, I sold someone else my purchase position, and even that “someone else” (the counterparty) would have profited from this contract by purchasing it from me for Rs. 2460 and holding it until Dec. 23, 2014. Here are two straightforward questions for you:

  1. What would my profit and loss (P&L) be if I had held the Tata futures from December 15, 2014 (Rs. 2374.9) to December 23, 2015, both per share and overall? (Rs.2519.25)
  2. I closed out my position on December 16th, 2014, for Rs. 2460. This was done because the contract’s square had definitely been assigned to a counterparty. What would the counterparty’s total and per-share profit and loss (P&L) be if he kept the TCS futures contract open until December 23rd, 2014?

If you are unable to respond to either of the two questions above, please leave a question in the comment section below, and I will be pleased to explain the solution. But I genuinely hope you discover the solutions to the aforementioned queries on your own.

In the next chapter, we will discuss margins, an essential aspect of futures trading.

CONCLUSION

  • By entering into a futures agreement, you can profit financially from having a directional opinion on the price of an asset.
  • A token advance known as the margin must be deposited in order to transact in a futures contract.
  • We digitally sign the contract with the counterparty when we trade in a futures transaction, obliging us to uphold the terms of the deal.
  • Due to the futures pricing mechanism, there is a difference between an asset’s futures price and spot price (we will discuss this topic later)
  • The bare minimum number of shares that must be traded is one lot.
  • Until the contract’s expiration, we are under no duty to abide by the terms of any futures arrangement we enter into.
  • Every futures deal needs a certain amount of margin, which is blocked when you place the order.
  • The agreement is revocable at any time, so you have a little window of time after entering it to withdraw your consent.
  • We essentially transfer the risk to another party when we square off an agreement.
  • Margin unblocking occurs once the futures position has been squared off.
  • Your trading account is immediately credited or debited with any profits or losses you incur during a futures transaction.
  • In a futures transaction, the gain of the buyer is the loss of the seller, and vice versa.