• 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
Introducing Future contract
Establishing the context
The simple Forwards Contract example from the previous chapter involved two parties agreeing to trade cash for items at a later date. We looked at the transaction’s structure to see how the price variation would affect the various participants. By the end of the chapter, we had identified four major concerns (or hazards) relating to forward contracts, and we came to the conclusion that a futures contract is to address these concerns.
- Liquidity risk
- Default Risk
- Regulatory Risk
- The rigidity of the transitional structure
In this chapter, we will also make reference to the same example. Therefore, it could be a good idea to review your grasp of the example from the previous chapter.
One thing is quite evident from the last chapter: If you observe the price of an asset, you can gain a lot by engaging into a forward arrangement. Finding a counterparty prepared to adopt the opposing position is all that . A forward agreement is obviously constrained by the associated risks, which are entirely eliminated by a futures agreement.
A modification of the forwards agreement is the futures contract or futures agreement. The fundamental transactional structure of a forwards market by the way the futures contract is constructed. It also does away with the dangers related to the forward contract. If you have a precise understanding of the direction in which an asset’s price is moving, a forward agreement could be profitable for you; this is what I mean by the phrase “basic transactional structure.”
This may seem a little ludicrous, but consider that the “transaction structure” of an automobile from a previous generation was to get you from point “A” to point “B.” Airbags, seat belts, ABS, power steering, etc. are among the safety elements that have been improved in the new generation of cars.
An overview of the Futures Agreement
Since we now understand that the fundamental transactional structure of futures and forwards is the same, it seems reasonable to consider the elements that set futures apart from forwards. In this chapter, we’ll give you a brief overview of these aspects; later on, we’ll delve deeper into each one.
Remember that in the example from the previous chapter, ABC Jeweller and XYZ agree to buy a specific amount of gold at a specific time in the future. Imagine that ABC had a difficult time locating XYZ to serve as a counterparty to the transaction. Even though ABC has a particular opinion on gold and is eager to enter into a financial arrangement, it would be helpless in such a situation since there would be no counterparty to take the other side of the agreement.
Consider this further. What if ABC decides to stroll into a financial supermarket where numerous counterparties are eager to take the opposing stance instead of investing the time and effort to look for a counterparty? The willing counterparties would line up to take the opposing position as soon as ABC announced its plan in the presence of such a financial supermarket. Furthermore, a real financial supermarket of this nature would not just feature individuals with opinions on gold but also on silver, copper, crude oil, and pretty much every other asset class, including stocks!
The Futures Contracts are actually made available in this manner. They are accessible and open to all of us, not just corporations like ABC Jewelers. We have access to futures contracts through the financial (super) market, also known as the “Exchange.” The exchange could be a commodity or stock exchange.
We are aware that a futures contract and a forwards contract are structured somewhat differently. The major goal of this is to reduce the risks associated with the forward market. Let’s examine each of these features that set futures apart from forward contracts.
Be aware that you can still be unclear about the future; it’s okay; just keep the following things in mind. You should understand how a futures agreement operates before we analyze a futures example.
The underlying is by futures contracts
The forward’s agreement between ABC Jewelers and XYZ Gold Dealers was on gold (as an asset) and its price. A futures contract, on the other hand, is on the asset’s anticipated price in the future. The asset, also known as the underlying, by the futures price. One such asset is gold, which has a “Gold Futures” contract. Consider the underlying and its futures contract as being somewhat sibling twins. The futures contract mirrors the actions of the underlying asset. As a result, the price of the futures contract would increase if the price of the underlying rose. Likewise, if the cost of the underlying decreases, the cost of the futures contract does as well.
Using the ABC jewelers and XYZ Gold Dealers example once more, the agreement called for dealing with 15 kg of gold of a specific purity. If both parties had agreed, the agreement may have been for 14.5 kg, 15.25 kg, or any other weight they deemed appropriate. The specifications, however, in a futures contract are standardized. They cannot be.
Futures contracts can be –
Trading futures contracts is simple. Contrary to a forward contract, I am not to honor a contract until it expires if I enter into one with a counterparty (also called the expiry day). If my opinion changes at any time, I can assign the contract to another party and terminate the agreement.
Futures markets are subject to strict regulation by a regulatory body (or, for that matter, the entire financial derivatives market). “Securities and Exchange Board of India (SEBI)” is the regulating body in India. This implies that someone is continually keeping an eye on market activity and ensuring everything goes according to plan. This also indicates that it is extremely unlikely that a futures contract will default.
Futures contracts are time-bound.
We will discuss this issue in more detail later, but for the time being, keep in mind that each of the futures contracts you have access to has a unique time frame. In the previous chapter’s example, ABC Jewellers had a particular perspective on gold while keeping a 3-month time frame in mind. ABC would have access to contracts in the 1-month, 2-month, and 3-month time frames if they entered into a comparable agreement on the futures market. The term “contract expiry” refers to the end of the contract’s duration.
The majority of futures contracts are in cash. This indicates that simply the cash difference is out. Moving the physical asset from one location to another is not a concern. The regulatory authority oversees the cash settlement, ensuring complete openness in the cash settlement procedure.
Here is a table that briefly compares the “Forwards Contract” and “Futures Contract” differences.
I believe it is necessary to emphasize the difference between the spot price and the futures price at this time. The price at which the asset trades in the “regular” market, also known as the “spot market,” is known as the spot price. If we are discussing gold as an underlying, for instance, there are two prices we are referring to: gold on the spot market, also known as the normal market, and gold on the futures market, also known as the Gold Futures. Prices in the spot market and prices on the futures market move together, so if one increases, both do as well.
With these historical contexts in mind, let’s concentrate on a few additional futures contract quirks.
Ahead of your initial futures trade
We must first comprehend a few other facets of futures trading before delving further and understanding how a futures contract functions. Please keep in mind that we will return to these topics later and go into more detail about them. But for the time being, solid practical understanding of the following topics is need.
Lot size – Future is a standardized contract where everything related to the agreement is pre-determined. The lot size is one such parameter. Lot size specifies the minimum quantity that you will have to transact in a futures contract. Lot size varies from one asset to another.
Contract Value – In our example of ABC jeweller and XYZ Gold Dealers, ABC agreed to buy 15 kgs of Gold at the rate of Rs.2450/- per gram or Rs.24,50,000/- per kilogram. Since the deal was to buy 15 kgs, the whole deal was valued at Rs.24,50,000 x 15 = Rs.3.675 Crs. In this case, it is that the contract Value’ is Rs.3.675 Crs. Simply put, the contract value is the quantity of the price of the asset. We know the futures agreement has a standard pre-determined minimum quantity (lot size). The contract value of a futures agreement can be to “Lot size x Price”.
Margin – Again, referring back to the example of ABC jeweller and XYZ Gold Dealers at the time of the agreement, i.e. on 9th Dec 2014, both the parties would have had a gentleman’s word and nothing beyond that. Meaning both the parties would have just agreed to honour the contract on the agreement’s expiry day, i.e. 9th March 2015. Do notice there is no exchange of money on 9th Dec 2014.
However, in a futures agreement, the moment a transaction occurs, both the parties involved will have to deposit some money. Consider this as the token advance required for agreeing. The money has to be with the broker. Usually, the money that needs to be is as a % of the contract value. This is the margin amount’. Margins play a pivotal role in futures trading; we will understand this in greater detail later. For now, remember that to enter into a futures agreement, a margin amount is required, which is a certain percentage of the contract value.
Expiry – As we know, all futures contracts are time-bound. The expiry or the expiry date of the futures contract is the date upto which the agreement is valid. Beyond the valid date, the contract ceases to exist. Also, be aware that the day a contract expires, the exchanges introduce new contracts.
With these few points that we have discussed so far, I guess we can now understand a simple example of futures trading.
- The forwards and futures markets give you a financial benefit if you have an accurate directional view of an asset’s price.
- The Futures contract is an improvisation over the Forwards contract.
- The Futures price generally mimics the underlying price in the spot market.
- Unlike a forwards contract, the futures contract is tradable.
- The futures contract is a standardized contract wherein all the variables of the agreement is predetermined.
- Futures contracts are time-bound, and the contracts are available over different timeframes.
- Most of the futures contracts are cash-settled
- SEBI in India regulates the futures market.
- The lot size is the minimum quantity specified in the futures contract.
- Contract value = Lot size times the Futures price.
- To enter into a futures agreement, one has to deposit a margin amount, a certain % of the contract value.