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In the world of finance, investor sentiments wield significant influence, swayed by the economic climate, market stability, and global factors. While confidence in a company prompts investment, a more profound belief in an asset’s performance may lead one to explore futures trading. Futures, being derivatives, derive their value from underlying assets, which can range from commodities like oil, minerals, and gold, to everyday items such as vegetables and fruits. For those inclined towards speculation, futures present an enticing investment avenue. Today, we embark on unravelling the meaning of futures trading and addressing the fundamental question — what is futures trading? Let’s delve into the concept of futures and its multifaceted implications.
Table of Contents
Defining Futures Contract
A futures contract is a derivative contract between two parties—a buyer and a seller This arrangement determines the exchange of a certain item at a predetermined price before an expiration date. The price will stay fixed in accordance with the contract regardless of the market price of the underlying item at the time of the trade.
- This kind of trading is available for individual stocks, goods, currencies, interest rates, and baskets of corporate stocks called indices.
- The futures contract will include the underlying asset’s information.
- You can bet on the value of an item using futures without ever having to buy it.
- You pay only a portion of the money to trade futures contracts, and the remaining amount is paid during the delivery of the underlying assets.
- There is a ‘first disclosure date’ in the case of physically deliverable futures on which the assets are delivered.
An Example
Shyam founded a business that regularly needs steel. His business is already in contact with a supplier of silver. Using a futures contract, the steel supplier mandates Shyam and his business. The supplier pledged to sell a certain amount of steel at a specified rate and time. So, Shyam accepts the agreement. They are now both required to exchange the steel in the future at a predetermined price.
Like silver, any commodity or investment instrument can be the subject of a futures contract. Almost every financial instrument you can imagine has futures contracts, including maize, soybeans, oil, silver, interest rates, and more.
Features of Future Contracts
Expiration Date
Futures are traded with a certain time period in mind. Hence, each futures contract has an expiration or settlement date. On this date, all open positions (shorts or longs) are closed. The final Thursday of the expiry month is the expiration date for equities futures contracts.
Contract Size
One must pay close attention to the lot size when entering a futures transaction. One lot may contain multiple units of the underlying asset. The participants trading in the futures market can only place orders in multiples of the specified lot size. Everything is already specified; whether it be the amount of wheat or rice in the case of an agricultural commodities futures contract, the value of the currency in the event of a currency futures contract, or the value of the stock in the case of an equity futures contract.
Market Cycle
Trading cycles for equity futures last for three months. One can buy or sell the underlying security or index for the current month and the next two months at any moment. For instance, if it is presently March, one can decide whether to enter into a contract to purchase or sell the asset in March, April, or May. When trading futures contracts on stock exchanges, a trader can select either the near month, the next month, or the far month position. Similar to this, contracts are exchanged in cycles of 12 months in the currency futures market.
Date of Agreement
In India, in the case of equity and equity index futures contracts, the former is physically settled and the latter is settled in cash. Therefore, on the closing date, the net payout is calculated, and settlement is executed with cash or actual delivery of assets. Additionally, the settlement type of different commodities differs in the commodity futures market on the MCX (Multi Commodity Exchange of India).
There are four main reasons to start futures trading.
- Increasing Portfolio Diversification: Including futures can help you acquire exposure to several investment vehicles that aren’t as commonly accessible.
- Possibility of Profits from Correct Predictions: Speculators may find significant gains more quickly than in other markets.
- Hedging: Businesses employ futures contracts to reduce the risk of unforeseen price changes.
- Gaining Tax Advantages: Under the 60/40 rule, some futures contracts may be eligible for preferential tax rates: 60% of earnings will be classified as long-term capital gains and the remaining 40% as short-term capital gains.
Advantages of Futures
The following are the advantages of future contracts:
- Enables Investors to Access Markets: Investors who can tolerate risk will find futures contracts handy. Investors have the opportunity to engage in marketplaces that they otherwise would not have.
- Stable Margin Conditions: The majority of commodities and currencies in the futures market have well-established margin requirements. Therefore, a trader knows the appropriate margin to provide for a future contract.
- No Time Decay is Present: The value of the contract decreases with time in options, which significantly lowers the trader’s profitability. This is referred to as time decay. A futures trader does not have to think about time decay.
- Strong Liquidity: Most futures markets have considerable liquidity, particularly for commodities, indices, and common currencies. As a result, traders can join and leave the market with their interests.
Disadvantages of Futures
The downsides of futures contracts are as follows:
- Susceptible to Future Events: You don’t have any influence over future occurrences, which is a frequent disadvantage of futures trading. The predicted demand-supply balance might be severely upset by natural disasters, unexpected earnings surprises, political difficulties, etc.
- High Volatility: Futures prices can quickly fluctuate due to high volatility. Prices fluctuate every day, every few minutes, and even every few seconds.
- End-of-Life Dates: Future contracts have a specific end date. As the end date approaches, the negotiated pricing for the provided assets may become less appealing. As a result, a futures contract occasionally may even expire as a wasted investment.
Conclusion
An agreement to exchange shares at a certain price in the future is known as a futures contract. It is a speculation on the direction in which the price of a stock will go. A buyer of futures benefits from a price increase, while a seller benefits from a price decrease. Most of the prominent stock exchanges around the globe facilitate futures trading. In India, both the Bombay Stock Exchange (NSE) and the National Stock Exchange (NSE) offer futures trading. Hedging against risk and leverage are two benefits of futures trading. So, investors can prefer futures trading for good returns. However, learn derivatives trading properly before trying your hand at it.