5 Mantras for Trading in Futures
1. Tool for Hedging or Speculation: Futures contracts can be a tool for an investor for purposes of hedging or speculation. An investor expecting a temporary downturn in the market could short a futures contract instead of liquidating his portfolio. The gains from the futures contract could offset the loss his portfolio would incur. For speculation, an investor could buy a naked contract without any correlation to his other exposure.
2. Difference from Equity: Unlike stockholders, future traders are only participating in the price movements. They do not receive any dividends. They are not part-owners of the company, nor do they have voting rights. Futures trading is completely a zero-sum game, it does not create any value. One trader’s loss is completely another trader’s gain.
3. Cash Settled: Future’s contract expire every last Thursday of the month. This means that on expiry, every futures contract is automatically squared off on closing. The difference is cash-settled, meaning the profit or loss is credited or debited to each investor’s account and there is no requirement to actually exchange the asset. If an investor wishes to prolong his exposure, he would have to close out this month’s contract and take a new position in next month’s contract, this is called Roll Over.
4. Losses are not limited to your margin: When trading futures, an investor has to deposit a margin with the broker. The position size you can take with this margin is many multiples of your margin. The potential loss could be far larger than anticipated, especially in a volatile market. When the price of the future falls below the margin requirement, you are required to deposit more margin else the contract is squared off to safeguard credit risk. This could lead the investor to book a loss at an unfavourable price.
5. Short Exposure: Future contracts allow you to sell before you buy. This means that you could have a negative exposure in a futures contract. If an investor has an unfavourable opinion about a stock, he could benefit from the same by shorting it and buying it back at a lower price.
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