All About Futures

3.1 How to Trade in Futures?

• Trading in futures is a sophisticated financial practice that involves the buying and selling of contracts to purchase or sell an asset at a future date and at a predetermined price. This form of trading is prevalent in various markets, including commodities, indices, currencies, and more. To begin trading futures, you must first choose the specific market you wish to engage in. Each market has its unique characteristics and requirements, so thorough research is essential.
• Once you’ve selected your market, the next step is to create a trading account with a reputable broker who offers futures trading services. This process typically involves providing personal identification, financial information, and sometimes undergoing a suitability assessment to ensure you understand the risks involved in futures trading.
• After setting up your account, you must decide whether to take a long or short position. A long position means you are buying the contract, anticipating that the asset’s price will rise in the future. Conversely, a short position involves selling the contract, expecting the asset’s price to decline.
• Placing your trade involves entering an order through your broker’s trading platform. Most platforms provide various order types, including market orders, limit orders, and stop orders, to help you execute your trading strategy. Setting stop-loss and limit orders is a crucial step in managing risk, as these orders automatically close your position if the market moves against you by a specified amount.
• Monitoring your trade is essential as the market can be highly volatile, and prices can change rapidly. Once you achieve your desired profit or wish to limit your losses, you can close your position by placing an opposing trade to your initial one.

3.2. Trading Stocks vs. Trading Futures

Trading stocks and trading futures in India present unique opportunities and challenges, shaped by the regulatory environment and market dynamics. When trading stocks in India, investors buy and sell shares of companies listed on stock exchanges like the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). Stock trading in India involves owning a portion of the company, with potential for dividends and capital appreciation. The performance of these stocks is influenced by factors such as company performance, economic indicators, and global market trends. Indian stock markets offer a mix of large-cap, mid-cap, and small-cap stocks, catering to different investment strategies.

In contrast, trading futures in India involves entering into standardized contracts to buy or sell an underlying asset at a predetermined price on a specific future date. These assets can include commodities, stock indexes, currencies, and interest rates. Futures trading is conducted on exchanges like the Multi Commodity Exchange (MCX) and the NSE. Unlike stock trading, futures trading relies heavily on speculation and hedging rather than ownership of the underlying asset. Futures contracts in India are often leveraged, allowing traders to control large positions with a relatively small margin. However, this leverage amplifies both potential gains and losses, making risk management crucial.

A significant difference between the two is the investment duration and flexibility. Stock traders in India can hold their investments for the long term, benefiting from the growth potential of companies. Futures contracts, however, have expiration dates, requiring traders to either close or roll over their positions before the contract expires, necessitating more active management. Additionally, futures trading in India is subject to stringent regulations by entities like the Securities and Exchange Board of India (SEBI), which ensures transparency and reduces market manipulation.

Furthermore, the tax implications differ between the two. Short-term capital gains from stock trading are taxed at a different rate than the gains from futures trading, which are considered as business income. Both forms of trading require a solid understanding of market dynamics, regulatory frameworks, and effective risk management strategies.

By understanding these nuances, traders can better navigate the Indian financial markets and choose the approach that aligns with their investment goals and risk tolerance.

3.3. Lot Size and Margin Requirement

• Trading stocks and trading futures in India present unique opportunities and challenges, shaped by the regulatory environment and market dynamics. When trading stocks in India, investors buy and sell shares of companies listed on stock exchanges like the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). Stock trading in India involves owning a portion of the company, with potential for dividends and capital appreciation. The performance of these stocks is influenced by factors such as company performance, economic indicators, and global market trends. Indian stock markets offer a mix of large-cap, mid-cap, and small-cap stocks, catering to different investment strategies.
• In contrast, trading futures in India involves entering into standardized contracts to buy or sell an underlying asset at a predetermined price on a specific future date. These assets can include commodities, stock indexes, currencies, and interest rates. Futures trading is conducted on exchanges like the Multi Commodity Exchange (MCX) and the NSE. Unlike stock trading, futures trading relies heavily on speculation and hedging rather than ownership of the underlying asset. Futures contracts in India are often leveraged, allowing traders to control large positions with a relatively small margin. However, this leverage amplifies both potential gains and losses, making risk management crucial.
• A significant difference between the two is the investment duration and flexibility. Stock traders in India can hold their investments for the long term, benefiting from the growth potential of companies. Futures contracts, however, have expiration dates, requiring traders to either close or roll over their positions before the contract expires, necessitating more active management. Additionally, futures trading in India is subject to stringent regulations by entities like the Securities and Exchange Board of India (SEBI), which ensures transparency and reduces market manipulation.
• Furthermore, the tax implications differ between the two. Short-term capital gains from stock trading are taxed at a different rate than the gains from futures trading, which are considered as business income. Both forms of trading require a solid understanding of market dynamics, regulatory frameworks, and effective risk management strategies. By understanding these nuances, traders can better navigate the Indian financial markets and choose the approach that aligns with their investment goals and risk tolerance.

3.4 Futures Pricing

• Futures pricing is a complex process driven by the interplay of multiple market factors. At its core, the price of a futures contract is anchored to the spot price of the underlying asset—the current market price at which the asset is bought or sold for immediate delivery. However, the futures price doesn’t merely mirror this spot price; instead, it incorporates several additional elements to predict the future value of the asset.
• One of the key factors influencing futures pricing is the risk-free interest rate, often represented by government bond yields. This rate reflects the return on an investment with zero risk, serving as a benchmark for other investments. In the context of futures, the interest rate is crucial because it determines the opportunity cost of capital—the potential gains investors forgo by locking their funds in a futures contract instead of investing them elsewhere.
• Time to maturity is another significant factor. Futures contracts have specified expiration dates, and the length of time until this date affects their pricing. The longer the duration, the greater the uncertainty and the higher the potential for price fluctuations, which is factored into the futures price.
• The concept of “costs of carry” also plays a pivotal role. These are the costs associated with holding the underlying asset until the futures contract expires. For physical commodities, this includes storage and insurance costs. For financial instruments, it might involve borrowing costs or the foregone dividends on stocks. The costs of carry are added to the spot price to derive the futures price.
• Market expectations and speculation significantly impact futures prices as well. Traders’ perceptions of future market movements, influenced by economic indicators, geopolitical events, and market sentiment, can drive prices up or down.
• Lastly, supply and demand dynamics can’t be overlooked. The balance between the number of contracts available and the number of traders wanting to buy or sell these contracts affects futures prices. High demand for a contract typically drives its price up, while an oversupply can lead to lower prices.
• By considering all these factors, futures pricing aims to provide a realistic and efficient market forecast, allowing investors to hedge against risks or speculate on future price movements. The interplay of these variables ensures that as the contract nears expiration, the futures price converges with the spot price, maintaining market equilibrium.

Here’s the basic futures pricing formula for a non-dividend-paying asset:

F=S × e^(r×t)

Where:

• F is the futures price
• S is the spot price of the underlying asset
• e is the base of the natural logarithm (approximately equal to 2.71828)
• r is the risk-free interest rate
• t is the time to maturity of the contract, expressed in years

For assets that pay dividends or have other income, the formula adjusts to account for these payments:

F=S × e^(r−q)×t)

Where q is the dividend yield or the income rate of the underlying asset.

These formulas encapsulate how futures prices are derived from the spot price, adjusted for the time value of money (represented by the risk-free rate) and any income generated by the asset. This mathematical approach helps in understanding the theoretical pricing of futures contracts, aiding investors and traders in making informed decisions.

3.5 Futures Expiry and Settlement

• Futures contracts have a specified expiration date, which is the date on which the contract must be settled. Settlement can occur in two ways: physical delivery or cash settlement. In physical delivery, the actual asset is delivered to the buyer upon contract expiration. This is common in commodity futures, such as agricultural products and energy.
• In cash settlement, no physical delivery takes place. Instead, the difference between the futures price and the spot price at expiration is settled in cash. This is more common in financial futures, such as stock indices and currency futures. The settlement process ensures that all obligations are met and that the futures market remains fair and orderly.

3.6 Futures Rollover 

Futures rollover is a strategy used by traders to extend the expiration date of their futures contracts. This process involves closing a near-expiry futures contract and simultaneously opening a new contract with a later expiration date. Here’s a detailed explanation:

Why Rollover?

1. Maintaining Market Exposure: Traders use rollovers to maintain their market exposure without having to close their existing position. This is particularly useful if they believe the market will move favorably in the future.
2. Avoiding Settlement Costs: Futures contracts often require physical or cash settlement upon expiration. By rolling over, traders avoid these costs and obligations.
3. Cost of Carry: Rolling over can sometimes be more cost-effective than maintaining the same position in a new contract due to factors like interest rates and dividends.

How to Execute a Rollover

1. Evaluate Your Position: Assess your current futures position and determine if a rollover aligns with your trading strategy.
2. Timing: Choose the right time to execute the rollover, considering factors like market liquidity and the cost of carry.
3. Execute the Trade: Close the near-expiry contract and simultaneously open a new contract with a later expiration date. This can be done through your trading terminal.

Example

Imagine you hold a long position in a crude oil futures contract expiring in June. As the expiration date approaches, you decide to roll over your position to a July contract. You would sell the June contract and buy the July contract at the current market price.

Risks and Considerations

• Price Differences: There may be price differences between the expiring contract and the new contract, which can affect your overall position.
• Brokerage Fees and Taxes: Be aware of any additional costs associated with executing the rollover.
• Market Conditions: Ensure that market conditions are favourable for executing a rollover to avoid potential losses.