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Chapter 3 Future Contracts

Significance of Future Contract

This is an agreement made through an organized exchange to buy or sell a fixed amount of a commodity or a financial asset, on a future date, at an agreed price. The clearing house, associated with the exchange, guarantees settlement of these trades.

You can choose either to be a trader who buys futures contract and takes a long position, or a trader who sells futures and takes a short position. The words buy and sell are figurative only because no money or underlying asset changes hand, between buyer and seller, when the deal is signed.

Scope of Futures in the Indian Market

NSE and BSE are the two main exchanges that offer future trading. Contracts are available for different tenures (expiry). Typically, contracts are available for one, two or three months. You can choose any of the three contracts, provided there is liquidity of the same underlying.
Remember the Following

  • Last working Thursday is the date of expiry for the contracts of that particular month. If the last Thursday is a holiday, the expiry is advanced by one day, i.e. Wednesday.

  • Buyers and Sellers do not take or give delivery of the underlying.

  • Profit and Losses are settled in cash.

  • Since there is no delivery of underlying, you can trade in broad indices like NIFTY.

  • You may choose to open a trade in future by paying a small portion (%) of the contract value as Margin.

  • The contract size and margin percentages are set by exchanges. In cash trading, the settlement cycle is T+2 days; while in F &O, the trades are settled on T+1 day. If trade is opened with a buy, such position is called as Long and if a trade is opened with a sell, such position is called as Short.

Quotes Given on the NSE Website for Nifty Futures on Aug 28, 2017

Key Takeaways

Each futures contract has the following features-

Spot Price

This is the price at which an asset trades in the cash market. Underlying value of Nifty on Aug 28, 2017, was Rs. 9,913.4.

Equity Derivatives Watch

Futures Price

This is the price of the futures contract in the futures market. Nifty Future Price, on Aug 28 2017, was 9,919.15.

Equity Derivatives Watch

Expiration Day

This refers to the day on which a derivative contract ceases to exist. It is the last trading day of the contract. On expiry date, all the contracts are compulsorily settled.

Equity Derivatives Watch

Contract Cycle

It is a period over which a contract trades. Futures contracts have a maximum of three-month trading cycle - the near month (one), the next month (two) and the far month (three). New contracts are introduced on the trading day following the expiry of the near month contracts. The new contracts are introduced for three month duration. At any point in time, there will be three contracts available for trading in the market i.e., one near month, one mid month and one far month duration respectively.

Equity Derivatives Watch

Tick Size

It is the minimum move allowed in the price quotations. Exchanges decide the tick sizes on traded contracts as part of contract specification. Tick size for Nifty futures is 5 paisa.

Contract Size and Contract Value

Futures contracts are traded in lots. To arrive at the contract value, we have to multiply the price with contract multiplier/lot size/contract size.

Basis

The difference between the spot price and the futures price is called Basis. If the futures price is greater than spot price, basis for the asset is considered to be negative. Similarly, if the spot price is greater than futures price, basis for the asset is considered to be positive. Whatever the basis is—positive or negative—it turns to zero, at maturity of the futures contract. This means that there should not be any difference between futures price and spot price at the time of maturity/expiry of contract.

Equity Derivatives Watch

On Aug 28, 2017, Nifty Spot Price was 9,913.4 and Nifty Aug Future Price was 9,919.5. Therefore, current basis of Nifty is negative. But on Aug 31, 2017 i.e. expire day Nifty basis will be zero.

Cost of Carry

Cost of Carry is the relationship between futures prices and spot prices. It measures the storage cost (in commodity markets) plus the interest that is paid to finance or ‘carry’ the asset till delivery. It does not include the income earned on the asset during the holding period. For equity derivatives, cost of carry is the interest paid to finance the purchase, minus the dividend earned. It is important to note that cost of carry will be different for different participants.

Contract Specifications

Contract specifications include the salient features of a derivative contract like contract maturity and contract multiplier, also known as lot size, contract size, tick size, etc.

Price Band

Price Band is essentially the price range within which a contract is permitted to trade during a day. The band is calculated with regard to previous day’s closing price of a specific contract. For example, previous day’s closing price of a contract is Rs. 100 and price band for the contract is 10%, then the contract can trade between Rs. 90 and Rs. 110 for the next trading day.

Long Position

Outstanding/unsettled buy position in a contract is called “Long Position”. For instance, if Mr. X buys 5 contracts on Nifty futures, then he would be long 5 contracts. Similarly, if Mr. Y buys 4 contracts on Pepper futures, then he would be long 4 contracts.

Short Position

Outstanding/unsettled sell position in a contract is called “Short Position”. For instance, if Mr. X sells 5 contracts on Nifty futures, then he would be short 5 contracts on Nifty futures. Similarly if Mr. Y sells 4 contracts on Pepper futures, then he would be short 4 contracts on pepper.

Open Position

Outstanding/unsettled derivative contracts, either in long (buy) or short (sell) positions are called “Open Positions”. For instance, if Mr. X shorts 5 contracts on Infosys futures and longs 3 contracts on Reliance futures, he is said to be having open position, which is equal to short on 5 contracts on Infosys and long on 3 contracts of Reliance. Next day, if he buys 2 Infosys contracts of same maturity, his open position would be short on 3 Infosys contracts and long on 3 Reliance contracts.

Naked and Calendar Spread Positions

Naked position in futures market simply means a long or short position in any futures contract, without having any position in the underlying asset. Calendar spread position is a combination of two positions in futures on the same underlying, i.e. long on one maturity contract and short on a different maturity contract. For instance, a short position in near month contract coupled with a long position in far month contract is a calendar spread position. Calendar spread position is computed with respect to the near month series and becomes an open position once the near month contract expires or either of the offsetting positions is closed. A calendar spread is always defined with regard to the relevant months.

Opening a Position

Opening a position means either buying or selling a contract, which increases a client’s open position (long or short).

Closing a Position

A client is said to be closing a position if he sells a contract which he had bought before or he buys a contract which he had sold earlier.

Initial Margin

This is the margin amount that a trader needs to pay to the Exchange to open a trade. Buyers (long) and sellers (short) will be paying this margin. The margin percentage is specified by the Exchange and these percentages could change within the tenure of the contract, in case of high volatility.

Minimum Margin

Normally known as maintenance margin, it is the minimum margin that is blocked during the life of the contract.

Convergence of Spot and Future Price

The logic for difference between spot and future is the time value of money and one of the variables of time value is the number of days left in the contract. On the last day of the contract, there is no time value left. Hence, the price of future contract and cash market will be same. There could be many other market dynamics, which impact the prices during the last day/few days of expiry.

Benefits of trading in Index Futures compared to any other security

You can trade the ‘entire stock market’ by buying index futures instead of buying individual securities with the efficiency of a mutual fund. The advantages of trading in Index Futures are:

  • The contracts are highly liquid

  • Index Futures provide higher leverage than any other stocks

  • It requires low initial capital requirement

  • It has lower risk than buying and holding stocks

Pay-off for Buyer of Futures contract: Long Futures

Let us say that a person goes long in ABC stock futures contract at Rs. 100. This means that he has agreed to buy the underlying ABC stock at Rs. 100, on expiry. Now, if on expiry, the price of the underlying (ABC stock) is Rs. 150, then this person will buy at Rs. 100, as per the ABC stock futures contract and will immediately be able to sell the underlying in the cash market at Rs. 150, thereby making a profit of Rs. 50.

Similarly, if the price of the underlying (ABC stock) falls to Rs. 70 at expiry, he would have to buy at Rs. 100, as per the ABC stock futures contract. If he sells the same in the cash market, he would only receive Rs. 70, translating into a loss of Rs. 30. This potential profit/loss at expiry, when expressed graphically, is known as a pay off chart.

Short Futures Pay Off

As one person goes long, some other person has to go short, otherwise a deal will not take place. The profits and losses for the short futures position will be exactly opposite of the long futures position.

A short futures position makes profits when prices fall. If prices fall to 60 at expiry, the person who has shorted at Rs.100 will buy from the market at 60 on expiry and sell at 100, thereby making a profit of Rs. 40. This is shown in the given chart.

Pricing of Futures

The Cost of Carry Model is used for Future Pricing. It is defined as: F=S+C.

Herein, F=Future Price, S=Spot Price, and C=Holding Costs or Carry Costs

If F < S+C or F > S+C, arbitrage opportunities would exist, i.e. whenever the futures price moves away from the fair value, there would be chances for arbitrage.

If ABC stock is quoted at Rs. 1,000 per share and the three months futures of ABC stock is Rs.1070, then one can purchase ABC stock at Rs. 1000, in Spot, by borrowing @12% annum for three months and selling ABC stock futures for three months, at Rs. 1070. Here, F=1000+36 = 1036.

Drawbacks of Trading in Futures

Futures carry the potential for unlimited risks and, hence, unlimited losses. In futures, there is an obligation to honor the contract, irrespective of profit or loss.

Key Takeaways

  • Futures are standardized contracts which are traded on the exchange platform.

  • Through a futures contract we could either take a long position or a short position based on our view.

  • Margin- small portion of contract value you need to pay upfront.

  • F &O trades are settled on T+1 day.

  • Tick size for Nifty futures is 5 paisa.

  • The difference between the spot price and the futures price is called Basis

  • Outstanding/unsettled derivative contracts, either in long (buy) or short (sell) positions are called Open Positions.

  • Cost of Carry Model is used for Future Pricing. It is defined as: Future price = Spot price + Cost of carry.

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