Futures trading in India is very popular with traders and anybody who thinks they can make easy and quick money. In this article, we will focus on futures trading meaningand future trading basics and then move to easy steps for futures trading and finally frequently asked questions about futures trading in India.
Futures Contract Definition
Equity futures contract is an agreement between two parties – a buyer and a seller – where the buyer agrees to purchase from the seller, a fixed number of shares or an index at a specific time in the future for a pre-determined price. Both parties entering into such an agreement are obligated to complete the contract at the end of the contract period. Participants remain anonymous to each other. Indian equity derivative exchanges settle contracts on a cash basis. Each Futures Contract is traded on a Futures Exchange that acts as an intermediary to minimize the risk of default by either party. To enter into a futures agreement one has to deposit a margin amount, which is the certain % of the contract value.
Characteristics of Futures Contract
Futures Contract mimics the underlying
In Futures Contract, the agreement is based on the future price of the asset. The futures price mimics the asset, which is also called the underlying. Therefore if the price of the underlying goes up, the price of the futures contract would also go up. Likewise if the price of the underlying goes does, the price of the futures contract also goes down.
Futures Contracts are tradable
At any point of time within a futures contract, a can trader can go in and out of the trade. You need not required to hold your position till the expiry.
Future Contracts have an expiry date
All Futures contracts are time bound. The time frame upto which the contract lasts is called 'The expiry'of the contract. Futures contracts are usually available for 1 month, 2 month, 3 month time frame. These are called near month, middle month and far month respectively. Once the contracts expire, another contract is introduced for each of the three durations. This way, at any point in time, there will be 3 contracts available for trading in the market.Contract seize to exist beyond expiry date it means if you do not sell the contract by expiry date, the contract get expired and profit / loss is shared with you. Each contract expires on the last Thursday of the expiry month. If the last Thursday is a trading holiday, then the expiry day is the previous trading day.
Predetermined lot size
In the derivatives market, contracts cannot be traded for a single share. Instead, every stock futures contract consists of a fixed lot of the underlying share. The size of this lot is determined by the exchange on which it is traded on. It differs from stock to stock. For instance, a Reliance Industries Ltd. (RIL) futures contract has a lot of 250 RIL shares, i.e., when you buy one futures contract of RIL, you are actually trading 250 shares of RIL. Similarly, the lot size for Infosys is 125 shares.
No Demat Account required
Mostly all futures contracts are cash settled. There is no actual delivery of stocks so there is no demat account needed. Only cash differential is paid out. No exchange of shares or money is involved. Only Mark to Market (MTM) cash flow is calculated from the closing price of the underlying asset every day and the profit/loss is credit/ debit in your account.
Futures contracts are available on different kinds of assets
In Indian derivative market, Futures Contracts are available in stocks, indices, commodities, currency pairs and so on. The two most common futures contracts are stock futures and index futures.
Futures Contracts are Zero Sum Game
The profits made by the buyer is equivalent to the loss made by the seller and vice versa. Futures Instrument allows one to transfer money from one pocket to another, hence it is called Zero Sum Game.
Futures Trading Advantages
- In Futures contract, all parameters are standardized and predetermined. They cannot be change and are not negotiable.
- Futures contracts are guaranteed and honored by the stock exchange and regulated by SEBI. Thus, there is no chance of defaults in futures contracts.
- Unlike equity trading where all the stocks lie in the demat form in your account, there is no worry of moving the physical asset from one place to another.
- Unlike stocks, derivatives have an expiry.
- Profit or losses are calculated every day until trader sells the contract or it expires.
- Since it is based on margin trading, it gives opportunity to trade more with little cash and thus allows small speculators to participate and trade in the futures market by paying a small margin instead of the entire value of physical holdings.
Step by step Futures Trading
As we know the futures price fluctuates on a daily basis, by virtue of which we either make a profit or a loss. Adjusting this profit or loss in your account on daily basis is known as Mark to Market or M2M in short. M2M is calculated every day until trader sells the contract or it expires. The profits or losses are calculated based on the difference between the previous day and the current day's settlement price.
The transfer of such differences is monitored by the Exchange which uses the margin money from either party to ensure appropriate daily profit or loss. If the minimum maintenance margin or the lowest amount required is insufficient, then a margin call is made and the concerned party must immediately replenish the shortfall.
So, the Mark to market is a daily accounting adjustment where-
- Money is either credited or debited to your account based on how the futures price behaves.
- The previous day close price is taken into consideration to calculate the present day M2M.
Assume on 9th Aug at around 10:30 AM, you decide to buy Bank of Baroda Futures at Rs 157. The Lot size is 3500. 4 days later on 12th Aug 2016 you decide to square off the position at 2:25 PM at Rs 165. Clearly as the calculation below shows, this is a profitable trade –
Buy Price = Rs 157
Sell Price = Rs 165
Profit per share = (165 – 157) = Rs 8
Total Profit = 3500 * 8= Rs 28,000
However, the trade was held for 4 working days. Each day the futures contract is held, the profits or loss is marked to market. While marking to market, the previous day closing price is taken as the reference rate to calculate the profit or losses.
The table below shows the futures price movement over the 4 days the contract was held
|
Day |
Closing Price |
|
9th |
160 |
|
10th |
171 |
|
11th |
170 |
|
12th |
165 |
Now let's see on day to day basis in order to understand how M2M works:
On Day 1, the futures contract was purchased at Rs 157, clearly after the contract was purchased the price has gone up further to close at Rs 160. Hence profit for the day is 160-157 = Rs 3 per share. Since the lot size is 3500, the net profit for the day is 3*3500 = Rs 10500. The amount is credited to our account. Obviously it is coming from the counterparty which means the exchange is also ensuring that the counterparty is paying up Rs 10500 towards his loss. The futures buy price will be Rs 160 (closing price of the day) and not Rs 157.
On day 2, the futures closed at Rs 171, clearly another day of profit. The profit earned for the day would be Rs 171-Rs 160 i.e. Rs 11 per share or Rs 38,500 net profit. The profits that you are entitled to receive is credited to your trading account and the buy price is reset to the day's closing price i.e. Rs 171.
On day 3, the futures closed at Rs 170 which means with respect to the previous day's close price there is a loss to the extent of (171-170 Rs) =1 or Rs 3500. The loss amount will be automatically debited from your trading account. Also, the buy price is now reset to Rs 170.
On day 4, the trader did not continue to hold the position through the day, but rather decided to square off the position mid-day 2:45 PM at Rs.165. Hence with respect to the previous day's closing price, again made a loss. That would be a loss of Rs.170-165 = Rs 5 per share and (5 * 3500) = Rs 17500 net loss. Needless to say after the square off, it does not matter where the futures price goes as the trader has squared off his position. Also, Rs 17500 is debited from the trading account by end of the day.
Now, let us just tabulate the value of the daily mark to market and see how much money has come in and how much money has gone out :
|
Day |
Ref Price for M2M |
Closing Price |
Daily M2M |
|
1st Dec 2014 |
157 |
160 |
+ Rs 10,500 |
|
2nd Dec 2014 |
160 |
171 |
+Rs 38,500 |
|
3rd Dec 2014 |
171 |
170 |
-Rs 35,00 |
|
4th Dec 2014 |
170 & 165 |
165 |
- Rs 17,500 |
|
Total |
+Rs 28,000 |
Now if we sum up all the daily accounts, we will come up to Rs 28,000 which is initially calculated.
Note: Though the profit/loss are credited/debited on daily basis in traders account, the brokerages / fees / taxes are only charged at the time of buying and selling future contract.
What is an Underlying?
A derivative is a financial instrument which derive it value from price of the asset. The asset is called underlying. In case of Nifty future, Nifty Index is the underlying.
What is a Lot Size?
It is standardized and predetermined number of shares or its multiple that need to be bought for Future trading. Different stocks have different no of lot size.
What is contract value?
The lot size multiply by futures price gives the Contract Value.
What is Margin and and how is it calculated?
Margin is the certain percentage of the contract value that needs to be deposited by the trader while entering the future trade. The money has to be blocked in your Trading Account with the broker. The margin amount usually varies between 5 to 15% and usually decided by the exchange. This margin in your trading account is called Initial Margin.
It is made up of two parts: SPAN Margin and Exposure Margin.
Let's assume,the opportunity to buy Reliance on 4th Aug at Rs 1016 per share for expiry on 25th Aug 2016. Further we will assume the opportunity to square off this position occurs on 7th Aug 2016 at Rs 1046. The lot size is fixed at 500 shares. So in order to buy one lot of Reliance future, first we have to calculate the contract value
Contract Value = lot size* future Price
= 500* 1016 = 508000
The margin required to enter the trade is 12% of contract value, then the margin amount will be
Margin = 12 % * 508000= 60,960 Rs
Why Margin changes every day?
Now, as we know margin is % of contract value,
Contract Value = Future Price * Lot Size
Lot Size is fixed but future Price varies every day, so margin also varies every day.
Why to invest in Future Market?
Futures give you a lot of leverage and you can make (or loose) a large amount of money in a short period of time with the same amount of capital than you can with a regular cash position. Thanks to the existence of ‘Margins’ you require a much lesser amount to enter into a relatively large transaction. If your directional view is right, your profits can be really large.
What is leverage?
By virtue of margins, we can take positions much bigger than the capital available; this is called Leverage. Leverage is a double edged sword. If used in the right spirit and knowledge, leverage can create wealth, if not it can destroy wealth. The higher the leverage, higher is the risk, and the higher is the profit potential. The formula to calculate leverage is:
Leverage = contract value / margin
When leverage is high, only a small move in the underlying is required to wipe out the margin deposit.
How to calculate leverage?
In the above example of Reliance Future,
Leverage = Contract Value / Margin
= 508000 / 60960
= 8.33 or 8.33 times or simply as a ratio 1: 8.33
This means every Rs 1 in the trading account can buy upto Rs 8.33 worth of Reliance.
Note: As leverage increases, the risk also increases. It takes a slight variation in the price of underlying to make profit or loss.
It can be understood as follows :
1/8.33= 12%
It means Reliance has to go up or fall by 12% to lose all the margin money but if the leverage is high then only a small move in the underlying is required to wipe out the margin deposit.
What is Future Payoff?
Future Payoff is the amount of money we stand to make or lose based on the movement in the underlying.
What is Expiry?
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.
What is the Index?
Index is a composition of many stocks from different sectors which collectively represents the state of the economy. Index trading is only possible through the derivative markets.
Which are the popular indices in India?
There are two main market indices in India. The S&P BSE Sensex representing the Bombay stock exchange and CNX Nifty representing the National Stock exchange. The ‘Nifty Futures’ is the most widely traded futures instrument, thus making it the most liquid contract in the Indian derivative markets.
Is Margin fixed for all the stocks in India?
No, it varies from stock to stock depending on the risk involved in the stocks. It depends upon the liquidity and volatility of the respective stock.
Normally index futures have less margin requirement than the stock futures due to comparatively less volatile in nature.
How long should I hold on to a position in Futures Contract?
It depends on your personal preference, perspective and view point upon your holdings. You can take a short term trading view (a day, few hours or even minutes), medium term (few days or few weeks) or long term trading approach.
What is basis?
The difference between the spot price and the future price is called basis. Suppose Nifty Future trades at 5050 and spot Nifty is at 5000, then the basis is said to be -50 points or - 1%.
Why all the stocks are not available for trading in Futures?
Not all the stocks available in capital market are traded in Derivative market. Stock exchange decides which company's F&O contracts can be traded at the exchange. Only the stocks, that meet the criteria on liquidity and volume, are considered for futures trading.
Why my buy price changes every day in Future Contract?
The profit or loss earned for the day is already credited/debited in your account on daily basis through Mark to Market accounting procedure. Since you are fair and square for the day, and the next day is considered as a fresh start. Hence the buy price is now considered as the closing price of the previous day.
