Futures Trading in Share Market

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  • 02 Dec 2023

Futures trading is a fascinating and dynamic aspect of the financial world. It involves the buying and selling of contracts, known as futures contracts, that are based on an underlying asset. This form of trading has existed for centuries, providing participants with opportunities to hedge risk, speculate on price movements, and capitalize on market trends. Read on to learn the intricacies of futures trading, explore its key features, and how it operates within the financial markets.

To understand the concept of futures trading, you must have a solid understanding of derivatives trading. Derivatives are financial contracts that obtain their value from the price movements of other financial assets. Essentially, a derivative's price is linked to the cost of another underlying asset.

One specific type of derivative is the futures contract, which involves an agreement or contract between a buyer (holding the long position) and a seller (holding the short position). In this contract, the buyer commits to purchasing a derivative or an index for a predetermined price at a specified future date.

As time progresses, the price of the futures contract fluctuates in relation to the fixed price at which the trade was initially executed. These fluctuations in price result in either profits or losses for the trader. It is worth noting that the relevant stock exchanges closely monitor the trade and settlement of each futures contract.

The futures market attracts a diverse range of financial participants, including investors, speculators, and companies seeking to either physically accept or supply the commodity as per the terms of the futures contract. Hedgers utilize futures contracts to establish fixed buy or sell prices for the underlying commodity on a specific future date.

To better understand the mechanics of futures trading, let's take the example of a jar of beans. If the price of beans were to increase, a large food processor reliant on beans for their business would have to pay more to the farmer or dealer. To protect against this sudden price rise, the processor may choose to "hedge" their risk by purchasing bean futures contracts to offset the potential price fluctuations. Such a strategy would prove advantageous for the buyer of the futures contract if the price of beans were to rise.

Similarly, individuals can hedge against stock price changes in the stock market through stock futures. You can acquire these contracts for individual stocks or broader market indexes. Notably, the buyer of a futures contract does not need to pay the full contract value upfront but instead only requires to provide an initial margin payment.

In the world of futures trading, two distinct types of traders exist: hedgers and speculators. Each group has different objectives and approaches to the market.

  • Hedgers:

Hedgers are investors who utilize derivative instruments to protect their capital from potential losses. They enter into futures contracts to hedge against adverse price movements in the underlying asset.

For example, a wheat farmer may use futures contracts to secure a favorable price for their crop, thereby safeguarding themselves against potential price decreases. By hedging, they aim to minimize their exposure to price volatility and maintain stability in their financial positions.

  • Speculators:

On the other hand, speculators participate in futures trading to generate profits from price fluctuations in derivative contracts. They take positions in futures and options contracts based on their assessment of market conditions and the demand-supply dynamics of the underlying asset.

Speculators analyze various factors such as economic indicators, market trends, and news events to anticipate price movements and make speculative trades accordingly. Their profit potential lies in accurately predicting the direction of price changes and timing their buying and selling activities effectively.

To engage in futures trading, the first step is to establish a trading account with a broker registered with SEBI. This account is essential as it enables participation in the F&O market and allows for trading futures contracts. While not mandatory for trading futures, it is advisable to open a Demat account as well, considering that futures are often intended for delivery, and most brokers will recommend its activation alongside your trading account.

Once the necessary procedures for opening the account, including signing the trading agreement and completing the KYC process, are completed, your trading account will be activated. Once done, you will be ready to trade futures. It is also vital to ensure the activation of online trading, which empowers you to have complete control over your orders throughout the trading process.

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In Conclusion

Futures trading offers a unique avenue for market participants to manage risks, speculate on price movements, and capitalize on market trends. With its standardized contracts, leverage, and active markets, futures trading has become integral to the global financial system. However, it is important to approach futures trading with caution, as it involves significant risks. Educating oneself about the intricacies of futures markets, developing effective risk management can help you get the most out of futures trading.

FAQs on What is Futures Trading?

Futures trading is a type of contract between a buyer and a seller made for the future with an expiration date.

Futures contracts are legally binding agreements between two parties where they buy or sell an asset at a pre-agreed price in the future date. These contracts are standardized in terms of quality, quantity, delivery date, and location.

Futures trading serves multiple purposes. It allows participants to hedge against price risks associated with the underlying asset, speculate on price movements to generate profits, and provide liquidity to the market potentially.

Leverage in futures trading allows traders to control a larger position with a fraction of the contract's total value. It enables traders to amplify potential profits but also magnifies potential losses. Exchanges set margin requirements to regulate leverage usage.

Yes, futures trading allows you to trade contracts without owning the underlying asset. This is known as speculating or taking a position based on price movements rather than physical ownership.

Risk management is crucial in futures trading. Traders can implement various strategies such as setting stop-loss orders to limit losses, diversifying their portfolios, using hedging techniques to offset risks, and staying informed about market trends and news.

Futures trading may be profitable depending on several factors. These include market conditions, trading strategy and risk management. You must choose a suitable strategy based on your risk tolerance. It is also essential to use tools like stop-loss to mitigate risks.

For safe trading, you should diversify your portfolio across several assets. Always follow a long-term strategy. In addition, employ risk management techniques like stop-loss orders and dynamic position sizing.

Futures may or may not be better than stocks. It depends on your investment objectives and risk tolerance. However, futures are usually considered more risky than stocks. So, an individual's trading skills and experience determine whether futures are better than stocks.

In India, Section 43(5) of the Income Tax Act states that futures trading are non-speculative transactions. The profits earned from futures trading are considered as business income. So, they are taxed according to the income tax slab applicable to an individual.

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