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Chapter 2.2: What are Futures Contracts?
In the previous section, we learned about the derivatives market. Now, let’s go a little deeper and understand the futures contracts.
What are futures contracts:
A futures contract is an agreement between two parties – a buyer and a seller – wherein the former agrees to purchase from the latter, a fixed number of shares or an index at a specific time in the future for a pre-determined price. These details are agreed upon when the transaction takes place. As futures contracts are standardized in terms of expiry dates and contract sizes, they can be freely traded on exchanges. A buyer may not know the identity of the seller and vice versa. Further, every contract is guaranteed and honored by the stock exchange, or more precisely, the clearing house or the clearing corporation of the stock exchange, which is an agency designated to settle trades of investors on the stock exchanges.
Futures contracts are available on different kinds of assets – stocks, indices, commodities, currency pairs and so on. Here we will look at the two most common futures contracts – stock futures and index futures.
What are stock futures:
Stock futures are derivative contracts that give you the power to buy or sell a set of stocks at a fixed price by a certain date. Once you buy the contract, you are obligated to uphold the terms of the agreement.
Here are some more characteristics of futures contracts:
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Lot/Contract 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.*
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Expiry: All three maturities are traded simultaneously on the exchange and expire on the last Thursday of their respective contract months. If the last Thursday of the month is a holiday, they expire on the previous business day. In this system, as near-month contracts expire, the middle-month (2 month) contracts become near-month (1 month) contracts and the far-month (3 month) contracts become middle-month contracts.
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Duration: Contract is an agreement for a transaction in the future. How far in the future is decided by the contract duration. Futures contracts are available in durations of 1 month, 2 months and 3 months. 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
The month in which it expires is called the contract month. New contracts are issued on the day after expiry. -
Example: If you want to purchase a single July futures contract of ABC Ltd., you would have to do so at the price at which the July futures contracts are currently available in the derivatives market. Let's say that ABC Ltd July futures are trading at Rs 1,000 per share. This means, you are agreeing to buy/sell at a fixed price of Rs 1,000 per share on the last Thursday in July. However, it is not necessary that the price of the stock in the cash market on Thursday has to be Rs 1,000. It could be Rs 992 or Rs 1,005 or anything else, depending on the prevailing market conditions. This difference in prices can be taken advantage of to make profits.
What are index futures:
A stock index is used to measure changes in the prices of a group stocks over a period of time. It is constructed by selecting stocks of similar companies in terms of an industry or size. Some indices represent a certain segment or the overall market, thus helping track price movements. For instance, the BSE Sensex is comprised of 30 liquid and fundamentally strong companies. Since these stocks are market leaders, any change in the fundamentals of the economy or industries will be reflected in this index through movements in the prices of these stocks on the BSE. Similarly, there are other popular indices like the CNX Nifty 50, S&P 500, etc, which represent price movements on different exchanges or in different segments.
Futures contracts are also available on these indices. This helps traders make money on the performance of the index.
Here are some features of index futures:
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Contract size: Just like stock futures, these contracts are also dealt in lots. But how is that possible when the index is simply a non-physical number. No, you do not purchase futures of the stocks belonging to the index. Instead, stock indices points – the value of the index – are converted into rupees.
For example, suppose the CNX Nifty value was 6500 points. The exchange stipulates that each point is equivalent to Rs 1 , then you have to pay 100 times the index value – Rs 6,50,000 i.e. 1x6500x100. This also means each contract has a lot size of 100.
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Expiry: Since indices are abstract market concepts, the transaction cannot be settled by actually buying or selling the underlying asset. Physical settlement is only possible in case of stock futures. Hence, an open position in index futures can be settled by conducting an opposing transaction on or before the day of expiry.
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Duration: As in the case of stock futures, index futures too have three contract series open for trading at any point in time – the near-month (1 month), middle-month (2 months) and far-month (3 months) index futures contracts.
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Illustration of an index futures contract: If the index stands at 3550 points in the cash market today and you decide to purchase one Nifty 50 July future, you would have to purchase it at the price prevailing in the futures market.
This price of one July futures contract could be anywhere above, below or at Rs 3.55 lakh (i.e., 3550*100), depending on the prevailing market conditions. Investors and traders try to profit from the opportunity arising from this difference in prices
What are the advantages and risks of futures contracts:
The existence and the utility of a futures market benefits a lot of market participants:
- It allows hedgers to shift risks to speculators.
- It gives traders an efficient idea of what the futures price of a stock or value of an index is likely to be.
- Based on the current future price, it helps in determining the future demand and supply of the shares.
- Since it is based on margin trading, it allows small speculators to participate and trade in the futures market by paying a small margin instead of the entire value of physical holdings.
However, you must be aware of the risks involved too. The main risk stems from the temptation to speculate excessively due to a high leverage factor, which could amplify losses in the same way as it multiplies profits. Further, as derivative products are slightly more complicated than stocks or tracking an index, lack of knowledge among market participants could lead to losses.
What are index futures:
Now that we have read and understood the basics of futures contracts, let us move on to how they are priced. Click here
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