Forward contracts are the oldest type of derivative instrument that have been in existence since ages. However, as stated in the previous chapter, these instruments had their own set of problems. In order to address these problems, futures contract came into existence. Futures is said to have originated in the early 18th century when rice futures was traded in Japan. However, it was not until 1960s that standardized futures contracts first began trading on the CBoT. But what exactly is a futures contract?
Well, a futures contract is similar to a forward contract. Just like a forward contract, a futures contract is an agreement between two parties to buy or sell an underlying asset at a specified time in the future for a pre-determined price. The buyer of a futures contract assumes a long position on the underlying and is obliged to buy the asset at a specified time in the future for a pre-determined price. Similarly, a seller of a futures contract assumes a short position on the underlying and is obliged to sell the asset at a specified time in the future for a pre-determined price.
However, there is one noticeable difference between the two. A futures contract is traded on an exchange. Because of this, a futures contract is standardized (fixed) in terms of several aspects such as the size of the contract, quantity, quality (if applicable), settlement date, settlement price, place of settlement, margin requirements etc. Also, in case of futures contract, the exchange assumes the counterparty risk and ensures that none of the parties to the contract default on their commitment. In order to achieve this objective, the exchange levies periodic margins on futures contracts. These contracts are marked-to-market daily rather than at the end of the contract period, which is a norm in case of forward contracts. As such, profits and losses on futures get adjusted each trading session until the time the contract is held onto or expires, rather than adjusting the same at the end of the contract period.
Before presenting an example of futures contract, let us first understand a few key terminologies relating to futures. These are as mentioned below:
As we saw above, a futures contract is an agreement to buy or sell an underlying asset in the future for a pre-determined price and on a pre-determined date. The underlying asset could be stock, stock index, commodity, currency pair, bond, interest rate, etc. What is important to keep in mind is that a futures contract is based on futures price, which is calculated from the spot price of the underlying instrument. At any point in time, futures price of an underlying instrument could be trading above, at, or below the corresponding spot price. Over time, as futures contracts approach their expiration date, the gap between the futures price and the spot price keeps reducing, before eventually converging at expiration. We shall talk more about this later in the module.
Earlier, we talked about certain standardized aspects of a futures contract. One of them was size of the contract, also known as the lot size. The lot size refers to the number of units that form a part of 1 futures contract. For instance, the lot size of Reliance Industries futures contract on the NSE is 505, meaning that 1 Reliance Industries futures contract comprises of 505 shares of Reliance. Similarly, the lot size of Niftyfutures contract is 75, meaning that 1 lot of Niftyfutures contract is equivalent to 75 shares of Nifty. The lot size of a futures contract is determined by the exchange and varies from securities to securities, and from asset class to asset class.
Total contract value, as the name suggests, is the total value of the futures contract. It is calculated as the lot size multipliedby the current price of the corresponding futures contract. For instance, continuing with the above example, if the current price of Reliance futures is ₹1,500, then the total contract value for 1 lot of Reliance futures is ₹7,57,500 (505lot size * ₹1,500 current market price). Similarly, if the current price ofNiftyfutures is 10,000, then the total contract value of 1 lot of Nifty futures is ₹7,50,000 (75lot size * 10,000 current market price). Keep in mind that to calculate the total contract value, the lot size must be multiplied by the futures price of the underlying and not the spot price.
To minimize the risk of defaults, exchanges levy margins on futures contracts. This means in order to take a position in futures, the buyer/seller must have a certain amount of money in his/her trading account beforehand. Let us take an example. Let us say that a trader wants to buy 1 lot of Reliance futures. Earlier, we saw that at the prevailing futures price of ₹1,500, the total contract value for 1 lot of Reliance futures was ₹7,57,500. Let us assume that the margin needed to trade Reliance futures is 25% of the total contract value. This means the buyer would need at least ₹1,89,375 in his/her trading account for creating a long position in Reliance futures. Once the position has been established, this ₹1,89,375 would be blocked and would remain so as long as the trader has not closed out his/her long position.Because profits/losses in futures are adjusted at the end of each trading session, the trader must maintain sufficient funds in his/her trading account to account for any adverse move in the price of the underlying. In case of a favourable price movement, money is credited into the trader’s account at the end of each session; while in case of an unfavourable price move, money is debited from the trader’s account.Meanwhile, once the margin in the trader’s account reaches a certain lower threshold, he/she will get a margin call from his/her broker to top up the account.
Keep in mind that, in this chapter, we will present an overly simplified example of margin. This is because our objective in this chapter is to just introduce the concept of margin in the futures segment. We will talk about margin in a much greater detail later in the module. In fact, given the importance of margin in futures trading, we will be dedicating one whole chapter for understanding its various aspects including the detailed calculation part. For now, just keep in mind that a futures contract is subject to two types of margins, one that is levied at the time of contract initiation and the other that is adjusted at the end of each session until the position is held onto.
Now that we understand the basic dynamics of futures, let us present one simple example to understand how the payoff calculation for a futures position differs from that of a forward position.
Let us assume a few things as follows:
Spot price of the underlying at the time of contract initiation = ₹100
Quantity of the underlying to transact = 5,000 units
Date of entering into the contract = 20th January
Date of contract maturity = 30th January
Buyer = ABC
Seller = XYZ
What would happen if the underlying price at the time of contract maturity is ₹120?
Keep in mind that that in case of forwards, there is usually no exchange of money on the day the contract is entered into. Instead, the money/asset changes hands only on the day the contract matures. So, the entire payoff occurs on the day of maturity.
On January 30th, ABC will make a payment of ₹5 lacs (agreed upon price of ₹100 * quantity of 5,000) to XYX who in turn will deliver 5,000 units of the underlying to ABC. Given that the prevailing price of the underlying on January 30th is ₹120, ABC will make a gain of ₹20 per unit for a total gain of ₹1 lac. This is because the underlying would be delivered to him at the agreed upon forward price of ₹100 instead of the prevailing market price of ₹120. On the other hand, XYZ will incur a loss of ₹20 per unit for a total loss of ₹1 lac as he would be selling the underlying ₹20 below the prevailing market price.
Let us use the same data as above, but with a few additional assumptions. Let us say that ABC wants to buy a stock futures, the details of which are as mentioned below:
Spot price of the underlying on 20th January = ₹100
Futures price of the underlying = ₹101
Lot size = 5,000 shares
Contract expiration: 30th January
Margin = 25%
Total contract value = ₹5,05,000 (₹101 * 5,000)
Funds in ABC’s trading account at the time of initiation = ₹3,00,000
Given a margin of 25%, ABC will need at least ₹1,26,250 (₹5,05,000 * 25%) in his trading account to buy the futures contract. As he comfortably has much more funds than this, he will able to create a long overnight position. Given that futures are subject to daily profit/loss adjustment, the calculation for futures will differ quite a bit. This is as shown in the below table:
|Date||Daily Settlement Price||Price Change||Profit/Loss||Margin|
|20-Jan||101 (Price at Initiation)||-||-||₹1,26,250|
Below mentioned are the calculations to note in the above table:
Price change for a session is calculated as current session’s price less prior session’s price
Profit/loss for a session is calculated as current session price change multiplied by lot size
Current session margin is calculated as prior session margin + current session profit/loss
Note above that ABC initiated the trade on Jan 20th at ₹101 and exited it on Jan 30th at ₹120. This means he has made a gain of ₹19, which in value terms turns out to be ₹95,000 (₹19 * 5,000). If you notice, this is the same figure that we arrived at in the table above. But note the way the payoff of a futures contract is calculated each day. Again, the objective of charging a margin at the start and then marking-to-market each session is to ensure that parties to the trade do not default on honouring the contract.
We will talk about margin and its calculation in much greater detail later in the module.
Now that we understand forwards and futures, let us conclude by highlighting the key differences between them:
|Privately traded between two parties||Publicly traded on exchanges|
|Customizable contracts||Standardized contracts|
|Counterparty risk exists||Counterparty risk does not exist|
|Traded throughout the day||Traded when exchanges are open|
|Less regulated||Highly regulated|
|Settlement at the end of the contract||Settlement takes place daily|
|Limited access to retail market participants||Easily accessible to retail market participants|
|Difficult to close contract before maturity||Contract can be closed any time after initiation|
There are three participants in the futures market. These are hedgers, speculators, and arbitrageurs. Each of them participates in the futures market for different goals and reasons. We will briefly talk about them in this chapter. Keep in mind that we will be talking about hedging, speculation, and arbitrage in greater detail later in this module.
Hedgers have an exposure in the underlying asset. To protect against any unfavourable move in its price, they participate in the futures market wherein they take an opposite position to lock in the price of the asset and thereby reduce price risk as much as possible. A hedger could be anyone who has an underlying exposure to the asset and wants to hedge it. A few examples include:
A retail equity investor who may want to hedge his/her underlying position in a particular stock ahead of the release of the earnings report of that company
Large oil producing companies who may want to hedge their future oil production
A multinational company who may want to hedge against currency risks
Banks who may want to hedge against changes in interest rates, etc…
While hedgers participate in the futures market to hedge their price risk, speculators do so with the primary objective of making a profit. By assuming the risk of market price fluctuation, speculators provide liquidity to the markets. Unlike a hedger who has an underlying exposure in the underlying instrument, a speculator does not have exposure in the underlying. Instead, a speculator just has a view on the underlying and trades according to that view to make money. Depending on their objectives, the time frame for which they are into the market could vary from as little as a few seconds to as long as a few weeks. As speculators usually do not have an intention to take delivery of the underlying asset, they tend to close out their open positions before expiration of the futures contracts or in some cases rollover their positions to subsequent futures contracts.
The third type of participant in the futures markets are arbitrageurs. The objective of an arbitrageur is to earn a risk-free profit from price inefficiencies that exist between the same underlying but in two different markets, or between the cash price andthe futures price of a particular underlying instrument, etc. Let us talk about the latter strategy, which is also known as Cash and Carry Arbitrage (the opposite of which is the Reverse Cash and Carry Arbitrage). Under the Cash and Carry Arbitrage strategy, an arbitrageur buys the underlying in the cash market and simultaneously creates a short position in the same underlying and in the same quantity in the futures market. The objective is to earn a risk-free profit between the cash-futures price differential, which tends to converge at the time of the expiration of the futures contract. That said, for such strategies to be profitable, it is pivotal that the revenues from deploying them offset the transaction and other related costs.
With the advancement in technology and increased participation, arbitrage opportunities that are available today are extremely limited. Any price discrepancy that occurs between identical assets/markets are quickly eliminated within seconds by computer-driven algos that are pre-programmed by large institutions and professional traders to precisely take advantage of such opportunities. As such, as and when such anomalies appear, they are quickly eliminated before they even come to the notice of retail and individual traders.
Let us conclude this chapter by taking about instruments that are available for trading futures in India. These include:
Equity index futures
Interest rate futures
In India, equity-related futures (stock futures, equity index futures, and volatility futures) are pre-dominantly traded on the NSE, currency futures are traded on the NSE and BSE, commodity futures are pre-dominantly traded on the MCX and NCDEX, while interest rate futures are traded on the NSE.
Speaking of stock futures, there are nearly 150 stocks that are actively traded on the NSE every day (as of 12th June 2020, there are precisely 142 stock futures that are traded on the NSE). Besides, there are 3 equity index futures that are traded on the NSE (Nifty 50, Bank Nifty, and Nifty IT). Furthermore, VIX (which stands for Volatility Index) futures is also traded on the NSE, although this is less illiquid.
In this Module, we will not be speaking much about Commodity and Currency futures as we have already talked about them in their respective modules. Instead, we will focus mostly on Stock futures and Equity index futures for most of our discussions from next chapter onwards.
Elements of a Futures Contract7 Lessons
In the previous chapter, we talked about some of the key aspects of a futures contract. These included the underlying instrument, lot size, total contract value, and margin. In this chapter, we shall continue with our discussion from the previous chapter and talk about other vital aspects of a futures contract.
Pricing of Futures Contract7 Lessons
In this chapter, we will talk about the pricing of futures contracts. Although it is not an absolute must for a trader to know how the pricing is done, we still advise reading this chapter because knowing how the futures price is calculated would be helpful when deploying advanced strategies using futures, when hedging, understanding whether the futures contract is underpriced or overpriced etc
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