What is Futures Trading? Who, Where, How to Trade in Future Contracts with examples

Futures Trading Definition:

Unlike stock market traders, futures traders get the benefit to trade using only part of the capital which is entitled as “risk capital”. While futures trading can be used to effectively hedge other investment positions, they can also be used for speculation. Doing so carries the potential for large rewards due to leverage (which will be discussed in greater detail later) but also carries commensurately outsized risks. Before beginning to trade futures, you should not only prepare as much as possible, but also make absolutely certain that you are able and willing to accept any financial losses you might incur. Olden days when farmer growing cotton, wheat, etc come to sell his product turn out to be dealer as well. Contracts are drawn up between the dealer and buyer agreeing to deliver specific product at specific amount at specific date. For example: 1 tonne of cotton to be delivered after two month at Rs.50,000/-  From here futures trading started. Now a day’s system has been made legalised in order to assure both the parties at a specified date. Apart from future commodities trading now we have other financial instruments also been traded in similar fashion.

Who Trades Futures?

Mostly across the world Futures traders are classified into types hedge fund trader or speculator fund trader.

Hedging Trading:

A hedger is a creator or maker of the commodities (For example: Company or a Farmer) who comes into futures contract to keep safeguarded himself from unforeseen future price. For example: If the farmer believe that price of cotton is going to rise yield time then he can buy a future contract and by the time if cotton price rises then he can sell at higher price and can make profit from the future trade.

Other hedge fund traders include Banks, Insurance, Finance companies, who use futures to hedge against fluctuations in the cash price of their products at future dates.

Speculation Trading:

Speculators are the private investors who are neither creator nor maker of the commodities. They simply try to make a profit by trading futures contract that is buying future contract when they expect price to rise and selling when expect price to fall. In other words, they invest in futures merely to make profits by buying at low and selling at a higher price.

What are Futures Contracts?

Futures are termed as contracts mainly because like any other contracts, Future contract has expire date. You have option to hold until expiration or can cancel it at anytime you like. The different commodities have different expiration dates, and can choose according to your objective. There is no limit to the number of contracts to be traded by an individual or an investor. One can trade thousand lakhs contracts at any given time.

For example: Assume you Buy future contract for underlying NIFTY for expiry date 28JAN2016 at the price of Rs.7900 believing that you will make profit on the rise. By the end of January price of NIFTY 28JAN2016 Future Contract reach to Rs.8000 which means upon expiration you have made a profit of Rs.100 per contract. Now if you believe price of the NIFTY will rise till March 2016 then you can opt to buy again a new contract NIFTY which expires on 24MAR2016. This way you can be in the market with the intension of making profit on further rise.

Where to Trade Futures?

Those future contracts whose underlying is stocks are traded in National Stock Exchange (NSE), Bombay Stock Exchange (BSE) and those whose underlying is commodity are traded in Multi-Commodity Exchange (MCX) in India. For trading in future contracts you do not require to hold demat account only trading account is enough for futures trading contracts.

How Futures Trading works?

Let us take futures trading demo to understand operations of future trading:

Contracts are highly leveraged investments. Either to buy or sell futures contract an investor rather than paying actual amount they only has to invest fraction of the contract amount mostly 10% as a margin amount or leverage amount and profits are multiplied on the actual amount. Minimum margin is required to hold the future contract as a form of security. With leverage it gives benefit to traders to buy or sell around ten-times as much although losses can be minimised with Stop-Loss orders. This makes future contracts an outstanding investment return instrument when compared with buying gold, silver, cotton or wheat in physical.

For example: Assume you wish to buy 1 lot of NIFTY Future contract for expiry 28JAN2016 at Rs.7900/- with then intension of rise in price. 1 lot consist of 50 contracts (or 50 shares) bind together to form a single lot of Nifty future contract. At the expiry you sell the contract at Rs.8200/-. Let us calculate the leverage margin, actual amount and returns on the investment.

Results are really outstanding, By merely investing Rs.39,500/- as a margin amount you make a profit of Rs.15000/-  which is 33.71 percent. Whereas same thing if you invest in stock then you’re investing capital would be Rs.3,95,000/- and profit would be Rs.15000/- which is 3.37 percent (Profit * 1000 / Actual Investment). When comparing, difference in investment return percentage makes future instrument excellent when comparing same investment with same profit.