Futures in Stock Market : Futures Contracts & Trading

What are Futures?

Futures are financial derivative contracts in which the parties are obliged to purchase or sell an asset at a price and date that are fixed in the future. The underlying asset must be purchased or sold at the agreed-upon price, regardless of its current market value as of the expiration date. Financial instruments and physical commodities are examples of assets under Futures. Futures contracts enable investors to secure a predetermined price for the underlying commodity or asset. For example, assume a coffee farmer is worried about a possible reduction in coffee prices. They can hedge against this risk by selling coffee futures contracts, which lock in a selling price for their coffee. If the actual market price falls, the physical market losses will be offset by profits in the futures market. These contracts are defined by predetermined costs and expiration dates. The identification for futures are expiration months. For instance, the expiration date of a December gold futures contract is December.

Geeky Takeaways:

• Futures are financial contracts that are classified as derivatives. They put an obligation on either the buyer or the seller to purchase or sell an asset at a specified future date and price.
• An investor may engage in speculation regarding the price of a financial instrument or commodity using a futures contract.
• By hedging the price movement of an underlying asset, futures contracts assist in preventing losses caused by unfavorable price changes.
• Hedging involves adopting the opposite position from which one holds the underlying asset; in the event of a loss on the underlying asset, the profit generated from the futures contract can serve as a means to alleviate that loss.
• Futures contracts are traded on a futures exchange, and the price of a contract is resolved after each trading session.

Use of Futures

1. Hedging: Commodity producers and consumers frequently utilise futures contracts to hedge against price volatility. A farmer, for example, can use a maize futures contract to lock in a price for their crop before it is harvested, protecting themselves from any price drops.

2. Speculation: Commodity futures are used for speculative reasons by traders, including institutional investors and individual speculators. They intend to profit from predicted price swings but do not intend to take physical delivery of the product.

3. Price Discovery: Futures markets are critical in price discovery. The frequent buying and selling of futures contracts contributes to the establishment of a transparent and widely accepted market price for commodities. This price data is useful to producers, consumers, and investors.

4. Diversification of Investment Portfolios: Commodity futures are frequently used in investing portfolios to diversify risk. Commodities, which may not necessarily move in lockstep with traditional financial assets, can provide an inflation hedge and diversification benefits.

5. Market players: Futures are used by a variety of market players, including farmers, miners, energy producers, commodity dealers, and financial institutions, to manage risk, speculate on price changes, and participate in commodity markets.

Why Trade Futures?

Trading futures provides multiple benefits to market participants, and people trade futures for a variety of reasons. Here are some of the main reasons traders prefer to trade futures:

1. Risk Management: Futures contracts are used by businesses and manufacturers to hedge against price volatility in underlying assets such as commodity or financial instruments. It helps in the management and mitigation of the effect of adverse pricing swings on their business.

2. Speculation: Futures trading is frequently used by traders to make assumptions on the future price swings of underlying assets. Traders can earn from both positive and negative market trends by correctly forecasting price changes.

3. Leverage: Futures contracts enable traders to manage a significant position with a little amount of capital. This is known as leverage, and it has the ability to compound both gains and losses. Leverage is used by traders to potentially increase the returns on their investments.

4. Portfolio Management: Futures contracts add diversification to an investing portfolio. Commodities, financial instruments, and equity indexes are among the asset classes covered by futures. Diversification can aid in risk distribution and overall portfolio stability.

5. Price Discovery: Futures markets help to price discovery by reflecting market participants’ collective expectations and opinions. The pricing information provided in futures markets is utilised to value the underlying assets.

6. Liquidity: Futures markets are frequently highly liquid, indicating an increased volume of trading. Because of this liquidity, traders are able to quickly switch positions, lowering the possibility of market effect.

7. Efficiency and Transparency: Futures markets are governed by tight rules that ensure openness and fair business practices. Traders may rely on the futures markets’ integrity, and pricing information is easily available.

8. Global Expansion: Futures contracts give you contact with global markets and asset types. Traders can engage in marketplaces all over the world without having immediate control of the underlying assets.

9. Risk Transfer Mechanism: Futures markets serve as a means of moving risk from those who want to steer clear of it (hedgers) to those who want to take it (speculators). This risk transfer improves market efficiency.

10. Arbitrage Opportunities: Traders may participate in arbitrage by exploiting price differentials between connected marketplaces or instruments. Price convergence is aided by arbitrage activity.

Types of Futures

Futures contracts are classified according to their underlying assets and financial instruments. Here are some examples of common sorts of futures:

1. Commodity Futures: These are contracts that are entirely based on tangible commodities such as gold, oil, wheat, or cattle.

2. Financial Futures: These are financial products such as currency pairs, rates of interest, stock indexes and bonds.

3. Currency Futures: Includes the swap of a particular currency against another at a fixed exchange rate.

4. Stock Indicator Futures: These are contracts that are linked to the outcomes of a particular stock market index, such as the S&P 500.

5. Interest Rate Futures: Interest rates on different financial products, such as government bonds, are linked to interest rate futures.

6. Single-Stock Futures: These are contracts based on a future price of a single stock.

7. Crypto Futures: These futures invests in cryptocurrencies like Bitcoin.

8. Real Estate Futures: These futures contracts are based on the worth of real estate indices in the future.

9. Weather Futures: Derivatives based on weather conditions that are employed by companies that are affected by weather variations.

10. Commodity Index Futures: Tracks the efficiency of a basket of commodities.

Examples of Futures

An agreement exists for an American importer to acquire products from an Indian supplier Madhav Ltd. The transaction shall be settled in Indian Rupees, and the importer based in the United States is anxious regarding possible volatility in the INR/USD exchange rate. In anticipation of unfavourable currency fluctuations, the importer opts to employ an INR/USD futures agreement as a hedge.

The following are the essential details of the contract:

1. The underlying asset is the Indian Rupee (INR) in relation to the U.S. Dollar (USD)

2. The contract size is a specific amount of INR, such as 1,000,000 INR per futures contract.

3. The contract expiration date is in three months

4. The contract price (Futures Rate) is the mutually agreed-up swap rate for the INR/USD futures contract, which is 73.50 INR/USD

5. The initial margin made with the exchange is necessary to enter into the trade.

6. Profit Situation: The futures rate that the U.S. importer has agreed to is reduced in the event that the INR strengthens.

7. Loss Situation: Loss on the spot market is mitigated in the event that the INR diminishes by the higher mutually agreed-up futures rate.

The above example demonstrates how enterprises involved in international trade can mitigate currency risk by making use of INR/USD futures. Through the use of a futures contract to secure in the exchange rate, the importer can enhance cost predictability and safeguard against adverse currency fluctuations.

Pros of Futures

Pros of Futures Trading	Explanation
Hedging Opportunities	Hedgers can use futures to protect themselves against price volatility, lowering the risk associated with swings in commodity or financial prices.
Speculative Profits	Traders can earn from both bull and bear markets, which provide opportunities for speculation as well as potentially better rewards.
Price Discovery	Futures markets help to price discovery by reflecting market participants’ collective expectations and opinions.
Leverage	Futures contracts frequently require a percentage of the contract value as margin, giving traders the ability to control larger positions.
Liquidity	Many futures markets are highly liquid, enabling traders to easily enter and exit positions while minimising transaction costs.

Cons of Futures

Cons of Futures Trading	Explanation
High Risk and Volatility	Futures trading involves significant risk and can be highly volatile, leading to substantial financial losses.
Margin Calls	Because futures traders utilise leverage, they may suffer margin calls, which require additional funds to cover possible losses.
Complexity	Understanding futures agreements, market dynamics, and different strategies can be difficult, necessitating a substantial amount of monetary knowledge and expertise.
Limited Predictability	Market movements can be unpredictable, making it challenging to accurately forecast price changes and time entry or exit points.
Counterparty Risk	There’s a risk associated with the counterparty in futures transactions, particularly if the other party fails to meet its contractual obligations.

What are Futures Contracts?

A futures contract is a standardised contractual arrangement between two parties to purchase or sell an item at a fixed future date for an agreed-upon price established today. These contracts are exchanged on regulated futures markets and encompass a diverse array of assets, such as commodities, securities, stock indexes and others.

Risks of Futures

1. Leverage Risk: The use of leverage increases both profits and losses. Although it boosts the possibility for profit, it also elevates the chance of substantial financial losses.

2. Market Risk: Market risk in futures markets is characterised by high volatility, as prices can experience abrupt fluctuations due to factors such as economic data, geopolitical events, and market emotion.

3. Margin Calls: In the event that the market moves unfavourably for a trader, they may be subjected to margin calls, which demand additional funds to uphold their position. Failure to meet margin calls may lead to the compulsory liquidation of positions.

4. Counterparty Risk: Futures contracts entail a contractual arrangement between two parties. There is a possibility of a party failing to fulfil their responsibilities, which could result in financial damages.

5. Interest Rate Risk: It refers to the potential influence of fluctuations in interest rates on the pricing of futures contracts, particularly those related to financial instruments. Traders must remain cognizant of fluctuations in interest rates.

6. Liquidity Risk: Certain futures contracts may have inadequate liquidity, posing difficulties in executing trades at targeted prices. Illiquid markets may lead to broader bid-ask spreads.

7. Event Risk: Event risk refers to the possibility of unexpected or unfortunate occurrences, such as natural disasters, legislative changes, or unforeseen economic developments, causing significant fluctuations in the market and heightened levels of risk.

8. Rolling Risk: Traders who maintain positions in expiring futures contracts face possible risks while moving to new contracts, as there may be price disparities between the two contracts.

Difference Between Options and Futures

Basis	Options	Futures
Contract Type	Grants the holder the right, without imposing any duty, to purchase or sell the underlying asset at a specified price.	Obliges both parties to fulfill the contract by buying or selling the underlying asset at a predetermined price.
Obligation	Holder has the choice to exercise or not exercise the option.	Both parties are obligated to fulfill the contract terms.
Risk	Limited to the premium paid for the option.	Potentially unlimited, as both gains and losses can be substantial.
Market Direction	Depending on the type of option, it allows you to profit from price changes that are either up or down.	Profits can be made from both upward and downward price movements.
Profit Potential	Unlimited potential profit if the market moves favorably.	Limited to the difference between the entry price and the market price at expiration.
Cost	Options involve the payment of a premium to the option seller.	Initial margin payment is required before entering into a futures contract. Frequent modifications may be required due to market conditions.
Common Use	Used for hedging, speculation, or generating income.	Used for hedging and speculation on future price movements.
Flexibility	Provides flexibility because the holder can choose whether or not to exercise the option.	Less flexible as both parties are generally obligated to fulfill the contract.
Expiration	Options have a limited lifespan and expire on a specific date.	Futures contracts have expiration dates, but new contracts are continually issued.
Examples	Call and put options.	Contracts on commodities, financial instruments, or indices.