As we specified in our derivatives section, Future contract is an agreement between two parties to buy or sell an underlying asset (stock index or individual stocks) at a particular price at a particular time in the future. The future contracts are traded in the stock market and stock exchanges act as the mediator in the transactions.
Normally three futures with three immediate expiry dates are traded in the share market and provide good liquidity for the trading purposes. InIndia, there is only one expiry date per month and it is always falls on the last Thursday of a month. If the last Thursday is holiday, then the previous working day will be the expiry date.
The future price is derived from the current price of the underlying stock or index along with the trading behavior. Too much optimism about short term market movement (bullish) increases the number of buyers and makes the future trading at higher premium and the too much pessimism about the short term market movement (bearish) decreases the number of buyers and makes the future trading at higher discount. In any case, the future price stays near the underlying price and at the end of expiry date future price becomes same as underlying asset priec.
Future can be traded for both the different indexes and shares with different lot size which determines the unit of future trading. The quantity of future trading has to be any numerical multiple of the lot size. InIndia, Nifty future has a lot size of 50.
Stock index Nifty’s futures are the most famous once and have sufficient liquidity to facilitate the trading process. Suppose on 25th July 2011, the Nifty index is trading at 5700 and its futures are trading at the below price
Now the trader can trade on any of the futures to take long or short positions. Buying a future helps a trader to take long position where he can make profit from any upward movement and selling a future helps a trader to take short position where he can make profit from any downward movement. The trading is done between traders one of them take the long position and the other take the short position.
The most important risk involved in the future trading is the credit risk and default risk. As we have already seen in this zero sum game, one trader loses money and the other trader gains the same amount of money. The investor who has lost money may not have the credibility to give the money to the other investors who will receive money or may get default on the money obligation. To resolve the credit risk and any potential default case, all the investors are required to deposit margin amount with the stock exchange and the margin amount is calculated on day-to-day basis.
Based on the day-to-day margin calculation the money is either deposited into or subtracted from the trader’s account. If there is no money to be recovered from the trader’s account, then the future position is closed automatically.
Les us check the below transactions to understand the transaction details with the daily margin calculation
Future trading is more risky than holding the security as it involves day-to-day margin requirement and it mainly focuses on short term market movement which is very unpredictable and risky. In spite of this, lots of active traders use futures to take long and short positions in the market and gain profit out of any anticipation or prediction.