• Futures Trading

    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.

    Example

    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

    • Nifty Future with expiry date as 28th July 2011 is trading at 5610.
    • Nifty Future with expiry date as 25th August 2011 is trading at 5613.
    • Nifty Future with expiry date as 29th September 2011 is trading at 5625.

    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

    • Suppose one trader A believes that the market will go up in short term and he can generate profit by taking long position in the Nifty index.
    • At the same time another trader B believes that the market will go down in short term and he can generate profit by taking short position in the Nifty index.
    • So on 25th July, trader A buys a lot (lot size 50) nifty future with expiry date as 28th July at 5613 and trader B sells one lot of the same future at the same price of 5613.
    • Suppose after 1 day (26th July) as per trader A’s prediction market moves up and Nifty future is trading at 5653. Here the profit for trader A will be = Change in price * lot size* number of lots = Rs. (40*50*1) = Rs 2000 which will be the loss for trader B. As one trader’s gain is equal to other trader’s loss, it is termed as zero sum game. Rs 2000 will be credited into A’s account and the same amount will be debited from B’s account.
    • Next day (27th July) the nifty collapsed because of some poor earnings by some big companies and the future is trading at 5500.
    • At the end of second day, trader A’s loss will be Rs 5150 (103*50*1) and trader B’s profit will be Rs 5150. Rs 5150 will be credited into B’s account and the same amount will be debited from A’s account.
    • On 28th July, the Nifty settles at 5630 and the future will be settled at 5630 only at the end of expiry date. At the time of settlement, the trader A’s profit will be Rs 4000 (80*50*1) and trader B will lose the same money. Rs 4000 will be credited into A’s account and the same amount will be debited from B’s account.
    • Overall, A’s profit will be Rs 850 (17*50*1) and B’s loss will be the same amount.
    • Both the traders can close their position at any time during the period with some other trader. If someone wants to close the position, it is not necessary that the other trader has to close that.
    • There are huge number of buyers and sellers in the market which makes it possible for anyone to buy and sell the future at the current market price.
    • During the holding period if anyone fails to satisfy the margin requirement, his position will be closed.

    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.

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