Part 2 - What is a Futures Contract?
In the previous chapter, we talked about the various risks associated with trading forward contracts like Liquidity Risk, Default risk, regulatory and compliance risk, and non-availability of foreclosure risk.
The futures contracts are designed in such a way that it eliminates the risk associated with the forward contract. Essentially the futures contracts are designed on the same premise as the forward contracts i.e., to lock in the price and duration at the time of entering of the contract.
In our discussion of the Futures contract, we will be using the same example of the Silver contract which we used while understanding forward contracts.
What are Futures Contracts/ Agreements?
Having known that the basic premise of both forwards and futures contracts is the same, it will be easier for us to understand the futures contract, if we could understand how a futures contract solves the problem faced by forward contracts.
Lack of liquidity was one the biggest challenge faced while trading forward contracts as there may be no counterparty who is willing to take opposite positions. But this problem is solved while trading futures contracts as one can walk into the financial market and there are multiple parties who are willing to take the counter positions. Therefore, if I have a strong stance on the strength of the silver prices then it will be easy for me to find parties with opposite views on silver in financial markets.
The risk of default is completely eliminated while trading futures contracts as the willing participants will have to deposit the margin for trading with exchange and broker. And they can't default in paying if the market moves opposite to their views.
In case of the Forward contracts, there is no official governing authority, but in the case of Futures contracts, there is a proper official governing authority (NSE and SEBI in India) and exchanges where these contracts are traded.
Foreclosure of the Futures contract is very easy as there is always a counterparty with whom you can enter an opposite position to your existing position, and which ultimately cancels your existing position.
Characteristics of Futures Contract
- Prices are derived from the prices of Underlying Asset: The price of futures contracts is derived from the prices of the underlying asset. If we are trading Nifty 50 futures, then the underlying asset, in this case, is the Nifty 50 Index. If the price of the underlying asset goes up, then the respective future contract value also goes up and vice versa if the price of the underlying asset goes down.
- Futures contracts are tradeable: The futures contracts are very easily tradeable. If we get into a contract and if we want to exit the position before the expiry of the contract, it is very simple as the contracts are tradeable.
- Well Regulated: The futures contracts are very well regulated. In India, they are regulated by the regulatory body SEBI (Securities and Exchange Board of India). And which makes it nearly impossible to cheat or default while trading futures contracts
- Cash settled: The futures contracts are cash-settled in India. There is no physical delivery of the underlying asset. Only the cash differential will have to be played.
- Margin Required: This is a certain percentage of total contract value deposited with the broker at the time of entering the futures trade. This margin money has to be in the trading account of both parties at the time of entering of contract.
- Futures contracts have specific Expiry dates: All the futures contracts have specific expiry dates. Say, if we were to take the example of futures contracts of Reliance Industries. There are three expiry contracts - near month expiry, middle month expiry and far month expiry. Upon the expiry of the near month contract, a new far month contract is added.
Understanding the Futures Contract
Let us understand the mechanism of futures contracts with the help of a simple example. The underlying asset under consideration here is the shares of Reliance Industries.
- Spot price of Reliance Industries - Rs. 1980
- Reliance January Futures price - 1971
- Share per lot - 250
Say, if the share price goes up by Rs. 20, then
- Spot price of Reliance Industries - Rs. 2000
- Reliance January Futures price - 1991
If we were to buy, one lot of futures contract at the spot price of Rs. 1980
(futures price = 1971), then the total profit with one lot will be-
= (1991-1971) * 250
= Rs. 5000.
We will be understanding the technical nuances of futures contracts in chapters to follow.
Key Takeaways of this Chapter
- The Futures contract is an improvisation of the Forwards contract.
- The futures contracts are a replica of the spot price of the underlying asset.
- The futures contract is tradable.
- Futures contracts are time-bound, and the contracts are available over different timeframes (one month, two months, and three months).
- Most of the futures contracts are cash-settled
- The futures market in India is regulated by the Securities and Exchange Board of India
- The lot size is the minimum quantity specified to be traded in a futures contract.