What is a futures contract with example ?

In a very layman term Futures contract is a agreement between two parties where both parties agree to buy or sell a particular asset of certain quantity and at a predetermined price, at a specified date in future . It’s also known as a derivative because futures contracts derive their value from an underlying asset. Futures contracts can be bought and sold on recognized stock exchange like NSE ,BSE or commodity exchange .

The future agreement is based on the ‘future price’ of the asset. Asset can be stock ,commodities ,bond ,indexes etc. “Futures contract” and “futures” refer to the same thing. The futures price imitate the asset, which is also called the underlying. For example silver as an asset can have a ‘Silver Futures’ contract. If you want to learn about Futures market ,first you need to have basic understanding of what is derivatives & Forwards market .

We know the price of stock (Infosys,Tcs) may rise or fall ,commodities like gold ,silver may fluctuate , currency prices can also increase or decrease .These changes which happens everyday can help investors or traders to get benefited . If the price of a futures contract increases the buyer get benefited . similarly seller makes profit in case price of a futures contract decreases . Any trader should have directional view of market in order to make profit through Futures .

 

Example of Futures Contract :

To illustrate let us take an example of a onion farmer . In 2 Acre of his land he decided to grow onions . Usually every year he produces 5 ton of onion ,however he is worried if the season is terrible and the supply of onion falls ,he might need to bear the losses. Here comes the role of futures contract .

You could either grow the onion and then sell it for whatever the price is in market when you harvest it, or you could fix a price now by selling a futures contract .This will obligates farmer to sell 5 tons of onion after harvest for a fixed price. By fixing the price now, farmer  is eliminating the risk of falling onion prices in future . However he need to find someone who is ready for such type of agreement .

A local hotel owner decided instead of buying it from market ,if he can directly buy from farmer the cost would be lesser. Now they both can go through an agreement with specific quantity & certain date of expiry (let’s say after 3 months ) .The market price of onions at that time could be very different than the current price .

It can be risky for both under different circumstances . If the prices of onions go up in future ,hotel owner need to pay fix amount as per contract and this will benefit him .On the contrary farmer can get benefited if the prices stoop low from the current market price .

Important points :

  1. what if farmer find it really hard to search counter party available for the agreement ? I just took the hypothetical case for explanation . If there will be no buyer than agreement can not happen .
  2. It will take enormous time and effort to look for the counter party .
  3. That is why there is need of a place known as Exchange . An Exchange is a place where different parties with different views can buy or sell various securities .

Basic things to know about futures contracts Basic things about Futures Contract : 

Before we proceed to trade in futures we should be familiar with certain terminologies used . We all should be aware of certain aspects of future trading .Let us go and learn them one by one .

  1. Lot Size  In futures contract the minimum number or quantity you would be transacting is know as lot size . It depends on different securities and are predetermined . You can not choose it by yourself how many shares you want to buy . As you can see in the image below market lot quantity for TATA MOTOR’S Future contract is 2000 . This is the minimum quantity you need to buy in order to get the futures contract for this particular share .

 

What is a futures contract with example ?

2. Contract worth As we know now the quantity is predetermined contract value or worth would be multiplying quantity with current value of securities . So ,Lot Size x Price = Contract total worth in case of above image Rs.169.40 x 2000 = 3,38,800 . So this amount would be the total contract value .

3. Expiry –  In the image above you can see expiry date showing 27 JUN 2019 . As we have discussed in example of farmer about time boundation. The owner will take the onions after 3 months . Likewise every futures contract is bound to time known as expiry . So if you purchase the contract for month of June after 27 it will get expired . Expiry happens on last Thursday of every month . After this new contracts will be introduced by exchanges .

4. Margin Requirement As we know now the contract value ,Margin is the minimum amount need to be deposited for purchasing a futures contracts . It is certain %(percentage) of the total contract value , need to be deposited to your broker . It’s different for every stock ,you can know the minimum margin need to be deposited to trade a futures contract by calling to your broker or it might be mentioned on there website as well . You can calculate the margin requirement to trade in futures and option on Asthatrade FNO Margin Calculator .

5. Instrument Type As you can see the image below instrument type is Stock Futures , underlying asset is the stock of a company as we want to trade futures , we will select stock futures here .

What is a futures contract with example ?

6 . Symbol Symbol represents the name of the stock or Index . In the case above its Yes Bank .

7. Underlying ValueThis is current market price at which stock is trading in spot market . Spot market is the regular equity market , you would see the price difference in spot market and futures price . You might ask why is there difference in prices ? Spot prices are for immediate buying and selling, while futures contracts delay payment and delivery .

Why and how to trade  Why and how to trade Futures Contract :

Participants in a Futures market can be classified into two sets based on their trading motives :

  • Hedgers

  • Speculator

You can read here how hedging is done and who are hedgers .

If you are a intraday trader or regular investor who takes delivery of the stock ,futures provide you a middle way . For example let’s say due to hot weather this summer electric companies in business of AC , Coolers ,Fan would be profitable .You checked which all companies are performing best in market by doing fundamental analysis . Knowing there strength , Revenue generation model , profit earned , etc.

Now for instance you choose Voltas Limited (618.55) You think it would go up within this month . Instead of buying and taking delivery of stock you can opt for futures contract for that month .

Why trade in Futures Contract :

  1. Time period , as you can buy it anytime and sell it anytime before expiry ,even the very next day . You can buy contract for 1,2 or months as well .
  2. Margin benefit ,You did not need to have the full amount as in case of delivery of a stock .Because futures contracts can be purchased on margin, meaning that the investor can buy a contract with a partial amount from his broker, traders have an incredible amount of leverage with which they can trade much higher worth of contracts with very little of his own money.
  3. You can hedge positions by making a counter position in the futures market .

Futures contracts require daily settlement . In case if the futures contract bought on margin is out of the money on an any given day, the contract holder must settle the shortfall of money that day. Futures is a risky proposition that takes a tremendous amount of skill, knowledge and risk taking appetite . As prices of any underlying asset can move up or down significantly within a day ,recent example that comes to my mind is Jet airways ,Yes bank , Manspasand beverages , Vakrangee etc .

To place a trade you can call your broker and ask him to buy whatever lot you want and at specified rate for specific expiry .You can buy it yourself through your broker’s trading terminal as well . At Asthatrade call&trade is absolutely free .

Point to remember :

  1. The money that you make through profit or lose get’s credited or debited to your trading account the same day .
  2. You can exit the contract anytime, which means you can exit the contract within seconds of entering in it .
  3. The margins amount are blocked the moment you enter a futures trade on exchange
  4.  If the loss gets too high, the broker will ask the trader to deposit more money to cover the loss. This is called maintenance margin.
  5. The final profit or loss of the trade is realized when the trade is closed by exiting the contract .
  6. Futures positions are settled on a daily basis, it means that gains or losses are calculated each day. It gets added or subtracted from a contract holder’s trading account.
  7. Trading in futures requires a directional view of the market . whether you are trading stocks indexes or any other securities .
  8. Futures are highly leveraged investments .The trader typically only needs to put up 10%-15% of the value of the underlying asset as margin .Thus, you can trade larger amounts with less money.

Conclusion :

In the end I would just like to tell you the importance of better trade . It’s true that you can earn maximum through futures ,if you do proper research ,makes fantastic strategy , back-test them . However the risk do comes with large money ,so be aware , do not get influenced by any news or tips . Do your own homework before taking any trade in Futures .

I will end this article with a quote perfect for the situation . I hope you you have learned few new things about market today . Keep learning and keep growing .

example of deivative trading

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