All About Futures
| What are futures? Futures are derivatives. These are securities whose value depends on the value of an underlying asset, which could be a commodity or a financial instrument. A future or a forward contract is an agreement between two parties to buy or sell an underlying asset at a certain time in the future for a certain price, which is fixed now. One party buys the asset and the other party sells the asset. |
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| What are some commonly used derivatives? Some commonly used derivatives are forward contracts, futures, options, swaps and warrants |
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| What is meant by a contingent claim? A contingent claim is another word for a derivative security. It is so called because they are claims whose values are contingent (i.e., depend on) on the value of the underlying asset. |
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| What is the nature of the underlying asset? Underlying assets can be of several types, such as :
The first |
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| Are futures and forward contracts the same? No. Forward contracts are contracts entered into privately between two parties as above. Futures contracts are contracts that are traded on an exchange. |
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| What are the differences between futures contracts and forward contracts? In quite a few ways, futures contracts are superior to forward contracts. Some of them are :
Still,
Such marking of the contract to changes in market price does not happen with forward contracts. |
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| What are financial futures? Financial futures are futures where the underlying asset is a financial instrument such as a share, currency or an index. |
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| Is there a difference between financial futures and commodity futures, other than the nature of the underlying asset? Commodity futures are settled partly by cash and partly by delivery of the concerned commodity. Financial futures are mostly settled in cash, by paying out or receiving differences and rarely by delivery. |
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| What is meant by standardisation of futures? The exchange standardises futures contracts in terms of the following features :
In the case of commodity futures, the exchange also specifies the product quality and the delivery location. |
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| What is meant by ‘going long’ or ‘going short’ in a futures contract? The buyer of a future contract is said to ‘go long’ the future, whereas the seller is said to ‘go short’ that future. |
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| What do price changes of a futures contract reflect? The price changes of the future will reflect the price changes of the underlying instrument (share or index). With a long position, the value of the position rises as the price of the underlying instrument rises and it falls as this price falls. With a short position, a loss ensues if the price of the underlying instrument rises, while profits are generated if this price falls. |
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| How is the performance of the parties to a futures contract guaranteed? Clearing houses at futures exchanges guarantee the performance of the parties to a futures contract. This is accomplished by a process called novation, wherein the clearing house functions as a seller to every buyer and a buyer to every seller. As a result, after a trade is concluded, the two parties to the trade need not interact with each other at all. The clearing house settles each leg of the trade independently. In the case of commodity futures, clearing houses also facilitate settlement by delivery. |
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| How do clearing houses guarantee trades? Each clearing house will have a mix of strategies to ensure that, even in the most volatile of markets, each party to a contract fulfils its obligation. These are accomplished by a strict system of initial and mark to market margins imposed on the members of the clearing house, who settle the trades with the clearing house. In addition to this, most clearing houses also get themselves insured against failure of their members and build up contingency funds from contributions by their members to safeguard against large scale failures. |
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| Is futures trading meant for someone like me? Futures trading is very useful to three categories of people. If your investing style matches any of the three following categories, you would find futures trading useful :
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| What is a spot price in a futures market? The spot price is the price of the underlying commodity in the spot or cash market. In this market, settlement takes place in 48 hours. |
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| What is a delivery price in a futures contract? The specified price in a futures contract is called the delivery price. |
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| What is a forward price in a futures contract? This is defined as the delivery price that would make the contract value zero. At the time of entering into the futures contract, the forward price and the delivery price are equal. As time passes, the forward price and delivery prices tend to diverge. The delivery price remains the same, while the forward price varies with the maturity of the contract. |
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| What is the maturity date of a futures contract? The maturity date of a futures contract is the date on which the buyer and seller have to settle their obligations to the exchange. |
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| What is the maturity value or terminal value of a long position in a futures contract? The value at maturity or terminal value of a long position is defined as the difference between the spot price on the day of maturity and the delivery price. That is, ST – D, where D is the delivery price and ST is the spot price at maturity. If the terminal value is negative, it indicates that the buyer of the contract has incurred a loss. |
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| What is the maturity value of a short position in a futures contract? The value at maturity of terminal value of a short position is the difference between the delivery price and the spot price at maturity. That is, D – ST, where D is the delivery price and ST is the spot price at maturity. If the terminal value is negative, it indicates that the seller of the contract has incurred a loss. |
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| What is an index future? Futures contracts whose value depends on the value of an underlying share index are known as index futures. Each share trades at a specific price at any point of time. But there is a need to represent the price of the market as a whole. This is done by identifying a basket of shares that s representative of this market, and tracking their consolidated value in terms of their base value. The value of this basket of shares is the value of the share index comprising these shares. |
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| How do investors benefit from index futures? As investors are always affected by fluctuations in the market index, hedging using index futures is more effective for an investor rather than hedging with a (single) share future. |
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| Where can I trade in futures in India? You can trade index and stock futures in Indian markets. Both the Bombay Stock Exchange and the National Stock Exchange offer trading in futures linked to the value of their underlying. Besides, the BSE Sensex and the S&P CNX Nifty, you can also trade in NSE Bankex and NSE IT indices. |
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| What is a futures contract cycle? Contract cycles are trading periods for which futures contracts remain active. For example, a 3-month futures contract would come into existence on 1st January and would expire on 31st March. On 1st April, this contract would cease to exist, and the next contract with expiration on 30th June would start trading. |
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| What is a calendar spread? A calendar spread is a position where one contract cycle of a future is hedged by an offsetting future position of different contract cycle in the same underlying asset. For example, a short position in three month index futures contracts may be hedged by a long position in six month index futures contracts. |
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| What is a daily price movement limit? Daily price movement limits are the limits on the extent to which futures prices are allowed to vary from day to day. These limits are prescribed by the exchanges to prevent large price movements due to excessive speculation. |