What is Futures Trading?
Buying and selling contracts for future delivery of commodities, financial instruments, or indexes is known as futures trading. Trading professionals can make predictions about these assets’ future values by using this short-term investment approach. Traders use the futures contract market, investors, and even companies to get hold of the supply chain and make it available for their production purposes. A commodity that is traded in futures contracts is steel, for instance. Likewise, traders can also trade in a futures contract like the S&P 500.
Key Highlights
- Futures trading involves buying and selling contracts for future delivery of commodities, financial instruments, or indexes.
- It is a short-term investment strategy used to predict future values of underlying assets and manage supply chains for production purposes.
- Various futures contracts can be traded in the stock market, including those for interest rates, currency, grains, energy, softs, livestock, and natural resources.
- Key benefits of futures trading include leverage through margin trading, high liquidity, minimal brokerage fees, hedging against price risk, and the ability to short sell.
Table of Contents
Futures Trading Meaning
Futures trading is one kind of derivative trading. A legal agreement to purchase or sell a derivative at a fixed price at a fixed future date is known as futures trading. A financial instrument or a commodity may be the derivative’s underlying asset. One important thing to keep in mind while trading futures is that both the seller and the buyer are obligated to complete the transaction at the agreed-upon price and date.
The predetermined time is known as the delivery date, and the predetermined price is known as the futures price. Moreover, there is no set minimum account size requirement for trading futures in India. However, for the equity segment, the lot size is 100 shares.
Nonetheless, if you intend to engage in futures trading regularly, you will need to begin with a capital of ₹50,000, though some traders may recommend substantially more.
Types of Futures Contracts
There are many types of futures contracts that are tradeable in the stock market.
1. Interest Rates
2. Currency
3. Grains
4. Energy
5. Softs
6. Livestock
7. Natural Resources
Remember that futures contracts require physical delivery. So in this situation, the investor holding onto the contract deal will need to manage and store the goods, handle physical storage, and maintain futures contract assets.
Benefits of Futures Trading
The following are some advantages of incorporating futures trading into your overall financial strategy:
- Leverage as a Result of Margin Trading Availability
By utilising a margin trading account, positions in the futures market can be taken with a small down payment of the entire contract value. The return on investment increases significantly if the market moves in the anticipated direction, but losses also increase if the market moves against expectations.
- Liquidity
The futures market is highly liquid due to the large volume of futures contracts that are exchanged each day. Entering and leaving the market at any time is simple. The result of this is that the market does not move very much.
- Minimal Brokerage Fees
The trader does not have to pay a significant amount in commission because the futures contract has relatively modest brokerage and fees.
- Hedging
One crucial tool for portfolio diversification and risk hedging is futures trading. Futures trading is particularly useful in hedging price-related risk in the foreign currency and interest rate markets. Importers and exporters use it extensively to manage their risks associated with fluctuations in foreign exchange prices at the time of order and delivery.
- Short Selling
Individual stock short sales are subject to numerous restrictions; nonetheless, it is permissible to short-sell futures contracts and a trader may sell a futures contract to have short exposure to a stock.
- Simple to Understand
Trading futures is less complicated than trading options; it is straightforward and easy. Because regulatory bodies like SEBI closely monitor and control the futures market, it is extremely equitable for all players.
Overall, futures trading is a very effective technique for profit since it allows for hedging and leverage. However, traders must exercise extreme caution when trading in the futures market because they are equally vulnerable to hazards because of the high leverage and high contract values.
How to Trade in a Futures Contract?
India’s National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) allow investors to trade futures. Let’s look into Indian futures trading.
Step 1. Know exactly how futures and options operate: In contrast to other financial instruments like equities and mutual funds, futures are complex financial instruments. For someone who is investing in stocks for the first time, trading in futures may seem difficult. Understanding futures trading’s workings and related risks and expenses is essential if you want to begin trading them.
Step 2. Assess your risk tolerance: Although everyone wants to profit from the markets, futures trading has a chance of losing money. Knowing your risk tolerance is crucial before learning how to invest in future. You need to be aware of how much financial loss you can tolerate.
Step 3. Choose your trading strategy: Selecting a trading strategy is vital for future trading. Your understanding and knowledge may lead you to wish to purchase futures. You can also get the same assistance from an expert by hiring them.
Step 4. Practice on a simulated trading account: After learning the basics of futures trading, you can attempt to replicate the process on an online simulated trading account. You will be able to gain firsthand knowledge of how future marketplaces operate as a result. This improves your ability to trade futures without any real capital.
Step 5. Create a trading account: You must first create a trading account to begin trading futures. Before opening a trading account, conduct a comprehensive background check. You should enquire about the fees as well. Choosing the trading account that works best for you is crucial when investing in futures.
Step 6. Make arrangements for the margin money requirement: A security deposit of a certain amount, typically 5–10% of the contract value, is required for future transactions. After learning how to purchase futures, you must make the necessary arrangements for the margin money. Unless you are a day trader, you must pay the full purchase price of the shares when you buy futures in the cash sector.
Step 7. Paying the broker with the margin money: The next step is to pay the broker, who will then deposit it with the exchange. The exchange retains the money for the length of your contract. Throughout that time, you will be required to pay further margin money if it increases.
Step 8. Put buy/sell orders with the broker: After that, you can contact your broker to place your order. Using a broker to place an order is comparable to purchasing stock. The broker must be informed of the contract’s size, the quantity you desire, the striking price, and the expiration date. Brokers will provide you the opportunity to pick from a variety of different contracts, and you can do so.
Step 9. Final step: Future contracts need to be resolved. Either before or on the expiration date, this can be completed. All that remains of a futures contract are the delivery responsibilities known as a settlement. While physical delivery occurs in certain situations, such as those involving agricultural products, delivery of equity indexes and interest rate futures occurs in terms of cash payments. Contracts in the future may be settled before or on the expiration date.
Futures vs Options
Futures contracts require both the buyer and the seller to execute the deal at the predetermined price and date, which is the main contrast between them and options. On the other hand, until the contract’s expiration date, options contracts give the buyer the option—but not the obligation—to purchase or sell the asset at a fixed price.
| Feature | Futures | Options |
| Obligation | Both parties must fulfil the contract, buying or selling the asset at expiry. | The buyer can choose to exercise the contract. The seller must comply if exercised. |
| Risk Exposure | Both parties face potentially unlimited risk. | The buyer’s risk is capped at the premium paid. The seller faces potentially unlimited risk. |
| Profit Potential | Unlimited for both parties. | Unlimited for buyers; sellers’ profit is capped at the premium received. |
| Initial Financial Commitment | Margin deposit required (acts as a performance guarantee). | Upfront premium payment/receipt. |
| Contract Specifications | Standardised terms and conditions. | Available in both standardised exchange-traded and customised over-the-counter (OTC) formats. |
Example of Futures
In futures trading, players sign contracts to buy or sell specific assets, such as commodities, currencies, or stock market indices, at a defined price and date in the future. These standardised contracts, or futures contracts, are exchanged on regulated exchanges. Through futures trading, investors can make predictions about the changes in the value of the underlying asset without actually holding it.
Let’s take the case of an investor who believes that the price of crude oil will increase in the future. They can sign a futures contract to purchase a specific amount of oil at a specific price. The investor can make money by selling the contract at a higher price if the oil price rises.
Conclusion
Futures trading means investing in futures contracts to make substantial profits. But beware that borrowing money can be a risky affair and affect your professional life. The market condition plays a directly proportional relationship with futures contracts. Futures trading also helps you trade in shares of ETFs and even in bonds and government securities. Many traders and investors put their money into gaining profit and leverage rather than just owning the securities directly from the stock market. I hope you found this article helpful in understanding the futures trading meaning.
FAQs on Futures Contract
The futures represent an obligation to buy or sell a specific stock or commodity amount and quantity. The option does not oblige to buy or sell particular stocks or commodities.
The futures contract is riskier because of the obligation to buy or sell the asset in the mentioned contract. The margin fee imposed on the futures contract is much higher than the premium one has to pay to trade options. Apart from this, traders have to settle their M2M (mark to mark) losses daily if they make a loss. Due to these reasons, the capital one requires to trade futures also exceeds that of trade margins.
A call option is a contract that gives the right to buy an underlying asset at a specified price within a specific period that is locked in the contract.
A derivative is a contract whose value depends upon one or more underlying financial assets. The price of a derivative depends upon the fluctuations of financial assets in that particular derivative. The four common types of derivatives are futures, options, forwards, and swaps. Out which futures and options are the most commonly traded derivatives in the equity, commodity, and currency segments.
Trading derivatives like futures is a very risky play, so investors new to the stock market are generally advised to avoid trading them. Firstly, to trade futures, you need a very high capital. You also need to understand the concepts like margin fee and settlement of MTM losses concerning futures. And lastly, futures are speculative investments. There are indeed strategies to trade futures, but you have to holistically comprehend the futures market. So nonetheless, apart from being risky, there is also a high entry barrier to trade in the futures segment.
Futures trading can be profitable if executed with proper research, analysis, risk management, and a well-defined trading strategy. However, it is important to note that futures trading involves inherent risks, and profits are not guaranteed. Successful futures trading requires knowledge, experience, and the ability to navigate the complexities of the market.
The best time for futures trading depends on the specific market being traded and the trading strategy employed. Different futures markets have their own trading hours, and certain markets may be more active and liquid during specific times of the day.