About Futures Contract » Soved (2024)

Futures market were innovated to overcome the limitations of forwards. A futures contract is an agreement made through an organized exchange to buy or sell a fixed amount of a commodity or a financial asset on a future date at an agreed price simply futures are standardized forward contracts that are traded on an exchange. The clearing house associated with the exchange guarantees settlement of these trades. A trader who buys futures contract takes a long position. And the one who sells futures takes a short positions. The words buy and sell are figurative only because no money or underlying asset changes hand between buyer and seller when the deal is signed.

Futures contract is similar to forwards contract but futures contract are traded in exchange with forward contract risks. Overcome by futures agreement with same core transactional structure. As a example in past time everybody goes to school for learning but now a days learn at digital platform at home like YouTube, WebEx, Udemy, skill share, google meet etc. But learning is core transaction structure same in both.

The core transactional structure of the futures and forwards is the same, I guess it makes sense to look into the features that distinguishes the futures from the forwards.

Now you look in forward contract is common problem counterparty person in opposite view so seller have required a institute or platform where he get opposite view persons than he can make a contract between two parties. This platform if exchange then forward contract called as a futures contract. Exchanges are available NSE, BSE, MCX etc. Like it so we know a futures contract is structured a little different from forwards contracts.

•Futures contracts and forwards contracts both are mimics the underlying.

•Contract between two parties through exchange.

•Centralized trading platform i.e. Exchange.

•Price discovery through free interaction of buyers and sellers.

•Margins are payable by both the parties.

•Quality and quantity decided today.

•Standardized contracts.

•Futures contracts are tradable.

•Futures market is highly regulated.

•Contracts are time bound.

•Cash settled.

We know that two types of future instrument available in equity derivative 1^st is stock futures and 2^nd is index futures. Index and stock is the underlying asset of the futures contract. Some brief information about index and stocks are written below-

Stocks:

When we will buy some equity shares from any company then I will part of company owner or stock holder, share holder or stake holder of that company and stock is the financial asset of the company so stock represent any companies financial asset.

Stock futures:

So stock futures represent any company stocks as a underlying asset which one traded at exchanges. Stock futures price is derived from underlying company stock price.

Some securities (company) on stock futures derivative are written below by NSE website (source- www1.Nseindia.Com)

Index:

Index is the combined portfolio of more than one companies. Index number is based on market capitalization which one is derived from all companies current market capitalization to divided by base market capitalization.

Index futures:

Index futures represent to some index as a underlying asset. In index futures index numbers work as a index price. Some underlying asset as a index futures are written below by NSE website (source- www1.Nseindia.Com)

Futures Instrument Source Snapshot:

Now if you want nifty 50 index futures on your trading platform so go on watchlist search option and write-

For nifty 50 underlying-

1.Nifty Jul Fut

2.Nifty Aug Fut

3.Nifty Sep Fut

For underlying nifty bank futures-

Banknifty Jul Fut

For equity stock underlying-(aarti industries limited) stock futures

Aartiind Jul Fut

Note- maintain space between month and underlying asset name and also between month and fut. Use current month, next month, and far month don’t use July month if July month has gone suppose current month is November then 3 futures contract will be available for November month (current month), December month(next month), and January month(far month).

Futures contract name on exchange snapshot:

Spot price:

The price at which an underlying asset trades in the cash market. Also known as underlying value.

Future price:

The price of the futures contract in the futures market.

Contract cycle:

It is a period over which a contract trades on current date. Maximum number of index futures contract is of 3 months contract cycle- the near month ( current month), the next month/ mid month, the far month. Every futures contract expires on last Thursday of respective month, and a new contract is introduced on the trading day following the expiry day of the near month contract.

Expiration day:

The day on which a derivative contract ceases to exist. It is last trading day of the contract. The expiry dates in the quotes given is generally last Thursday of the expiry month. If the last Thursday is a trading holiday the contract expires on the previous trading day. On the expiry date all the contracts are compulsorily settled. If a contract is to be continued then it must be rolled to the near future contract. Currently all equity derivatives contracts are cash settled. If current month position square of an expire then buy next month contract called a rollover.

Nifty Index Future Quotes-(Nifty Futures As On 26/8/2022):

Rollover data:

If traders rolling over their existing long position to the next month then it is considered bullish, like wise if a lot of traders are rolling over their existing short positions to the next month then it is considered bearish. It is just perception of the market.

Contract size/lot size:

Futures is a standardized contract where everything related to the agreement is predetermined. Lot size is one such parameter. Lot size specifies the minimum quantity that you will have to transact in a futures contract. Lot size varies from one asset to another.

Price quotation:

Price quotation is the units in which the traded price of a contract is displayed bid price is the price buyer is willing to pay and ask price/offer price is the price seller is willing to sell. The difference between bid and ask prices is called as the bid-offer spread and also sometimes referred to as the jobbing spread.

Tick size:

It is minimum move allowed in the price quotations. Exchanges decide the tick sizes on traded contracts as part of contract specifications tick size for nifty futures is 5 paise(0.05).

Tick value:

Tick value refers to the minimum profit or loss that can arise from holding a position of one contract.

Tick value= contract size*tick size

For nifty tick value= 50*.05=Rs. 2.5/-

Contract value:

Contract value is the multiply of lot size*contract future price

For nifty contract value= 50*17678=Rs. 883900/-

Offset:

It refers to the liquidation of a futures contract by entering into opposite of an identical contract. If you have bought 2lot futures contract then its offset is if sell 2lot futures contract.

Basis:

It is normally calculated as cash price minus the future price. A positive number indicates a futures discount ( backwardation) and a negative number, a futures premium ( contango). Importantly basis for one month contract would be different from the basis for two or three month contracts. Whatever the basis is positive or negative it turns to zero at maturity of the futures contract i.e. There should not be any difference between future price and spot price (cash price) at the time of maturity/expiry of contract. This happens because final settlement of futures contract on last trading day takes place at the closing price of the underlying asset.

Contango:

Contango means a situation where futures contract prices are higher than the spot price and the futures contracts maturing earlier. Futures contracts may be in a contango because of fundamental factors like storage, financing ( cost to carry) and insurance costs.

Backwardation:

Backwardation means a situation where futures contract prices are lower than the spot price and the futures contracts maturing earlier. This happens because of demand and supply, in earlier maturing contracts basis is low, in falling market selling pressure increases in futures or low buyer participants for buying futures. For this reason sometimes futures price decreases from underlying value(cash price) it is temporary not permanent and on expiry same as underlying value.

Convergence:

This refers to the tendency of difference between spot and futures contract to decline continuously so as to become zero on the date on maturity.

Why futures price converge to the spot prices closer to the date of expiry:

As the future get closer to expiry the prices will naturally converge. This is because the futures price is in effect a price in the future(the price at expiry) that takes into account the cost of carry. If this premium or discount gets out of equilibrium the forces of supply and demand will react.

Example:

If future price>physical asset price (underlying value), then demand will increase physical asset so physical asset price go up.

If future price<physical asset price, then demand of future price will be increase so future price go up or less demand for the physical asset means the price comes down. So its pushing the markets towards convergence or prior to expiry a form of balance.

Cost of carry:

Cost of carry is the relationship between futures prices and spot prices. It measures the storage cost(in commodity market) plus the interest that is paid to finance or carry the asset till delivery less the income earned on the asset during the holding period for equity derivatives. Carrying cost is the interest paid to finance the purchase less (minus) dividend earned during contract cycle.

Margin account:

As exchange guarantees the settlement of all the trades to protect itself against default by counterparty, it charges various margins from brokers. Brokers in turn charge margins from their customers.

Initial margin:

Initial margin is the minimum collateral required by the exchange before a trader is allowed to take a position. Initial margins can be paid in various forms as laid down by the exchange and varies from asset to asset as well as from time to time. The level of initial margin is dependent on the price volatility of the contract. More volatile commodities generally have higher margin requirements.

Marking to market (MTM):

In futures market, while contracts have maturity of several months. Profit and losses are settled on day to day basis called mark to market(MTM) settlement. The exchanges collects these margins (MTM margins) from the loss making participants and pay to the gainers on day to day basis.

Example:

suppose that Mr. A buy 1lot nifty future contract and Mr. B sell 1lot nifty future contract.

Note- MTM settlement to be done by nifty future contract settle price.

Difference between open, high, low, close, LTP, settle price:

Open price-future price at the time of market opening.

High price– maximum future price go up on trading day.

Low price– minimum future price go down on trading day.

Close price-future price at the time of market closing.

LTP– LTP stands for last traded price LTP means last executed price by participants.

Settle price– last half an hour weighted average price at closing time of market.

Delivery date:

Delivery date or delivery period refers to the time specified by the exchange during or by which the seller has to make delivery according to contract specifications and regulations delivery date is often later than expiry date of a contract, especially in case of physically delivered commodities.

Open interest:

An open interest is the total number of contracts outstanding (yet to be settled) for an underlying asset. It is important to understand that number of long futures as well as number of short futures is equal to the open interest. This is because total number of long futures will always be equal to total number of short futures. Only only one side of contracts is considered while calculating/mentioning open interest. The level of open interest indicates depth in the market.

Volumes:

The total number of contracts that have been bought or sold in a specific period of time or during the trading day, or over a week, or month, or over a entire life of the contract.

Example For Open Interest And Volumes:

Contract specification:

Contract specifications include the salient features of a derivative contract like contract maturity, contract multiplier/lot size, contract size, tick size etc.

Price band:

Price band is essentially the price range within which a contract is permitted to trade during a day. The band is calculated with regard to previous day closing price of a specific contract on the first trading day of the contract, the price band is decided based on the closing price of the underlying asset in cash market. Price band is closely defined in the contract specification so that all market participants are aware of the same in advance sometimes, bands are allowed to be expanded at the discretion of the exchange with specific trading halts.

Example For Contract Specification:

SOURCE-https://www1.nseindia.com/products/content/derivatives/equities/fo.htm

As a market participant you will always deal with certain terms like long, short and open position in the market. Let us understand the meanings of commonly used terms.

Long position:

Outstanding/unsettled buy position in a contract is called “long position”.

Short position:

Outstanding/unsettled sell position in a contract is called “short position”.

Open position:

Outstanding/unsettled either long (buy) or short (sell) position in various derivatives contracts is called “open position”.

Opening a position:

Opening a position means either buying or selling a contract, which increases client’s open position (long or short).

Closing a position:

Closing a position means either buying or selling a contract, which essentially results in reduction of client’s open position (long or short).This is also known as a square off position if day trading or exit in position.

Offsetting a position:

Offsetting a position, a trader takes an equivalent but opposite position to reduce the net position to zero. For example, if you buy 1lot future/1share today and after sell same 1lot future/1share known as offsetting a position.

Unwinding:

unwinding is a process of reversing or closing a trade by participating in an offsetting transaction.

Long unwinding:

Closeout position of long i.e. Selling the securities to exit the long position.

Short covering:

Closeout position of short i.e. Buying back the securities to exit the short position.

Naked position:

Naked position in futures market simply means a long or short position in any futures contract without having any position in the underlying asset.

Covered position:

Covered position in futures market simply means a long or short position in any futures contract with having opposite position in the underlying asset.

Spread:

difference between spot price in cash market and future price in futures market in same underlying asset or difference between one month maturity contract price to another month maturity contract price in same underlying asset known as spread.

Calendar spread:

Calendar spread is a simple extension of the cash and carry arbitrage. If buying current month and selling mid month contract. One can make money opportunities of this type are called calendar spread. Bull spread- future price>spot price. Bear spread- future price<spot price.

Calendar spread position:

Calendar spread position is a combination of two positions in futures on the same underlying. Long on one maturity contract and short on a different maturity contract. For making a calendar spread position timing is very important in opening and closing time position means long in one contract short in another contract open a position with same time with no little differences in time.

As futures are standardized contracts introduced by the exchanges. They too have certain limitations in the context of limited maturities, limited underlying asset, lack of flexibility in contract design, and increased administrative costs on account of MTM settlement etc.

Shorting means selling A any security but shorting in spot market only intraday possible but in futures and options market shorting available for overnight till expiry. So when you feel the price of A underlying asset decline in coming days then you can make money by shorting in futures market first sell and later buy.

We will look in the quote of price that bid price is less than offer(ask) price this difference called bid-offer spread let us see A example-

Now the difference between best buy and the best sell order is 0.50 called bid-ask spread. Bid ask difference happen by illiquidity. In high liquidity bid-ask spread is very less.

For calculating impact cost we have to defining the ideal price as the average of the best bid and best offer price which is in our example (4.0+4.5)/2=4.25, now if you buy or sell then you have to pay more than in buy case and less than in sell case. Price gap from ideal price 4.25 known as A impact cost.

Buy side impact cost-

Ideal price=(4.0+4.5)/2=4.25

Average buy price=(50*4.5+50*4.6)/100=4.55

Impact cost for (100shares)=(4.55-4.25)*100/4.25=7%

Sell side impact cost-

Ideal price=(4.0+4.5)/2=4.25

Average sell price=4.0

Impact cost for (50shares)=(4.25-4.0)*100/4.25=5.8%

Impact cost is the loss associated by executing A round trip trade. The loss is expressed as A percentage of the average of the bid and ask price. Round tripping is an instantaneous arbitrary trade you carry out by buying at the first best available sell price and selling at the first best available buy price. Let us execute this on above example-

Roundtrip loss= first best sell price-first best buy price=4.5-4.0=0.5

Avg bid and ask price=(4.5+4.0)/2=4.25

Impact cost=0.5*100/4.25=11.76%

• Impact cost gives A sense of liquidity.
• The higher liquidity means lesser impact cost.
• Higher the spread, higher the impact cost & lower the spread, lower the impact cost.
• Higher the liquidity lesser the volatility.
• In illiquid security market order is not a great idea.