Futures Contract A Comprehensive Guide to futures trading

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In the previous chapter, we examined a Forwards Contract example detailing how two parties agreed to exchange cash for goods at some point in the future, and delved into how price fluctuations affect those involved. At the end of the chapter, we outlined four chief risks pertaining to forward contracts, concluding that futures contracts are formulated to diminish these critical issues.

  1. Liquidity risk
  2. Default Risk
  3. Regulatory Risk
  4. The rigidity of the transitional structure

The Futures Agreement is an improved version of the original Forwards Market Agreement. It offers the same core transactional arrangement, but obviates any potential dangers associated with the Forward Market. This means that, if you’re correct about where prices are heading, then you stand to benefit financially from a Futures Contract in the same way as you would from a Forward Agreement.

It may be far-fetched, but consider this: cars of the old generation were designed to transport you from point ‘A’ to point ‘B’. Nowadays, new vehicles are equipped with safety features such as airbags, seat belts, ABS and power steering – yet still maintain the same essential primary goal of transporting you from A to B. This same comparison can be drawn between forwards and futures contracts.

 

 – A sneak peek into the Futures Agreement

Now that we are familiar with the shared transactional structure of futures and forwards, let us take a closer look at the differentiating features between these two. We will cover these features quickly in this chapter, yet dive deeper into each one later on.

Let’s consider this example: ABC jeweller comes to an agreement with XYZ to buy a certain amount of gold at a certain point in the future. But if they can’t find someone to enter into the agreement with, they are left without a choice – though they may have a strong opinion on gold and are willing to make a financial arrangement, there is no one to take the opposing side.

Picture this — ABC no longer needing to scout for a counterparty, but rather being able to step into a financial supermarket with plenty of potential counterparties willing to take the opposing view. This supermarket wouldn’t simply facilitate trading of gold, but instead offer a diverse range of asset classes including silver, copper, crude oil and stocks. All ABC needs is to announce their intentions and the customers will be lined up ready to do business.

In fact, Futures Contracts are accessible to all of us, not just ABC Jewerlers. The available markets on which they can be found are commonly referred to as “Exchanges,” such as a stock exchange or commodity exchange.

It’s evident that futures contracts and forwards contracts vary in structure. This is basically to confront the potential risks of the forwards market. Now, let us analyze the differences between these two agreements.

Though you may not have much understanding of Futures yet, we will soon examine a sample to put everything into perspective. Through this, you should be able to fully grasp how a Futures agreement works.

In the case of ABC Jewellers and XYZ Gold Dealers, the forwards agreement was based on gold and its price. But if we shift to a Futures Contract, it is based on the asset’s future price which is linked to the underlying. To put it another way, you can think of the underlying, and its corresponding futures contract as two sides of the same coin – whatever happens to one affects the other. For example, if gold’s price rises then there will be a corresponding rise in Gold Futures’ contracts prices; similarly, if gold’s price decreases then so does that of Gold Futures’ contracts.

In the case of ABC jewellers and XYZ Gold Dealers, they had reached an agreement to exchange 15 Kgs of gold of a particular purity. Nevertheless, when it comes to futures contracts, there is no room for negotiation since the parameters are already set.

Futures Contracts are highly liquid – If I enter into a Futures Contract agreement, as opposed to a forward contract, I need not be locked in until expiry day. This gives me an opportunity to adjust my outlook if need be and transfer the contract onto someone else, providing great liquidity.

Futures Market is highly regulated by the Securities and Exchange Board of India (SEBI). This ensures that all activities are closely monitored, making default a rare event. Such oversight ensures smooth functioning of the financial derivatives market.

Futures Contracts have expiry dates; these vary depending on the agreement. In the example from the previous chapter, ABC Jewellers had a three-month outlook for gold. In the futures market, contracts for ABC would be available in one, two or three-month increments. The date of termination is referred to as ‘expiry’. We will look at this concept in more detail soon.

Most futures contracts are cash-settled; this eliminates the worry of transporting the physical asset from one place to another, as only the cash differential is payable. Furthermore, the regulatory authority oversees and ensures complete transparency in the settlement process.

To conclude, the following table presents a comparison between the “Forwards Contract” and “Futures Contract.”

At this point, it’s essential to clarify the dissimilarity between spot and futures prices. In the case of gold, for example, we’re looking at two values: one in the regular market, known as the spot price, and another in the Futures market, or Gold Futures. Both movements are interconnected – if one rises, so does the other.

Considering our past observations, let us now switch our concentration to further subtleties of futures contracts.

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what is futures trading

Before your first futures trade 

Before we delve deeper into how a futures contract works, it is important to have a basic understanding of some aspects of futures trading. We will come back to these topics and go over them in depth at a later stage. For now, having a good grasp on the following elements is essential.

Lot size – Future is a standardised contract where everything is predetermined, including the lot size. This parameter determines the minimum quantity an investor must transact in the futures contract, which varies from one asset to another.

The contract value of ABC jeweller and XYZ gold dealer’s agreement is Rs.3.675 Cr; this figure is determined by multiplying the pre-decided lot size (15 kgs) with the price per gram of Gold, which is Rs.2450/- – resulting in a total of Rs.24,50,000/- per kilogram. Thus, it can be said that the contract value is determined by multiplying the quantity of an asset by its price.

Referring to the example of ABC Jeweller and XYZ Gold Dealers, on the day of the agreement,9th Dec 2014, both parties had simply agreed to honour their contract’s terms until its expiry date – 9th March 2015. There was no exchange of money done at this time.

In a futures agreement, both parties will have to put forward some money when the transaction takes place. This payment acts as a kind of guarantee for agreeing and is handed to a broker. The required sum is typically calculated as a percentage of the contract value; this is known as ‘margin amount’. Margins are important in futures trading, but we’ll explore this further down the line. For now, just bear in mind that entering into a futures agreement demands you pay a margin amount that is some proportion of the contract value.

All futures contracts are time-limited; to be precise, they have an expiry date. On this date, the contract will become invalid and ceases to exist, hence the expiration. Afterwards, new contracts will be introduced by exchanges.

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