A futures contract is an agreement between buyer and seller committing to buy or sell an underlying instrument (equity/commodity) to be settled on the predetermined future date. On settlement on or before expiry date, difference between the initial price and the active price of the underlying shares is to be paid in cash. The trader buys or sells futures contract without ever owning the underlying shares, where he transacts in market lots.
If you want to buy 3,000 shares of a company at Rs 100 in cash market, you have to invest Rs 3 lakh. But in futures market, you need to pay only Rs 60,000 (assuming the exchange–fixed margin is 20 per cent) to stay invested till the expiry date, usually, last Thursday of the month. If the share price rises to Rs 110 your net profit is Rs 30,000 (10 pts x 3,000 shares). Here, one must consider downside risk as well.
Volatility can be very high in futures stocks as there is no circuit filter (5-20 per cent) applied on them. But in case of indices circuit filter comes into play.
Going ‘Long’ or ‘Short’: When a trader foresees an appreciation in any stock or index, he initiates ‘buy’ order to take position in the market (going long or bullish) at current price level and square off the transaction by selling the same on or before the expiry date.
In the same manner, if a trader anticipates down trend he initiates ‘short sell’ order (selling a stock without owning one) to take position in the market and square off the transaction by buying.
Margin: One has to pay only a small portion of total transaction value to enter into a futures contract. In case of reverse price movement, to remain in the contract, an additional amount called mark-to-market margin (difference between transaction price and current price), fixed by the stock exchanges, on a daily basis. Or else, the transaction will be squared off by the clearing house to avoid pay-out problems later.
Trading at premium/discount: The difference between the value of underlying stock/index in the spot and futures markets is called the basis, which will fall as expiry date nears and will become nil as price of both the segments become the same. The difference could be in premium or discount to spot market. Usually, at the beginning of a trading cycle, the value of particular stock/index futures always exceeds the value of that of stock/index in the spot market.
If futures price of a stock is trading at 150 points (pts) and spot price of that stock is 148 pts, then it is said that the futures stock is trading at 2 pts premium and vice versa.
Open Interest: In futures the number of ‘long’ always equals that of ‘short’ contracts. The contracts not squared off - long or short - at any point are known as "open interest”. Usually, rise in price, volume and open interest indicates rising interest in the stock. If price is rising and open interest and volumes are falling, weakness is seen. When price is falling and open interest and volumes are rising, then interest is said to be waning. In contrast, decline in price, volume and open interest highlights some fresh interest in the stock.
Settlement: All futures contracts must be squared-off or rolled over to the next cycle on or before the settlement date, irrespective of gain or loss incurred by the trader. He will receive his initial margin including additional mark-to-market-margins (paid if any), with added profit in case he is gaining.
On the other hand, he will receive the remaining money after deducting the difference between cost and selling price from initial and additional margins paid by him.
Spot price: Rs.400
Lot size: 1000
Contract value: Rs.4,00,000/-
Margin fixed by the exchange: 20%
To initiate long or short, pay Rs.80,000/-
If price moves up to Rs.410, if you square off, profit is Rs.10,000/-
If price moves down to Rs.390, and if you square off, you will lose Rs.10,000/-
Rollingover: Rollover is the process of squaring off the transaction in the current month futures and initiating a fresh position in following month futures contract. This may involve additional funds cost.