Futures – About, Trading, Prices, etc.,

Futures are exchange-traded derivatives contracts. These contracts help in locking the future delivery of a commodity or stock at a price set today.

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What is a derivative contract

A derivative contract is a financial instrument that derives its value from the underlying assets, such as stocks, bonds, commodities, currencies, or interest rates.

Derivative contracts are agreements between two parties to buy or sell the underlying asset at a specified price and date in the future. The value of a derivative contract is based on the price fluctuations of the underlying asset.

A Fut contract is one such exchange-traded derivatives contracts. It is a form of financial trade that involves speculating on the potential of a stock. The two parties involved take opposing positions, with one agreeing to buy shares and the other agreeing to sell them at a specific price at a later date, regardless of the current market price.

Read: More derivative contract types

How futures trading works with an example

Suppose an investor is interested in purchasing futures of a company, ABC Ltd. The investor believes that the value of ABC Ltd will rise in the future. The current market price of the ABC Ltd stock is Rs. 100 per share.

The investor decides to buy 1 lot of ABC Ltd Fut, where each lot consists of say 100 shares. The Fut price for ABC Ltd is set at Rs. 110 per share, and the expiration date of the Fut contract is the last Thursday of the month.

Since the investor is buying a futures contract, they only need to pay a margin amount, which is a percentage of the total contract value. The margin required for ABC Ltd Fut is say 20%, so the investor needs to pay only Rs. 2,200 (20% of Rs. 11,000).

If the value of ABC Ltd shares rises to Rs. 120 per share by the expiration date, the Fut price will also increase to Rs. 130 per share (Rs. 120 current market price + Rs. 10 profit). The investor can now sell the futures contract at the current market price of Rs. 130 per share, resulting in a profit of Rs. 2,000 (Rs. 130 – Rs. 110). That’s a whopping 90.9% return on the margin. This is an example how leveraging works in Futures trading.

On the other hand, if the value of ABC Ltd shares falls to Rs. 90 per share by the expiration date, the Fut price will decrease to Rs. 100 per share (Rs. 90 current market price + Rs. 10 loss). The investor can either sell the futures contract at the current market price of Rs. 100 per share, resulting in a loss of Rs. 1,000 (Rs. 110 – Rs. 100), or hold onto (or carry over) the contract until the value of the stock increases again.

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How prices of Futures are determined?

The price of futures is determined by a combination of fundamental factors, such as the spot price, interest rates, and government policies, as well as technical factors such as supply and demand, volatility, and time to expiration.

1. Spot price: The price of the underlying asset, which the Fut contract is based on, has a direct impact on the price of the Fut contract. The higher the spot price, the higher the price of the futures contract.
2. Interest rates: The interest rate differential between two countries can affect the Fut price. Higher interest rates in one country relative to another can lead to higher Fut prices for the currency of the country with higher rates.
3. Time to expiration: The longer the time until expiration, the higher the price of the Fut contract.
4. Volatility: Higher volatility in the underlying asset can lead to higher prices for Fut contracts. There are several ways in which volatility can impact Fut prices in the market:
   • Increased demand: As volatility increases, investors may seek to hedge their exposure to price fluctuations by buying Fut contracts. This increased demand for Fut contracts can drive up the price of the contract.
   • Increased risk: Volatility is often associated with increased risk, and this can lead to higher prices for Fut contracts to compensate investors for the added risk.
   • Changes in margin requirements: Higher volatility can lead to changes in margin requirements for Fut contracts. Margin requirements are the amount of cash or securities that investors are required to deposit as collateral for the Fut contract. So, As volatility increases, margin requirements may also increase, which can lead to higher prices for Fut contracts.
   • Implied volatility: The implied volatility of a Fut contract is the market’s expectation of future volatility. Higher implied volatility leads to higher prices for Fut contracts, as investors are willing to pay more to protect against price fluctuations.
   • Price limits: Some Fut contracts have price limits. These limits are designed to prevent excessive price movements. As volatility increases, the likelihood of hitting these price limits increases, which can lead to higher prices for Fut contracts.
5. Supply and demand: The most significant factor in determining the price of Fut is the supply and demand for the underlying asset. So, If there is more demand for the asset, the price of the Fut contract will rise, and vice versa.
6. Government policies: Government policies can have an impact on the price of Fut in the market. For example, changes in import/export policies or subsidies can affect the demand and supply of commodities, which can lead to changes in the price of Fut contracts based on those commodities.
7. Dividends: Read Impact of dividend on Future price and calculation

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