The terms futures and options are quite common in the derivative market and have attracted huge traffic over the past few years. To effectively trade in the futures contract, the primary requirement is to know its meaning. But wait there is more! Do you know the types of futures contracts? Confused? Worry not as we have the answers. Check out this blog to learn the basics of futures contracts and their types.
What is the meaning of futures?
Futures are financial contracts that allow traders to speculate on the price movement of underlying assets, such as commodities, currencies, stock market indices, or interest rates. These contracts obligate the trader to buy or sell the underlying asset at a predetermined price on a specified future date. In simple words, futures work like an agreement to buy or sell a certain quantity of a particular asset (like gold, crude oil, or the Nifty 50 index) at a fixed price on a specific date in the future. The fixed price is known as the “futures price” or “strike price,” and the specific date is the “expiration” or “delivery” date.
Read More: What is lot size in futures and options?
What are the types of futures?
When we talk about futures, the most common form of trading in futures is index futures or stock futures. However, there are many types of futures contracts that a trader can enter into. The types of futures contracts and their details are mentioned hereunder.
Stock Futures
Stock futures are standardized contracts that obligate the trader to buy or sell a specified number of shares of a particular company’s stock at a predetermined price on a future date. These contracts are traded on exchanges, providing traders with exposure to the price movements of individual stocks without actually owning the shares. Stock futures are commonly used by speculators, hedgers, and arbitrageurs. They allow traders to profit from both rising and falling stock prices.
Index Futures
Index futures are contracts based on a specific stock market index, which represents a collection of stocks selected to represent a market or sector, for example, Nifty 50 and BANKNIFTY. When trading index futures, traders are essentially speculating on the future direction of the overall market, rather than individual stocks. These contracts are popular for managing portfolio risk and for taking advantage of broader market trends.
VIX Futures
VIX futures are contracts tied to the CBOE Volatility Index (VIX), which reflects market expectations for future volatility. The VIX is often seen as a measure of market uncertainty. Traders use VIX futures to speculate on changes in market volatility. If a trader believes that market volatility will increase, they may buy VIX futures as a hedge against potential market downturns.
Commodity Futures
Commodity futures involve contracts for physical goods like gold, silver, crude oil, agricultural products, and more. Traders speculate on the future price movements of these commodities and enter into futures contracts. For example, if a trader expects the price of crude oil to rise, they might buy a crude oil futures contract. These contracts are important for hedging against price fluctuations for producers and consumers of these commodities.
Currency Futures
Currency futures are contracts tied to pairs of currencies, like USD/INR or EUR/INR. These contracts represent agreements to buy or sell a specific currency against another currency at a fixed exchange rate on a future date. They allow traders to speculate on changes in currency exchange rates. These contracts are commonly used by individuals and businesses to hedge against currency risk resulting from international transactions and investments.
Interest Rate Futures
Interest rate futures are based on the future value of interest rates, often tied to government bonds or other financial instruments. Traders speculate on changes in interest rates. If a trader expects interest rates to rise, they might sell interest rate futures to profit from the expected increase in rates.
Who regulates futures in India?
The Forward Markets Commission (FMC) was the regulatory authority for India’s commodity and futures markets. It operated as a division under the Ministry of Finance, Government of India, and was subsequently integrated into the Securities and Exchange Board of India (SEBI) in September 2015.
What are the basic terms of future trading in India?
| Term | Description |
| Futures Contract | A standardized agreement to buy or sell an underlying asset (like stocks, commodities, indices, etc.) at a predetermined price on a specific future date. |
| Underlying Asset | The asset on which the futures contract is based, such as a specific stock, commodity, index, or currency pair. |
| Expiration Date | The date on which the futures contract expires. |
| Strike Price | The fixed price at which the underlying asset will be bought or sold when the futures contract is executed. |
| Contract Size | The quantity or amount of the underlying asset specified in a single futures contract. |
| Margin | The initial amount of money required to open a futures position. It acts as a security deposit to cover potential losses. |
| Mark-to Market | The daily adjustment of the futures position’s value based on the current market price. |
| Leverage | Using a relatively small amount of capital (margin) to control a larger position. |
| Hedging | Using futures contracts to offset potential losses from price movements in the underlying asset. |
| Speculation | Trading futures with the aim of making profits from price movements, without necessarily owning the underlying asset. |
| Market Order | An order to buy or sell a futures contract at the current market price. |
| Limit orders | An order to buy or sell a futures contract at a specific price or better. |
| Long Position | Holding a futures contract with the expectation that the price of the underlying asset will rise. Traders buy to go long. |
| Short Position | Holding a futures contract with the expectation that the price of the underlying asset will fall. Traders sell to go short. |
| Cash Settlement | A settlement process where the contract’s gains or losses are settled in cash rather than through physical delivery. |
| Initial Margin | The initial deposit required to open a futures position. It ensures that traders have enough capital to cover potential losses. |
| Maintenance Margin | The minimum amount of equity a trader must maintain in their account to keep a futures position open. |
| Margin call | A notification from the broker that a trader needs to deposit more funds into their account to meet the maintenance margin requirement due to losses. |
What are the benefits of F&O trading?
Futures and Options (F&O) trading offers several advantages to traders. It provides an avenue for leveraging investments, allowing you to control larger positions with a smaller capital outlay. F&O contracts also enable diversification beyond traditional assets, like stocks and bonds, into commodities, indices, and currencies. They serve as effective risk management tools, allowing you to hedge against potential losses from market fluctuations. Moreover, F&O trading caters to both bullish and bearish market views, enabling you to profit from price movements in either direction. However, it’s crucial to approach F&O trading with a well-informed strategy, as the amplified gains come with increased risk. Adhering to regulations and practising disciplined risk management are key to capitalizing on the benefits of F&O trading.
Conclusion
Trading in futures contracts requires a thorough understanding of the derivative market as well as the movement of the underlying asset to correctly determine the trading position and entry and exit points. While trading in futures has been gaining huge volume on stock exchanges, traders should also understand the pitfalls and therefore trade carefully.
