Trading in Futures: A Beginner’s Guide

Introduction

F&O – Futures and Options – is a profitable space if you are a high-risk taker. However, it is not as easy as it sounds. Here are a few skills to develop, knowledge to gain, and things to remember when you think of trading in futures.

Futures are derivative contracts getting their value from the underlying stock / currency / commodity / index / any other instrument. When we are dealing with such kinds of instruments, it is important to understand that the underlying and the future contract are related in a certain way.

Before diving deeper into how to trade in futures, here are a few technicalities to understand:

1. Margin – Since you do not own anything in the futures segment, you have to maintain a margin (a deposit) with your broker at all times. Based on the quantity of your futures position, the margin is calculated by your broker. It is a sort of safety deposit in case you incur any loss in your position.
2. The P&L calculation – When trading in futures, you have an option to carry forward your contract to the next day for a period of 3 months. However, the profit or loss that you incur every day is squared off daily. It means that your daily profit or loss will be effected in your trading account. Hence, even though you took a long (buy) position in say USDINR futures at 73.2000 and sell off the position after 10 days at 73.2550, your profit simply won’t be INR 55 (0.0550 x 1000) per contract (1 USDINR futures contract includes 1000 units of USDINR). With brokerage being subtracted, your actual profit would be around INR 30, for example. Be careful of how much brokerage your broker charges. (Quick Advice: Check the contract note to understand all the charges apart from brokerage).
3. While futures contracts get executed on their own on the expiry day, you can exit the position before expiry. Also, futures contracts are exchange-traded.
4. Futures can be taken on Carry-forward basis where you hold the position over several days. They can be taken for a single day where the position gets squared off (exited) on the same day itself.
5. Most futures contracts are cash-settled, i.e. no delivery of the commodity is made. The profit/loss is effected in the trading account balance.

Understanding the theory of Futures

As the term suggests, futures refers to the future possible price of the underlying asset. One may anticipate the price to go up or down or remain the same. Based on the anticipated future price, a trader will either take a long (buy) position or short (sell) position in the futures market. When the trader anticipates the price to go up in the future, he/she will take a long position otherwise he/she will take a short position.

Ideally, the price of any futures contract at expiry has to be equal to the spot price of the underlying asset. However, in reality, that may or may not be the case for multiple reasons.

Reasons for entering into the Futures market

One of the main reasons traders enter into the Futures market is to gain the advantage of the leverage. In Futures, the trader is liable to deal only with the margin amount and not the actual value of the contract. For example, stock A is trading at INR 5,000 per share in the spot market. A trader is bullish about stock A but cannot afford its hefty price. Hence, he will look out for alternatives. In the Futures market, stock A futures is available at a margin of say INR 3,000 per lot (assume one lot equals 10 shares). At this margin, it is easy for the trader to trade a higher sum for a lower amount of money blocked. The leverage the trader gains by trading in Futures gives him/her a chance to trade in multiple commodities which he/she would have otherwise not been able to afford.

The second reason is hedging. Hedging is simply mitigating current risk by taking new positions. For example, company A based in India has to pay USD 1,00,000 to company B based in the USA in say the next two weeks. However, considering the current economic situation in India, company A anticipates the value of INR to depreciate against the US dollar. Company A decides to take a long position, i.e. buys 100 lots of the USDINR Futures contract (note: 1 lot = USD 1,000). As anticipated, the price of INR against USD depreciates in two weeks and company A exits its position to gain a profit. The profit makes through this trade, sets off the loss made by company A while making the payment to company B at the end of two weeks.

The third reason is speculation. Certain traders have no above-mentioned motives behind entering a position in the Futures market. They solely enter the market to gain profits. They speculate, i.e. anticipate the upward or downward movement and take positions. Such traders make the market volatile.

The fourth reason is arbitrage. Arbitrageurs aim to book profits by tapping into the price differential between two markets. They help converge the futures price with spot price by closing out the difference in the price of the underlying in the two markets. For example, if the futures price is trading higher than the spot price, arbitrageurs will buy the underlying in the spot market and sell the futures contract in the futures market. This helps in closing out the difference and gain profits from both the markets.

Things to remember when trading in the Futures market

Now that you know the basics of the futures market, here are certain things to keep in mind:

1. Futures contracts require maintaining margin at all times in the trading account.
2. Never forget to put a stop loss while taking a position. You definitely do not want to lose all your life savings.
3. Unlike options, futures obligate you to exit the position and book a profit/loss at expiry.
4. Futures contracts are tradeable, and hence, you can exit the position until the expiry of the contract.
5. On expiry, a futures contract gets exited automatically. Every month, traders take fresh positions in the market even though they are rolling over their position.
6. Understand the underlying and the futures contract well before entering into any position. For example, if you anticipate INR’s value to appreciate, you will have to short (sell) the USDINR futures contract and not buy the contract. This is because the USDINR contract shows the value of INE against USD and hence, if the contract value rises from 74 to 74.25, the value of INR has risen against the USD which means, one has to pay a higher amount of INR to get 1 USD. This shows that the value of INR has depreciated.
7. Learn about hedging risks so that you can cover up the losses made, if any, in the futures market.
8. Keep emotions away and use mathematical methods or indicators while trading in futures. To get accustomed to a few profitable methods, read the article on Volume Spread Analysis, Fibonacci Retracements and other important technical indicators.

Happy Investing!

Disclaimer: This article is meant for educational purpose. Certain jargons have not been used in order to simplify the concepts. This blog aims at targeting beginners in the market with little to no knowledge about trading.