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Understanding futures

 

What are Futures?

To understand futures we must know what Derivative is. Derivatives are financial contracts whose price/ value is dependent on movement of price of one or more basic underlying assets [often simply known as underlings]. Underlying asset can be share, index, interest rate, bond, rupee dollar exchange rate, commodity, sugar, crude, oil, coffee etc.

Futures – Futures are exchange traded contracts to buy or sell an asset in future at a price agreed upon today.

Main features of futures contract are: 

  • Standardized contract
  • No counterparty risk – stock exchanges act as counterparty  i.e. payment & execution is through share exchange
  • Ample liquidity – futures are much more liquid & their price discovery is transparent
  • Squaring Off – futures contract can be reversed on screen of exchange unlike forward contract where it can be reversed with only same counterparty.

Benefits of futures: 

  • Enables Large positions with less capital outlay
  • Easy to cut losses – simply square off
  • Enables Short selling if  your view is bearish – without getting into any lending-borrowing

How does futures work – an example 

  • Bullish view – say TATA STEEL  trades at Rs. 3OO today & u expect it'll touch Rs 45O in one month – What would u do?
    • Buy TATA STEEL shares at Rs. 3OO
  • Other option is to buy TATA STEEL Futures – Advantage is that u pay only say 2O% of Rs. 3OO [margins] & not full value.
  • As u can increase your commitment approx. 5 times Returns multiply in derivatives market as compared to Cash market
  • On daily basis Mark To Market adjustment is made to your portfolio value which is either +ve [when market value increases compared to purchase prices] or –ve [when market value decreases compared to purchase prices]
  • Are there any risks?
    • Losses can multiply in same proportion as profits
  • Can this risk be minimized?
    • Squaring off of position is allowed at any time
    • Hedging of position can be done

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