What are
Futures?
To
understand futures we must know what a Derivative is. Derivatives are
financial contracts whose price/ value is dependent on the movement of the
price of one or more basic underlying assets (often simply known as
underlying). Underlying asset can be a 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 a
futures contract are:
-
Standardised contract
-
No counterparty risk –
stock exchanges act as counterparty i.e. the payment and execution
is through stock exchange
-
Ample liquidity –
futures are much more liquid and their price discovery is transparent
-
Squaring Off – futures
contract can be reversed on the screen of the exchange unlike forward
contract where it can be reversed with only the 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. 300 today and you expect it will touch Rs
450 in one month – What would you do?
-
Buy TATA STEEL
shares at Rs. 300
-
Other option is to buy
TATA STEEL Futures – Advantage is that you pay only say 20% of Rs. 300
(margin) and not the full value.
-
As you can increase
your commitment approx. 5 times the 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 price) or –ve (when
market value decreases compared to purchase price)
-
Are there any risks?
-
Losses can
multiply in the same proportion as profits
-
Can this risk be
minimised?
-
Squaring off of
position is allowed at any time
-
Hedging of
position can be done
