People can trade in an underlying asset for a future date through derived financial contracts, called future contracts. Traders use these future contracts to generate huge profit from an eminent future move in stocks, bonds, currency, commodities. Like most financial contracts, both parties must transact assets at a predetermined future date and price.
You might think about the need to use a future contract when one could trade on that date too. The answer to this lies in simple reasoning, which you can understand through the following example rarely taught in stock market courses for beginners:
Let’s assess a relationship between AB Constructions Pvt Ltd and YZ Steel Ltd. YZ provides steel bars to AB Construction, which builds readymade pillars at fixed rates. AB Construction understands that the steel bar price rises a couple of months before monsoon season every year. As they have fixed rates for the pillars to stand in cutthroat competition, there is an enormous risk for them. If the price of steel bars soars very high, they will end up in loss and if they increase their price, they may lose their footing in the market. To solve this uncertainty problem, they sign up a contract with YZ Steel that AB Construction will buy 10 metric tonnes of steel bars at Rs 50k/metric tonne 3 months before the monsoon starts. This way AB protects itself from the risk of buying steel bars at an insane price and YZ secures a big order when the sales may drop due to price hikes and low demand in the monsoon. Thus, both parties managed their risk of uncertainty with a future contract.
To hedge a position or to manage risk for future uncertainty is the goal of a future contract.
Important terms to understand a futures contract:
Lot size: Unlike stocks where one can buy or sell a single share, futures contracts have to be traded in multiples of fixed quantities, called lots. E.g., the Nifty Futures contract needs to be traded in a multiple of the lot size of 50.
Spot price: The current price of the underlying asset of a futures contract is the spot price. E.g., the spot price of Reliance future contract will be the CMP (Current Market Price) of Reliance itself.
Open Interest: Open interest means the total number of open contracts of that future.
Expiry: Every futures contract has its expiry date. These contracts are available for the current and 2 upcoming months. They get expired on the last Thursday of each month. Apart from these monthly contracts, there are weekly contracts too.
Mark to market: Mark to market simply means that your broker will debit and credit daily profit and loss in your Demat account.
Types of futures contracts:
To minimise risk in the portfolio after completing share market courses online, investors hedge their positions, whereas traders hope to make an additional profit in the following asset class derivatives:
Commodity futures: These contracts derive their value from commodity products like energy, oils, base metals, agriculture products, etc. These contracts help to understand the local and global demand for raw materials which drives the overall sentiment of the market. Producers of these commodities use these futures to hedge on the future uncertainty like a policy reform, price volatility of the commodity, etc. You can trade these contracts on two major exchanges in India-Multi Commodity Exchange (MCX) and National Commodity and Derivatives Exchange (NCDEX). More information can be found from here: NSE INDIA
Currency futures: Also known as Forex or FX futures, these contracts derive their value from currencies. People exchange one currency for other for a future date to hedge against foreign exchange risk on NSE, BSE and MCX SX using these contracts. Non-native investors also utilise these contracts as a hedge against the currency devaluation risk. One instance of the utilisation of these contracts is FPI (foreign portfolio investment) investments in Indian equities. To protect their investments from the devaluation of the Rupee against the USD, these organisations use FX contracts. 1 Unit of this contract equals 1000 units of other currency in the pair.
In Indian markets, these contracts are available in the following pairs: USD/INR, EUR/INR, GBP/INR and JPY/INR. Cross currency F&O contracts on EUR/USD, GBP/USD and USD/JPY. More information is available here: NSE INDIA
Interest rate futures: These futures are based on their underlying asset like debt instruments such as government bonds, Transaction bills (T-bills), etc. Traders and investors transact these contracts on NSE and BSE for hedging against interest rate risk. These standardised contracts are based on 6, 10 or 13 years of Government of India Security (NBF II), and the 91-day Government of India Treasury Bill (91DTB). Investors and traders can trade in these future contracts on NSE in multiple lots where one lot equals 2000 units or 2 lakh Rs of government security. More information is available here: NSE INDIA
Equity Derivatives: These derivatives are classified into two subcategories:
- Stock futures: These derivatives are used for hedging in the stocks whose contract is available on NSE and BSE. Traders often use these contracts to speculate the markets in a volatile situation or when results are about to be declared.
- Index futures: These contracts are the most popular and traded ones in Indian markets with the highest volumes in Nifty50 and Bank Nifty. They are less risky than stock futures and are traded on NSE and BSE. The most common way to use an Index future contract is hedging done by a long-term Index ETF investor in Nifty 50 in a short term correction. Their strategies are in high demand inside stock market technical analysis courses.
The list of these available contracts is available on NSE INDIA.
Big organisations mainly use futures contracts to hedge their existing positions and mitigate risks. People should avoid using these contracts for mere speculation. Even if traders use it to profit from an imminent move, they should place an SL by applying technical analysis to the futures chart as taught in a stock market institute in Noida like GSF.