Part 2: Futures and Options – How do Futures work?

by Manshu on April 20, 2012

in Investments

Between Options and Futures – I would say that Futures are a lot easier to understand than Options since they pretty much work in the same manner as shares. A Future is a contract between two people that has to be settled sometime in the future and with respect to the Indian stock market, here are the important things that you need to consider.

1. Not all stocks have Futures: There are only a handful of shares that have Futures traded on them and you can buy or sell Futures only on those shares. You can look at the list that your broker offers to see if you can trade Futures in a particular stock or index or not.

2. Futures have an expiry date: All Futures have an expiry date, and in India you can buy Futures of three durations – one that expire in the current month, one that expire in the coming month, and a third one that expires in the third month. All Futures contract expire on the last Thursday of the month. So, while in April you can buy an April contract that will expire on 26th April 2012, the May Future will expire on 31st May 2012 and the June Future will expire on June 28th 2012.

3. Futures are traded in lots: You can buy or sell one share of Infosys but Futures have predetermined lots and you have to buy or sell in those many multiples of shares. For example, an Infosys Future has a lot of 125 so when you buy one Future contract of Infosys – it is like buying 125 shares at a go.

The big difference however is that you won’t have to actually pay the price of 125 shares, but only cough up a margin amount which is usually a lot less and depends from one share to the other. Volatile stocks need more margin and less volatile shares need lesser margins.

4. You pay or get only the difference in value in Futures trading: Say you buy Nifty Futures on April 17 2012 when they were trading at Rs. 5,321; one Nifty lot is of 50 shares. Now, if this moves up by 20 points and reaches 5,352 and you sell the Future – you will net 20 x 50 = Rs. 1,000 as profit. On the other hand if it went down by 30 points and you decided to sell you will have to bear a loss of 30 x 50 = Rs. 1,500. If the margin requirement for this contract is 11% then you should have about Rs. 30,000 (11% of 50 x 5321) in your account to take this exposure. If the exchange or broker finds that the money in your account is less than the margin then it will automatically square your position (they will sell it if you bought the Future and buy it if you sold the future).

You can sell your Future at any time before the expiry and on the day of expiry your Future will be cash settled which means that you will either pay the difference if you are in a loss or you will be paid the difference if you are in profit.

5. You can sell a Future without owning it first: Since a Future transaction is settled on a upcoming date, it is possible to sell a Future without actually owning it. This is called going short and this is a useful feature of Futures since you can’t go short using a stock.

For example, you could sell a June Future today without owning it first, and you have till June 28th to buy back your Future and square your transaction. In this case you make profit when the price of the share goes down because you have already sold the share and are hoping to buy it back at a lower price.

Theoretically, this is more dangerous than buying a Future because there is no limit to how high a share can go. Practically, the limit is as much money as is present in your account and allocated for margin. Once your margin is triggered – the broker will square your transaction by buying back the share, and I think you should only buy or sell a Future if you are sure you can track it very closely throughout the day and if you can handle the volatility and price difference. If you’re buying so many Future contracts that your margin is close to being triggered you will never be at peace and even daily volatility can trigger a sale and make you lose a lot of money very quickly. In fact, it might just be better to buy Options instead of Futures because then your loss is defined.

I think I have covered the basics of Futures and if you have any questions then a leave a comment and I’ll answer that. In the next part I’ll take up how Options work.

{ 25 comments… read them below or add one }

CA Karan Batra April 20, 2012 at 9:49 AM

Thanks for the informative article Manshu

I would like to add one more thing here which is very rarely known about futures and that is the fact that in India the value of 1 Lot of a Future is Rs. 2,00,000 approx.

NSE & BSE try to maintain the value of a lot at Rs. 2,00,000 approx and in case the value increases/decreases due to increase/decrease in the share price, the lot size is also decreased/increased to keep the value at Rs. 2,00,000 approx

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Paresh April 20, 2012 at 10:57 AM

Yes.I think these changes takes place after heavy correction in stocks in 2008.Before,there was a fixed lot system independant of the future price ..thereafter it was changed to variable lot system with change in price.

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CA Karan Batra April 22, 2012 at 8:25 PM

Yes Paresh – you are right

Changing the lot size occurs only when there is a huge deviation in stock prices which affects the total value of the contract and the contract Sizes of almost all contracts were changed after the 2008 Fall

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Manshu April 22, 2012 at 8:40 PM

Thanks for adding that Karan.

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CA Karan Batra April 23, 2012 at 4:21 PM

Your welcome Manshu 😉

I was doing my internship in a stock-broking firm in 2008 when the market crashed, so I have a fair idea of how the stock market works and all developments that took place during that time.

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santonu April 21, 2012 at 11:11 PM

Yes, your article is very much informative and it may clear many doubts in the mind of investor.By going through serial No:04, everybody will be tempted to earn Rs.1000/- by 20 points movemet of Nifty.( it is possble even in 10-15 seconds).So nifty future trading can make you earn big money in single trading day. But I must suggest investor to keep away from future trading as it may even wipe out all your wealth on one bad day. Unless you have money , have courage to withstand 500 point volatility of Nifty (which may need 10-15 lakh roughly),better avoid it.
Sir you could have said about hedging technique. That is you have a buy position of a stock in April ’12 ,if stocks goes down alarmingly ,then immeiately sell a contract of May’12 instead squaring April contract. I am not sure whether this method is helpful or not but definately it may reduce your loss.
Sir , would you give your guidance regarding stoploss .Whether Stoploss should be applied or not. In most case stop losses are triggered.
Sir can you also clear my doubt that how price of contract of two different months moves in tandom( lets trading activites are going in April contract but no trading is going on may contracti.In such case if April contract moves up then May contract also moves up by the almost same points though trading is not taking placein May contract)

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Manshu April 22, 2012 at 8:08 PM

If the May contract is not trading or doesn’t have as much volumes then it won’t go up by the same amount is my guess. The far month contract is usually priced higher than the near one because it has more time to expire.

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santonu April 22, 2012 at 11:06 PM

Actually my doubt is related to commodity future. Two contract of two different months always maintain a constant difference.In case of Zinc,Aluminium or lead, the difference is almost Rs.1. Now April Zinc LTP is around 105 and May is 106. How this diffference is maintained if trade is not taking palce or with less volume in contract of one month

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Paresh April 23, 2012 at 12:27 AM

As far I think,there is always less volume in next contract and results in larger difference in Buy-Sell values only..it won’t affect the net price movement..Tick size for zinc is 5 paisa . But Most of the times in next Zinc contract one can find that Buy Price:105 and sell Price: 105.10…though net movement will be same in both of the contract under normal situations.
Under abnormal situations where number of traders get trapped in the wrong trade,chances becomes quite higher that hedging positions are added abnormally in next contract and difference gets higher or lower than the normal situations..This kind of scenario frequently being seen in commodities like Natural gas where difference in two contact is always abnormal…..
Finally Commodities are global assets…Value of Zinc whether in two contracts or at two different nations should have uniform trends….Otherwise it will be simple arbitrage opportunity for traders.
I remember,few years back one of the exchange conduct commodity trading awareness seminar in our city and one of member of FMC was the speaker…After seminar,number of people asked their doubts…I have also one:”How prices at MCX/ICEX able to achieve exact simulation of COMEX prices and that is also without having any time lag??” He just answered that its more about technical question and technical person can only answer it…But exact simulated trend indicate that there are low chances of local manipulation….and in that sense its safe to trade in indian commodity markets.

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santonu April 23, 2012 at 7:51 AM

Thanks , still there are lot of intricacies to be solved

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Paresh April 23, 2012 at 9:28 AM

You are true that there are lot of intricacies to be solved…
Just I was sharing my thoughts about commodity market.

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CA Karan Batra April 23, 2012 at 4:14 PM

@Santonu

Irrespective of whether there is volume in a share or not, the price of the far month always moves in correlation with the price of the near month

Both the buyer and the seller of the far month have a fair idea of the prices of the near month and expect a higher price in the far month. That is just commonsense that the price increases with passage of time.

As the time to expiry is more for the far contract than the near contract the prices of far contract will always remain higher in most of the cases

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CA Karan Batra April 23, 2012 at 4:18 PM

As far as stop-loss is concerned, it is a good practice to put a stop-loss trigger price and technical experts always suggest a stop-loss.

You are right in saying that stop-loss price usually get triggered but all experts suggest that you should put a stop-loss

PS: I personally dont put a stop-loss price and prefer to monitor the screen and prefer to sell it when I expect prices to be falling down rather than putting it to auto-sell

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CA Karan Batra April 23, 2012 at 4:18 PM

Feel free to ask in case there is any other query wrt Future & Options

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Umesh August 9, 2012 at 8:55 PM

Hi Karan

Can you please write a few lines on, how to trade in options and how call and put options are used as hedge for future trading. If possible please explain citing nifty as example

BTW, I know future trading and trade in nifty future.

Thanks

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Paresh April 23, 2012 at 5:14 PM

I think that stop loss orders attracts prices towards self as similar to the lightening is attracted by fewer of the objects.
Sometimes trader is thrown out of trade as similar to bus conductor kick off the extra passenger….and bus moves on.

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PP June 24, 2012 at 6:55 PM

waiting for part3

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Manshu June 25, 2012 at 5:09 PM

Wow! I don’t know how, but I had completely forgotten that I was meant to write this series….thanks for the follow up PP. I’ll pick it up next week.

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Umesh August 9, 2012 at 8:26 PM

Hi Manshu

I searched for the third part of this series, but could not be able to locate. Can you please post the link. OR I am missing something, you have not posted the third part yet.

Thanks

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Manshu August 11, 2012 at 10:18 PM

Hi Umesh, I’m sorry I’ve been very lazy with this and have not posted the third part yet. I will try to write about Options shortly.

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Souvik Ghosh November 29, 2013 at 9:09 AM

“EXPIRY OF FUTURE ” – IS IT POSSIBILE ?

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Maynard August 7, 2015 at 4:52 PM

Wow, thius paragraph is good, my sister is
analyzing such things, therefore I am goiong to
let know her.

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venu swamy May 28, 2016 at 2:19 PM

Sir,
How to square off value of stock.if we (not settled)leave the short position of stock till the last second of the contract period.

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ANURAG VERMA June 4, 2016 at 8:45 PM

sir i have a doubt..
suppose u buy a future in a commodity say some vegetable ( if it is even possible)…… who is the issuer of the future??
and on the expiry date of the contract if u are holding the future, will u have to take the delivery of the agreed quantity of thet vegetable??

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Rupendar Singh Rathore February 15, 2017 at 11:44 PM

Dear Sirs/madams,
I just wanted to know how does the settlement of future works..Can you please explain me.my knowledge regarding this is very basic. Thank you in advance

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