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.

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