A Futures Contract is a legal agreement to buy or sell any underlying security at a future date at a pre determined price. The Contract is standardized in terms of quality, quantity, time and delivery place for settlement with the confirmation of future date. Both parties (Buyer and seller) entering into such an agreement that is obligated to complete the contract at the end of the contract period with the delivery of cash or stock.
All Futures contracts are traded on a Futures Exchange that plays the role of intermediary to reduce the risk. The Futures Exchange is also a centralized marketplace for both (buyers and sellers) to take place in Futures Contracts with access to all market information, trending and price fluctuation. Indian equity derivative exchanges make contracts on a cash basis.
To get the benefits and participation in such a contract, a trader has to put up first (initial) deposit of cash in their accounts known as the margin. If the contract is closed, the initial margin is credited with any profit or losses.
If the minimum maintenance margin is insufficient, then a margin call is made and the related party must immediately fulfills the shortfall. This process of ensuring daily gain or loss is called as mark to market. However, if a margin call is made, funds must be delivered immediately.
If the delivery date is due, the amount finally exchanged and is not the specified price on the contract but the spot value. We will understand this by example; suppose A is a trader holds equity of a company, currently trading at Rs 100 and expects the price go down to Rs 90. So this 10 Rs. differential could result in reduction of investment value.
On other hand there is a B who tracks the performance of company of A and feels that stock price may increase to Rs 130 in next three months. He (B) wishes to buy that stock at a lower price and sell it later when the price is higher for that stock in the future.
Now, A and B submit their orders to the Exchanges to enter into a Futures Contract with a time period of 3 months (that is maximum available time limit for futures segment). Both traders (A and B) hold their desired Futures positions as decided before, and then A will hold a short position against his holdings. Hence if the stock price drops below Rs 100, A will not get lose the value of his holdings as he remains hedged against the lowering of price.
In the above example A would be the seller of the contract where B would be the buyer. Market position of A would be short (sell) while B would go long (buy). This thus shows the expectations of A and B from the Futures Contract they have participated in – B expects that the asset price will be increase, while A expects that it will decrease.
Futures trading are used to both hedge and speculate possible price fluctuation of the stock.
With this article, we hope that you are ready for the Futures!