In the world of the stock market, futures and options always attract many market participants, whether they are swing traders, short-term traders, or intraday traders. The options segment attracts many retailers these days, mainly because it requires a small amount of capital, starting at around Rs 5,000.
On the other hand, futures require a larger amount of capital compared to options. Today, we are not going to focus on options but on futures. So, before delving into futures, we need to understand forward contracts.
A forward contract is an agreement made directly between two parties to buy or sell any asset on a specific date in the future at the terms decided today. A forward contract is an over-the-counter (OTC) transaction where two parties agree on all the terms and conditions, and there is no regulatory body involved to protect the parties in case of default.
This is where the role of futures contracts comes into play. Futures contracts were introduced to overcome the limitations of forwards. A Futures contract is an agreement made through an organized exchange to buy or sell a fixed amount of an asset on a future date at an agreed-upon price. In other words, it is a standardised forward contract that is traded on the exchange. A trader who buys the futures contract takes a long position, and the one who sells takes a short position.
In this article, we are focusing on the basics and common terminologies of futures contracts, without delving into advanced concepts.
- Spot Price: The price at which an asset trades in the cash market. Let’s say the Nifty50 index is trading at around 19,800; this is the spot price or the levels as of writing this article at around 10:50 AM on October 10.
- Futures Price: The price of the futures contract in the futures markets. As of now, the futures contract of the current month’s expiry is trading at 19,845 levels.
- Lot Size: Futures and contracts are traded in lots; every stock or index has its own lot size. For example, the Nifty index has a lot size of 50.
- Contract Cycle: It is the period over which a contract trades. Currently, the maximum number of contracts for index futures is a 3-month contract cycle, which includes the near month (October), the next month (November), and the far month (December). These contracts expire on or before (in case of a holiday) every last Thursday of the respective months.
- Expiration Day: This is the day on which a derivative contract ceases to exist, and it marks the last trading day of the contract. As mentioned, it is generally the last Thursday of the month unless it is a trading holiday on that day. On the expiry day, all the contracts are compulsorily settled. If a contract is to be continued, then it must be rolled over to the near-future contract. For a long position, this means selling the expiring contract and buying the next contract, and the same applies for short positions.
- Tick Size: This is the minimum allowed in price quotations. Exchanges determine the tick sizes for traded contracts as part of contract specifications. The tick size for Nifty futures is 5 Paisa. The bid price is what the buyer is willing to pay, and the asking price is what the seller is willing to sell.
- Contract Value: As mentioned above, future contracts trade in lots, and to calculate the contract value, we need to multiply the price by the lot size. In our example, Nifty is trading at 19,845, and the lot size is 50, so the value comes to Rs 9,92,250 per lot.
- Basis: The difference between the spot price and the futures price is called the Basis in the futures markets. If the future price is greater than the spot price, the basis for the asset is negative; similarly, if the spot price exceeds the spot price, the basis is positive. In our example, the basis is negative for Nifty today, as the future price is higher than the spot price. Please note that the basis will converge to zero at the time of future contract expiry.
- Initial Margin: An exchange guarantees the settlement of all trades to protect itself against default by either counterparty; it charges margins from brokers, and brokers, in turn, charge margins from customers. The amount one needs to deposit in the margin account at the time of entering into a futures contract is known as the initial margin. As mentioned above, the contract value is Rs 9,92,250, and if the broker charges, let’s say, a 10% margin, then the initial margin would be Rs 99,225 per lot. Both parties need to pay the initial margin, and the initial margin depends on the price movement of the underlying asset. Higher volatility assets carry more risk, so the margins would be higher.
- Mark to Market: In futures markets, while contracts have a maturity of several months, profits and losses are settled on a day-to-day basis, which is called mark-to-market (MTM) settlement. The exchange collects money from the loss-making participants and pays the gains on a day-to-day basis.
We have not covered the open interest and related concepts in this article. Stay tuned with us for the next part of this article where we will cover other related terminology.
Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. It is based on several secondary sources on the internet and is subject to changes. Please consult an expert before making related decisions.