Market Live brings in the Stock Market Tutorial which explains the basics of trading in derivatives. Get answers to all your questions that you have about the basics of trading in futures, options and other derivatives.
- What are Derivatives ?
- So what exactly are futures ?
- What happens at expiry date of futures ?
- Why do they call the futures by name of months ?
- How to make profits in Futures trade ?
- Should I wait till the expiry for booking profits ?
- What is Lot size ?
- What is Mark to Market (MTM) settlement ?
Futures & Options are considered as ‘derivatives’ in the financial market. As the name itself suggests, derivatives are items that are derived from something else. So every derivative will be derived from an underlying asset. If the value of the underlying asset changes, the value of the derivative also changes accordingly. Usually, the underlying assets will be stocks, indices, commodities like gold, silver etc.
Let us consider an example of a derivative, which is based on the stock ‘Infosys’. So if the value of the stock changes during the trade in the market, then the value of the derivative also changes. Thus the underlying asset here is the stock of Infosys. Similarly as told before, the derivatives could be stocks of other companies, market indices like Nifty or Sensex, commodities like Gold, Silver, Oil etc. or even currencies such as the Indian rupee against US dollar and so on.
Future is a contract for trading the underlying asset for a specific price at a specific time. The price at which the trade takes place is determined at the time of entering the contract. However the trade will take place in the future.
For example, if you are entering a buying futures contract for the Infosys stock, then it means that you are agreeing to buy the underlying asset (the Infosys stocks) at the specified price. The price for the trade will be specified now. However the delivery of the underlying stocks will happen on a specified date called the “delivery date“.
If you are buying the underlying asset in the future, then you are called as “being long” for that asset. In this case, you hope that the asset price will increase in the future, thereby making profit for you.
Conversely, if you are selling the underlying asset in the future, then you are called as “being short” for that asset. In such a contract, you will hope that the price of the underlying asset will come down in the future, so that you can make profit.
Every futures contract is specified with an ‘expiration date’. This is the last date, at the end of which the contract will end. After this date, you will be required to stick on to the terms of the contract that you have entered to. A Final settlement will happen and if required, the delivery of the underlying asset will take place.
Cash settlement means that at the time of the contract expiry, instead of the actual delivery of the underlying asset, the corresponding equivalent cash will be settled between the parties of the contract. For example, the index futures such as the Nifty futures, are cash settled at the expiry of futures. However some commodities will have the physical delivery of the commodity itself after the expiry.
Usually, every futures contract is identified by its expiry date. For example, when we say Nifty futures for January, it means that we are talking about a futures contract, where the underlying asset is the Nifty index, that will expire in January. The exact date on which the contract will expire in every month varies. In the NSE, it is usually the last Thursday of that month. If that day happens to be a holiday, then the previous trading day is considered as the expiry date for all the futures contracts in that month. NSE & all the other exchanges publish the schedule of these expiry dates in advance for the entire year.
Similar to trading in stocks, you make profit by buying low and selling higher in the futures also. Similarly you can sell higher and buy at a lower price, thereby making profits.
Let us take an example to see this. Suppose on January 2nd, you buy a futures contract, containing 200 stocks of Infosys at a price of Rs. 1000. Let us assume that in our example, the expiry date falls on 29th of January. So if the price of the Infosys moves up to Rs. 1100, by the expiration date, then you make a profit of Rs.100 x 200 stocks = Rs. 20,000. However if the price falls below Rs. 1000, during this period, then you will be under a loss.
Very similar to this, you can sell the futures of an asset at a higher price, make profit if the price of the asset falls thereafter .
No, it is not necessary for you to wait till the expiry of the futures contract, to book profits. In fact, most of the traders, who trade in futures, square off their positions before the expiry. If you want to exit before the expiry, then you have to make a reverse contract for the same quantity of the asset.
For example, let us assume that you have bought the futures contract for 100 stocks of Infosys on Jan 2nd. And on 5th of Jan, the stock price has moved up, and you feel that you want to book the profits. Then you can sell the futures contract of 100 stocks, to square off and book the profit.
As a practice, when trading in futures, contracts are made in the multiples of the underlying asset. This is called as the Lot Size. This size varies from asset to asset. However it is pre-determined and announced by the exchange. Future contracts can only be traded in multiples of these lot sizes.
For example, for Infosys stock, the lot size might be declared as 200. It means that if you want to buy the futures of Infosys, then you have to trade a minimum of 1 lot comprising 200 stocks.
As another example, for the Nifty Index, the lot size might be declared as 50. It means that if you want to either buy or sell the futures of Nifty, then you have to trade a minimum of 1 lot comprising 50 units of the index value.
Since the futures price will generally vary daily, the difference in the prior agreed-upon price and the daily futures price is also settled on a daily basis. The exchange will take money out of one party’s account and put it into the other’s so that each party has the appropriate daily loss or profit. This continues till either the expiry of the futures contract, or till the holder squares off the contract.