Who Buys/Sells Futures?

Futures contracts are generally traded by three groups of people - namely, the hedgers, the speculators and the arbitrageours.

Hedgers are those who want to hedge their positions against future losses. Let us assume that you are holding 100 shares of Reliance and that it is trading at Rs.2000/- per share today. You have seen that it has become unexpectedly volatile now and it has been giving you jitters. You expect the price to stabilise again after a month and that you would like to hold on to it till that time but at the same time you do not want to get panicky during the volatility. So, the best thing to do would be to sell 100 shares of Reliance Industries in the futures. So, in case of any downmove, the price of Reliance would come down both in the spot market and the futures market. So, any loss that you incur on the spot market will be made up by the profits in the futures markets. Conversely, if the price were to go up, any profits in the spot market would have been set off against the losses in the futures.

The second group of people are the speculators. These are people who like to buy when prices are low and sell when prices are high without any intention of holding their position open for a long period of time. While they can speculate in the spot market too but the advantage in futures is that for the same quantity of shares, they are required to pay only about 20% of the total amount as against the 100% that has to be paid if they were to buy the shares in the spot market.

Arbitrageours are people who take advantage of the high difference between the prices in the spot and the futures market. Let us understand this with the help of an example. Let us assume that Reliance Industries is trading at Rs.2000 per share in the cash market and Rs.2080 per share in the futures. The arbritageours think that this difference is too high and would like to cash in on the opportunity and cover their positions when the difference reduces. So, they buy 100 shares of Reliance at 2000 and incur a transaction cost of Rs.10/- per share and at the same time they sell 100 shares of Reliance at Rs.2080 per share and incur a cost of Rs.1.04 per share. After 20 days Reliance Industries is trading at Rs.1800 in the cash market and Rs.1810/- in the futures. At this time, they reverse their positions, thus selling 100 shares in the cash market at Rs.1800/- with a transaction cost of Rs.9/- per share and buy 100 shares in futures at 1810 with a transaction charge of 91paise per share. Their transactions will have the following effect:

Cash Market

• Bought 100 shares at Rs.2010/- (2000+10) per share at a total amount of Rs.2,01,000/-
• Sold 100 shares at Rs.1791/- (1800-9) per share at a total amount of Rs.1,79,100/-
• Total loss in transaction Rs.21,900/- on an investment of Rs.2,01,000/-

Futures Market

• Sold 100 shares at Rs.2078/96- (2080-1.04) per share for a total amount of Rs.2,07,896/-
• Bought 100 shares at Rs.1810/91- (1810+0.91) per share for an amount of Rs.1,81,091/-
• Total profit of Rs.26,805/- on an investment of Rs.41,600/- (20% margin money)

Net Profit

Net profit on the transactions is Rs.4,905/- (26805-21900) on a total investment of Rs.2,42,600/- (201000+41600) which means a return of 2.02% in just 20 days or 36.9% annualised.

How Are Futures Priced?

The world is full of uncertainty and so are the markets. Anybody who buys or sells a share in the markets is taking a risk. The buyer takes a risk that the stock price will not fall further while the seller takes a risk that the price will not rise further. And when it comes to predicting prices in the future, it is even more risky.

And when the risk is high, the returns should be higher. As discussed in previous examples, you are not entering into a contract with Mr. X but with the stock exchange. If you are required to pay 20% margin to the exchange, so does Mr. X have to. And if Mr. X is willing to take a risk and is investing 20% money, he expects a reasonable return on it. Considering 15% as the reasonable rate of return on stocks, he should be at least expecting a return of 1.25% every month. So, if Reliance is trading at 2000 today and he is expecting a return of 1.25%, he will be willing to sell Reliance at a price above 2025 (Rs.25 being the return he is expecting). This is also known as the cost of carry. Mr. X is charging you a cost of carry because he is locking up a part of his money and is either paying interest on it (if the funds are borrowed) or losing some interest on it if he had invested it elsewhere.

The other important factor while pricing futures is the time value. Uncertainty is directly proportional to the time to expiry. Anything can happen in a month - the inflation (declared weekly) may increase, the economy may show signs of slowing down, the company's main director may resign, the government may impose some restrictions on the company, a neighbouring country may declare war or the government may fall. But as you come closer to the expiry, the same is not likely to happen and the uncertainty considerably decreases. So, the time value is the maximum at the beginning of a contract and least when it is close to expiry. This uncertainty also demands a certain amount of premium. So, most likely, Mr. X would charge you Rs.2000 (the spot price of Reliance today) plus Rs.25/- (the cost of carry) and something more (the time value premium). Which explains why he was willing to sell Reliance at 2040 in the beginning of the month when the spot price was only 2000.

How Are The Profits Worked Out?

The profits and losses of a futures contract depend on the daily movements of the market for that contract and are calculated on a daily basis. For example, say the price for Reliance in the futures market increases to Rs.2070/- per share the day after Mr. X and you enter into the futures contract of Rs.2040/- per share. Mr. X, as the holder of the short position, has lost Rs.30/- per share because the price just increased from the price at which he is obliged to sell his shares of Reliance. You, as the holder of the long position, have profited by Rs.30/- per share because the price you are obliged to pay is less than what the rest of the market is obliged to pay in the future for Reliance. On the day the change occurs, Mr. X's account is debited Rs.3000/- (Rs.30 per share X 100 shares) and your account is credited by Rs.3000/- (Rs.30 per share X 100 shares). As the market moves every day, these kinds of adjustments are made accordingly. Unlike the stock market, futures positions are settled on a daily basis, which means that gains and losses from a day's trading are deducted or credited to a person's account each day.

In the stock market, the capital gains or losses from movements in price aren't realized until the investor decides to sell the stock. As the accounts of the parties in futures contracts are adjusted every day, most transactions in the futures market are settled in cash, and the actual physical shares/commodity is bought or sold in the cash market in other countries, but in India, that too, is settled in cash. Prices in the cash and futures market tend to move parallel to one another, and when a futures contract expires, the prices merge into one price. So on the date either party decides to close out their futures position, the contract will be settled. If the contract was closed out at Rs.2200/- per share, Mr. X would lose Rs.16000/- on the futures contract and you would have made Rs.16000/- on the contract on an investment of only Rs.40800/- (20% of the amount of 100 shares @ Rs.2040/-).

Give me a Simple Example of Futures

Let's say, for example, that you take a personal loan from a bank. You enter into an agreement with the bank to return the loan in 5 years by paying a specific number of EMIs, calculated on the basis of a certain interest rate, every month for the next five years. This contract made with the bank is similar to a futures contract, in that you have agreed to return the loan at a future date, with the price and terms for the loan already set. You have secured your EMI for now and the next five years - even if the interest rates increase/decrease during that time. By entering into this agreement with the bank, you have reduced your risk of higher interest rates.

That's how the futures market works. Except, instead of a bank, there is Mr. X trying to secure a selling price for Reliance for the end of the month, while you are trying to secure a buying price to determine that if the markets moves along your expected lines, how much profit you would earn. So Mr. X and you may enter into a futures contract requiring the delivery of, say, 100 shares of Reliance to you at the end of the month at a price of Rs.2040/- per share. By entering into this futures contract, Mr. X and you secure a price that both parties believe will be a fair price at the end of the month.

So, a futures contract is an agreement between two parties: a short position - the party who agrees to deliver the shares/commodity - and a long position - the party who agrees to receive the shares/commodity. In the above scenario, Mr.X would be the holder of the short position (agreeing to sell) while you would be the holder of the long (agreeing to buy). So, it's important to know that every contract involves both positions.

In every futures contract, everything is specified: the quantity and quality of the shares/commodity, the specific price per unit, and the date and method of delivery. The “price” of a futures contract is represented by the agreed-upon price of the underlying commodity or financial instrument that will be delivered in the future. For example, in the above scenario, the terms of the contract are 100 shares of Reliance at a price of Rs.2040/- per share.

What are 'Futures'? Give me an Example.

Buying or selling “futures” involves entering into a contract today to settle the contract at a pre-decided price on a pre-decided date in the future. This future date is known as the expiry date. Futures contracts detail the quality and quantity of the underlying asset. They are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash.

Let us understand with the help of an example. Suppose Reliance Industries is today trading at RS.2000/- in the spot market. You are bullish on the stock and expect it to be available near Rs.2200/- before the month ends. You see that Reliance Industries futures expiring this month is trading at Rs.2040/-. So, you enter into a contract today to buy Reliance Industries on the last day of the month from a person X at a price of Rs.2040/-. The settlement will be at the end of the month, i.e. you will pay for your shares on the last day of the month. But, Mr. X does not trust you, so he says that if you give him 20% of the money now; he would deliver the shares to you on the last day after you pay the balance 80%. You agree to pay him 20%, which is known as the margin money.

Now, let’s go forward to the end of the month. As expected by you, Reliance Industries is now trading at Rs.2,200/-. So, you contact Mr. X, take the shares from him, pay him the remaining 80% of the money @ Rs.2040/- and sell those shares in the market at Rs.2200/-, thus making a clean profit of Rs.160/- per share. But what if Reliance falls to Rs.1900/-? Sorry, but you would still have to buy the shares from Mr. X at Rs.2040/-, thus losing Rs.140/- per share.