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.