Understanding Futures Contract and Its Types, Mechanics in Trading

In the previous chapter, we explored the basics of derivatives, laying the groundwork for understanding the various financial instruments that play a significant role in the market. As we move forward, this chapter aims to simplify and bring to light the concept of futures contracts, an integral part of the derivatives family.

This chapter delves into the mechanics of futures contracts, focusing on their structure, the necessity of margin requirements, settlement dates, and the options for delivery. Additionally, we'll analyse the factors that influence futures prices and outline the different types of futures contracts available, such as stock futures, currency futures, and commodity futures.

Understanding futures contracts is vital for anyone involved in the financial markets, whether for investment, trading, or risk management purposes. By the end of this chapter, you'll have a clearer understanding of how futures contracts work, their benefits, and their risks, setting a solid foundation for further exploration of the equity derivative market.

What are Future Contracts?

Futures contracts are agreements to buy or sell an asset at a future date at a price agreed upon today. These financial tools are widely used across India for various purposes, including hedging against price fluctuations in commodities, currencies, and financial instruments.

Mechanics of Futures Contracts

In this section on the mechanics of futures contracts, we will unpack how these contracts work, focusing on their specifications, margin requirements, and the processes of settlement and delivery.

Contract Specifications

Futures contracts are standardised to ensure consistency and liquidity in the market. This standardisation covers the quantity and quality of the underlying asset being traded. 

For example, an oil futures contract is typically for 1,000 barrels of oil. This means if you're trading in oil futures, you're dealing with contracts that each represent 1,000 barrels of a specified quality of oil. This standardisation simplifies trading, as it allows all market participants to know exactly what is being bought and sold.

Margin Requirements

To enter into a futures contract, traders must deposit a margin, which is a fraction of the total value of the contract. This deposit acts as a form of security to ensure that traders can cover any losses they might incur. The margin requirement allows traders to leverage their positions, enabling them to control large amounts of the underlying asset with a relatively small amount of capital. 

For instance, if the margin requirement is 10%, a trader can hold a position worth ₹1,00,000 with just ₹10,000. This can amplify both potential gains and losses, making it essential for traders to manage their risk carefully.

Settlement and Delivery

Futures contracts can be settled in two main ways: through physical delivery of the asset or via cash settlement. In physical delivery, the underlying asset of the contract is actually delivered on the settlement date. 

However, most futures contracts are settled in cash, meaning that no physical asset changes hands. Instead, the difference between the initial contract price and the market price at settlement is exchanged. The settlement date is crucial as it is when the contract comes to an end, and all obligations must be met.

Participants in future markets

In the futures market, participants can generally be categorised into three main groups: hedgers, speculators, and arbitrageurs. Each plays a unique role in the functioning and liquidity of the market.

• Hedgers

Hedgers are individuals or companies that use futures contracts to secure the price of the underlying asset they want to protect against future price fluctuations. Their main goal is not to profit from trading futures but to mitigate the risk of price changes that could adversely affect their business or investment portfolio. 

For example, a farmer might use futures contracts to lock in a price for their crop months before it is harvested. If market prices fall by the time the crop is ready for sale, the farmer is protected against the loss because they've already secured a higher sale price through the futures contract.

• Speculators

Speculators, on the other hand, are traders who participate in the futures market with the aim of making a profit from the price volatility of the underlying assets. They do not necessarily have an interest in the physical assets themselves but rather in the price movements. Speculators are willing to assume the risk that hedgers try to avoid. They make educated guesses on the direction in which they believe the market will move and buy or sell contracts accordingly. If their predictions are correct, they stand to make a significant profit; however, they can also incur substantial losses if the market moves against their positions.

• Arbitrageurs

Arbitrageurs are participants who look for and exploit price discrepancies between different markets or related assets. They engage in arbitrage, a strategy that involves simultaneously buying and selling an asset to profit from a difference in price. 

For example, if a futures contract is trading at a lower price on one exchange than on another, an arbitrageur might buy the contract on the first exchange and sell it on the second, capturing the price difference as profit. Arbitrageurs help to ensure market efficiency by correcting these price discrepancies, thus bringing prices into alignment across different markets.

Together, hedgers, speculators, and arbitrageurs contribute to the depth, liquidity, and efficiency of the futures markets. Hedgers provide the fundamental purpose of the market—risk management—while speculators add liquidity and volatility, which can be beneficial for price discovery. Arbitrageurs help to keep prices consistent across different trading venues, ensuring that no significant price discrepancies exist for the same asset.

Factors Influencing Futures Prices

The prices of futures contracts are influenced by a variety of interconnected factors, ranging from basic market dynamics to complex geopolitical events. Here's an overview of how these factors play into futures pricing:

• Supply and Demand: This fundamental economic principle significantly impacts futures prices. A decrease in supply or an increase in demand can drive prices up, while an increase in supply or a decrease in demand can lower them. Weather conditions, geopolitical events, and shifts in consumer preferences are among the factors that can alter supply and demand dynamics​​.
• Market Sentiment: The collective mood or attitude of investors can greatly affect futures prices. Positive market sentiment can lead to increased buying and higher prices, while negative sentiment can result in selling pressure and lower prices. Economic indicators, political developments, and news events are key influences on market sentiment​​.
• Interest Rates: The level of interest rates can influence future prices, especially in terms of financial futures. Higher interest rates may lead to reduced demand for some commodities as borrowing costs rise, thereby potentially lowering futures prices​​.
• Economic Indicators: Various indicators such as GDP growth, inflation rates, and employment data provide insights into the health of the economy and can influence future prices. Strong economic indicators might suggest rising demand and higher futures prices, whereas weak indicators could indicate falling demand and lower prices​​.
• Government Policies and Regulations: These can also significantly impact futures prices, especially in regulated or subsidised industries. Changes in policies or regulations can affect production costs, supply chains, and demand for commodities​​.
• Currency Exchange Rates: Since commodities are often traded internationally, changes in currency exchange rates can affect futures prices. A stronger domestic currency can lower demand for exports, potentially reducing futures prices for commodities priced in that currency​​.
• Speculation and Market Manipulation: Speculative trading based on future price expectations can create buying or selling pressure, leading to price fluctuations. Market manipulation can also distort prices and create volatility​​.

In addition to these factors, gold prices, as a specific example of futures trading, are influenced by inflation, interest rates, currency exchange rates, and supply and demand for gold itself. 

Inflation typically enhances the attractiveness of gold as a hedge, while interest rates can affect its opportunity cost. Currency strength can impact international demand for gold, influencing its price.

Types of Future Contracts 

Futures contracts can be categorised into several types, with each serving different market needs and investor interests. Here's an overview of commodity futures, financial futures, and currency futures, with a focus on examples relevant to the Indian market:

• Commodity Futures

Commodity futures are agreements to buy or sell a specific quantity of a commodity at a predetermined price on a specific future date. These commodities can be agricultural products, metals, energy, etc. In India, a significant portion of commodity futures trading involves agricultural commodities due to the country's vast agricultural sector. 

Examples include futures contracts for wheat, rice, and cotton, traded on exchanges like the Multi Commodity Exchange (MCX) and the National Commodity and Derivatives Exchange (NCDEX). These contracts allow farmers, producers, and investors to hedge against price fluctuations in the agricultural market.

• Financial Futures

Financial futures are contracts to buy or sell financial instruments or indices at a future date. These can include stock indices, interest rates, or bonds. A prime example in India is the futures contracts on the Nifty 50 index, which are traded on the National Stock Exchange (NSE). 

Nifty futures allow investors to speculate on the future direction of the market or hedge against their equity portfolio's risk. Besides index futures, interest rate futures are also significant, involving contracts based on underlying securities like government bonds.

• Currency Futures

Currency futures are contracts to exchange one currency for another at a specified date in the future at a price that is fixed on the purchase date. In the Indian context, currency futures trading involves pairs like the INR/USD, EUR/INR, GBP/INR, and JPY/INR. 

These contracts are traded on platforms like the NSE and the MCX-SX (Metropolitan Stock Exchange of India). Currency futures are a tool for hedging against foreign exchange risk, allowing businesses engaged in import and export activities to protect themselves from adverse movements in exchange rates.

• Pricing and Valuation

In the world of futures trading, understanding how futures prices are derived and the factors influencing them is crucial for both novice and seasoned investors. This understanding revolves around a few key concepts: spot prices, the basis, basis risk, and the cost of carry. Let's dive into these concepts to provide a clearer picture of pricing and valuation in futures markets.

• Spot Prices

The spot price is the current market price at which an asset, like a commodity, currency, or security, can be bought or sold for immediate delivery. It reflects the real-time value of an asset based on supply and demand dynamics in the market. 

For futures contracts, the spot price of the underlying asset is a critical reference point, as futures prices are often derived by adjusting the spot price for the time value of money, expected changes in supply and demand, and other factors.

• The Basis

The basis in futures trading is the difference between the spot price of the underlying asset and the price of the futures contract. It can be positive or negative, depending on whether the futures are trading at a premium or discount to the spot price. 

The basis is a key metric for hedgers and arbitrageurs, as it provides insights into the relationship between market prices for immediate delivery and future delivery, which they can exploit for profit or risk management.

• Basis Risk

Basis risk arises from the possibility that the basis will change unexpectedly over the life of a futures contract. Since hedgers rely on futures to lock in prices for future transactions, any change in the basis can affect the effectiveness of their hedge. 

For example, if the basis widens, a hedger looking to protect against falling prices might not fully offset losses in the spot market with gains in the futures market, and vice versa if the basis narrows. This risk underscores the importance of monitoring market conditions that could affect the supply and demand of the underlying asset.

• Cost of Carry

The cost of carry is the total expense associated with holding a position in a futures contract, including storage costs, insurance, and financing costs, minus any income earned from the asset, such as dividends or interest. In essence, it represents the cost of "carrying" the asset until the delivery date of the futures contract. 

The cost of carry is a significant factor in determining futures prices, especially for commodity futures, where physical storage is a major consideration. Futures prices must reflect these carrying costs to prevent arbitrage opportunities, where traders might exploit price discrepancies between the spot and futures markets for risk-free profits.

Advantages and Disadvantages of Future Markets

Advantages of Future Markets

• Liquidity: Futures markets are typically very liquid, especially for contracts on widely traded commodities and financial instruments. This high level of liquidity makes it easier for traders to enter and exit positions without significantly affecting the price of the contract, providing a more efficient trading environment.
• Risk Management: One of the primary advantages of futures is the ability to hedge against price movements in the underlying asset. For example, a farmer can sell futures contracts on their crop to lock in a selling price, protecting against the risk of falling prices. Similarly, an investor can hedge against a stock portfolio's potential losses by taking positions in stock index futures.
• Speculation: Futures markets also offer opportunities for speculation, where traders can attempt to profit from the expected rise or fall in the price of an underlying asset. Since futures contracts require only a fraction of the contract value as a margin, they allow speculators to leverage their investment to potentially earn higher returns.
• Price Discovery: Futures trading contributes to the price discovery process, which is the determination of the price of an asset in the marketplace through the interactions of buyers and sellers. The futures market incorporates various information, including supply and demand expectations, into prices, helping all market participants make more informed decisions.

Disadvantages of Future Markets

• Leverage Risks: While leverage allows traders to control a large contract value with a relatively small amount of capital, it also amplifies both gains and losses. This can lead to significant losses, potentially exceeding the initial investment, if the market moves unfavourably.
• Market Volatility: Futures prices can be highly volatile, influenced by a wide range of unpredictable factors including economic data, geopolitical events, and natural disasters. This volatility can lead to rapid price movements, challenging even for experienced traders to manage their risk effectively.
• Basis Risk: For those using futures for hedging, basis risk (the risk that the price of the futures contract may not move in perfect correlation with the price of the underlying asset) can lead to less effective hedges and unexpected losses.
• Complexity: The futures market can be complex and difficult to understand for beginners. Successful trading requires a good grasp of the market dynamics, contract specifications, and a well-thought-out trading strategy.

In India, commodity trading has a rich history but faced declines due to various factors over time. By 2016, India had six national commodity exchanges including the Multi Commodity Exchange (MCX) and the National Commodity and Derivatives Exchange (NCDEX). 

The Forward Markets Commission (FMC) initially regulated these, but in September 2015, it merged with the Securities and Exchange Board of India (SEBI), which now oversees futures trading along with the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) that entered commodity trading in 2018. This regulatory environment ensures the proper functioning and integrity of futures markets in India​

Bottom Line

Futures contracts are integral to financial markets, providing a mechanism for hedging against price volatility, enabling speculation, and contributing to market efficiency. By allowing market participants to lock in prices for future transactions, they mitigate risk for producers and consumers alike. 

Additionally, futures markets facilitate price discovery and liquidity, which is crucial for the smooth functioning of global trade and investment. As regulated by bodies like SEBI in India, these markets ensure transparency and fairness, underscoring their importance in bolstering economic stability and growth. Stay tuned as we study about option contracts in the next chapter.