What are futures?

First of all, thank you very much for all the encouragement that has been bestowed upon me for my first post. I wrote it casually but then I realized that there is some knowledge in what I am trying to say and can benefit a lot of people. I got some questions and also some very meaningful comments for the first post on the day trade of 24th Feb in Nifty Futures.

While, I would like to share more of my trades on a daily basis, I thought it is better to address some basic questions first. So, this one will be dedicated to writing about “What are futures?”

Let us take an example of buying a house. This one makes it easy to understand. Say, I want to buy a house in Bangalore, which is worth Rs. 1 Cr. If you are in Bangalore, nowadays, you would have come across the 10-80-10 or 5-85-10 or such similar schemes. Basically, you give some initial token amount of 5 to 10%, about 80% you go for loan and the remaining you pay at the possession. Now, say the house that I am going to buy is getting completed in December 2017. So, I go for something like a 20-80 scheme. Where I will put 20% from my pocket and the remaining 80% is a loan. Once, I pay the 20% the builder is going to sign something called a SALE Agreement with me. This sale agreement says that I shall pay the remaining 80% in installments during the course of the next 1 year and 10 months (assuming I am going to buy it today) and that the house will be delivered to me after the full payment made by me. So, what does the sale agreement consists:

1. Details of the product (House) – Its size, facilities, structure, etc.

2. Date of delivery (In our case, December 2017)

3. Price of the house (Rs. 1 Cr)

4. Token amount or the margin put by me (Rs. 20 lakhs)

Hence, the sale agreement is a contract between me and the builder today for a product (house) getting delivered in the future (Dec 2017) at a pre-decided price (Rs. 1 Cr.) for a margin or token amount (Rs. 20 lakh). This agreement is a “FUTURE” product of the HOUSE.

The definition of the future is a contract for the delivery of a product in the future at a pre-decided price for a token amount or a margin amount today. The contract is binding on both the buyer and seller.

So how does the futures work?

Now say, I have this sale agreement at Rs. 20 lakh for a house which is worth Rs. 1 Cr. In comes, my friend Mr. John Smith and says, this is a wonderful house and I think it should be priced at Rs. 1.3 Cr, about 1 year 10 months from now. I tell him, if you are interested, you can buy the sale agreement from me and pay the remaining amount to the builder. However, I will sell this agreement to you for Rs. 30 lakhs. When I do this, I get a profit of Rs. 10 lakhs. John pays me Rs. 30 lakhs and pays the builder Rs. 80 lakhs by December 2017, so his total cost becomes Rs. 1.1 Cr. However, if the prices go to Rs. 1.3 Cr, which was his prediction then he makes a profit of Rs. 20 lakhs.

Basically, the actual product, which in our example, the house is not traded but the contract of buying the house is traded. This is called futures trading. One just trades in the contract of the actual product. Futures is a DERIVATIVE product. A derivative product is one whose price is derived from the base product. Like in our example the price of the sale agreement is derived from the price of the house.

There are many kind of futures. We have the stock futures, the index futures, commodity futures and currency futures. For each future, the underlying product is mentioned before the future. Let us look at stock futures in a little bit of detail and understand the finances behind them.

What are stock futures?

Assume that you want to buy the share of Infosys. The closing price of INFY (it’s symbol) on NSE was Rs. 1122.10 today. You want to buy 500 shares. Which means, you have to pay Rs. 5,61,050. But, we are interested in futures of Infosys. One unit of INFY future has 500 Infosys share in it. This is called the lot size. Hence buying of one lot of Infy future means investing in 500 Infy shares. However, for this, you do not have to give the full amount. You only need the margin amount. The margin for Infosys is at 12.5% (decided by the exchange). Some brokers might top it up with their own risk management number. Buy don’t worry about it. Right now, we will assume that we have to pay 12.5% to buy 1 lot of INFY future. That comes to Rs. 70,131.25.

When we buy this 1 lot of INFY, for every unit it changes, we get Rs. 500 as there are 500 Infy shares in one lot. Hence when the price goes from Rs. 1122 to Rs. 1150, the profit that you make in cash is Rs. 14000 (Rs. 28* 500) on an investment of Rs. 5,61,500, which is 2.4%. However, for the same change of price, in the future, you make Rs. 14000 on an investment of Rs. 70,131, which is almost 20%.

Hence the futures give a lot of opportunities to make very high returns and also are equally risky products. As the same is true on the negative side. You can loose 20% in the futures, while for the same fall in the stock price your loss may be limited to only 2.4%.

Again, if you know how to trade, how to look at charts and how to money manage, FUTURES become truly attractive products for traders, especially the one’s with less initial capital.

Another advantage of futures is that, one can short the future. Shorting means selling when the prices are high and buying when the prices go low. There could be a post only on shorting. But, right now just understand that if you are thinking that the prices are going to fall for something, you sell it now and then buy it later when the prices are slow. When you short the future, you have an option to carry forward that trade for multiple days (at an additional cost charged by the brokers), but in the case of direct equity, you can short but only for that day. It means that if you short a stock on one particular day, i.e. you sell first, you are supposed to buy it back on the same day irrespective of what happens to the price. I will explain the concept of shorting in one dedicated post.

Well, I didn’t realize that it has become a bit lengthy but had to explain the concept. We still need to discuss the other kinds of futures and that will be done in subsequent posts. Keep showering your comments and inputs. Thank you for reading this.

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1 Comment

  1. Rajesh

    Very nice explanation…!!!! Keep up the good work.

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