Understanding Futures Trading by a simple example

What is Futures Trading?

The goal of this post is to explain the basic idea underlying a futures trading or futures contract by means of an example. Market derivatives like Stock Market futures and Options have the reputation of being 'hard to understand' although the underlying idea of futures trading is not that hard as it seem and is best understood by studying an example.

1. Stock Futures Contract.
2. Index Futures Contract (like Dow Futures, Nifty Futures, Sensex Futures, etc.)
3. Commodity Futures (like Gold Futures, Crude Oil Futures, etc.)

Although it looks like '3 types' the underlying principles and ideas behind trading any of the above futures contract is the same. Let me try to explain futures trading with the help of an example.

Futures Trading: Example of a Futures Contract:

Suppose the current price of Tata Steel is Rs. 200 per stock. You are interested in buying 500 shares of Tata Steel. You find someone, say John, who has 500 shares you tell John that you will buy 500 shares at Rs. 200, but not now, at a later point of time, say on the last thursday of this month. This agreed date will be called the expiry date of your agreement or contract. John more or less agrees but the following points come up in your agreement.

1. John will have to go through the hassle of keeping the shares with him until the end of this month. Moreover, the economy is doing well, so it is likely that the price of the stock at the end of the month will be not Rs. 200, but something more. So he says lets strike a deal not at the current price of Rs 200 but Rs. 202/-. The agreed price of the deal will be called the Strike price of the futures contract. He says you can think of the Rs. 2 per share as his charge for keeping the shares for you until the expiry date. This difference between the strike price and the current price is also called as Cost of Carry.
   
2. The total contract size is now Rs. 202 for 500 shares, which means Rs 101000. However both you and John realise that each of you is taking a risk. For e.g. if tomorrow the price of the stock falls from Rs. 200 to Rs. 190, in that case it is much more profitable for you buy shares from the market than from John. What if you decide not to honour the contract or agreement? it will be a loss for John. Similarly if the price rises you are at a risk if John doesn't honour the futures contract. So both of you decide that you will find a common friend and keep Rs. 25000 each with this friend in order to take care of price fluctuations. This money paid by both of you is called Margin paid for the futures contract.

Finally you decide that the futures contract will cash settled. Which means at the expirty date of the contract, instead of actually handing over 500 shares - John will pay you the money if the price rises, or if the price falls you will pay John the balance amount. For example at the end of the expiry date if you find out that the price of the share is Rs. 230, then the difference

Rs. 230 - Rs. 202 = Rs. 28

will be paid to you by John. You can then purchase the shares fromt he Stock Market at Rs. 230. Since you will get Rs. 28 per share from John, you will effectively be able to buy the shares at Rs. 202 , the agreed strike price of the futures contract. Similarly John can directly sell his 500 shares in the market at Rs. 230 and give you Rs 28 (per share) which means he effectively sold each share at Rs. 202, the agreed price.

Stock Futures trading - Commodity Futures trading - Index Futures trading

Just like the above example of Stock Futures you can have commodity futures where instead of dealing with stock you deal with commodities - for e.g. gold futures , crude oil futures, etc. You can also have futures on Index. For e.g. Nifty is a stock market index in India. If you buy 1 futures contract of Nifty then at the expiry date you will be gain or loose money accordingly as the index moves up or down. Index futures contracts are always cash settled as there is nothing to 'actually buy or sell' in case of an index. You simply pretend that you are buying the 'index' and cash settle it at the expiry date. Anyone can buy or sell a futures contract.

Futures Trading: some minor differences between Actual Futures contract and
the above example of futures contract

In concept the above example illustrates all the basic notions of a futures trading. However in real life, while trading stock futures on stock market exchange or commodities futures on commodity exchange you have to keep in mind the following points.

1. You directly deal with the stock exchange or the commodity exchange when buying or selling a futures contract. The Margin money is kept with the stock exchange. The margin is calculated in real time and constantly updated. For e.g. if you buy a futures contract and the price of the stock / commodity goes down - you will be required to provide additional margin, etc.
   
2. The expiry date of the futures contract is decided by the Exchange. It is usually the last Thursday of every month except when there is a public holiday in which case it is the earliest
   
3. All futures contract are sold in multiple of a lot size which is decided by the Stock Market exchange or the commodity exchange. For e.g. if the lot size of Tata Steel is 500, then one futures contract is necessarily for 500 shares. You can however buy or sell multiple futures contracts and hence you will be able to deal with only multiples of the given lot size of the contract.
   
4. The exchange decides whether the futures contract is cash settled or settlement is delivery based. For e.g. all index futures are always cash settled because there is no concept of actual 'delivery' of the index. In india even all stock futures are currently cash settled.
   
5. You dont have to actually have the stock or commodity (or index) in order to sell a futures contract. For e.g. even if I have no gold with me, and I believe that the price of gold is going to go down, I can simply sell a futures contract and hope to benefit from my speculation. In case the futures contract is delivery settled, you can simply buy it again (called squaring your position) just before the expiry.

Advantages of Futures Trading: Why trade Futures?

There are several advantages of trading in futures. Here are some.

1. Futures trading allows you to trade in 'large amounts' with low cash. For e.g. if you want to buy a futures contract of 500 shares of Tata steel - Actually buying them would cost much more than the margin you have to pay for trading futures. Note however, leveraged position of futures can also be dangerous.
2. Trading in stock market Futures is usually less expensive than actually buying stocks. For e.g. if you realise that you have 500 stocks and want to sell them and again buy them when the price is low, it is much cheaper (brokerage charges etc.) to sell futures than actually selling stocks.
3. You can sell futures contract even if you dont have shares or the commodity. Thus if you have reasons to believe that the stock market is going down you can sell a particular stock future or index future and benefit from the price fall. This is possible only if you trade futures and not with physical stocks or commodity.
   
4. Trading futures can be used in several hedging strategies which will be discussed in a later post.
   

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