A futures contract is a contract or agreement between two parties to conduct a transaction at a predetermined locked down price at some point in the future. It is essentially a bet on the prospects of a stock, one of the multiple financial trades you can perform. Two parties take opposing stances, with one agreeing to buy shares and the other agreeing to sell them at a certain price sometime later, irrespective of the prevailing market price then.
To illustrate, consider two trading entities A and B. A holds the view that the value of a stock would rise from its present value in the future while B believes the opposite. A and B enter into a contract with A agreeing to buy shares of the stock from B at the present price sometime in the future. If A’s bet comes true, that is, if stock value rises, A can get shares of the stock at a discounted price from B. Conversely, if the share value drops, B can sell shares to A at a premium, that is, at a value greater than the market price.There are 2 primary benefits to future trading - the leverage you receive, and the risk mitigation it offers.
Margins and leverage
Unlike buying equity, one needn't pay in full to buy futures. One need to only pay a percentage of the total contract value to buy or sell in futures. This percentage is called margin and varies between different stock futures. Thus you could buy/sell a lot more shares of futures than equity with a certain amount of money. For example, if the margin is fixed at 20% for futures in a stock, one could buy/sell 5x times more shares in futures than in equity. This ratio is called leverage. Thus, with 20% margin, the leverage is 5. Leverage is a double-edged sword. It multiplies profits manifold but also multiplies losses.
If futures in a stock has a leverage of 5, it means that profits would be five times than that of equity profits. If the equity returns a profit of 20%, the futures offer a return of 100% ( Futures profit percentage = Equity profit percentage*Leverage). This is possible because only a fraction of the price is paid to buy futures (margin). But losses would be equally magnified too. A 20% loss in equity would cause 100% loss in futures having a leverage of five.
Hedging against risks
Futures can be used to mitigate or hedge against systemic risk to investment in a single stocks or a portfolio of stocks. For single stocks, hedging can be done easily by selling futures at a higher price than the price at which equity was bought. The number of futures sold must be equal to the number of equity shares held by one. Thus, if prices fall, the profit from the selling order in stock futures would offset fall in equity value and vice versa. A fixed return is guaranteed and market fluctuations don't affect the returns. Futures can also be used to hedge against risks to investment in a portfolio of stocks.
Points to remember
There are some specific futures indices which include the following:
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NSE Futures: Nifty IT, Nifty Bank, Nifty Midcap 50, Nifty Infrastructure, Nifty PSE, Nifty CPSE indices.·
BSE Futures: BSE TECK, BSE FMCG,
BSE Metal, BSE Bankex and BSE Oil & Gas. The Nifty 50 is the most popular
index futures that witnesses the highest volume of trade among all available
futures.
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With Futures, you do not have to worry about closing your
position at the end of the day, while with Cash Trading you need to be mindful
of closing intraday positions if you are taking margin.
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Nifty and certain Equity Futures are usually very liquid; therefore,
through liquidity there is a a good chance that the trader will capture the
price he seeks.
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Futures is 0.01%, while intraday Cash Trading charges 0.025% on
sell side trading and 0.1% on both buy and sell side trading for delivery
transactions.
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