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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 . 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 risks to investment in a single
stock 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
· 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.
·
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.
· 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.
