Futures: End note


CONNECTING THE LOOSE ENDS.

As we come to the end of basic theory on futures , there are some loose ends to be connected. These were collected from the questions that readers have asked us.

  • Not all stocks have corresponding futures. In India, Stock futures are introduced by the exchange and it’s decided based on criteria specified by the Securities Exchange Board of India.  If an existing security fails to meet the eligibility criteria for 3 months consecutively, then no fresh future contracts will be issued in that stock. In the case of existing contracts, if the exchange is of the view that continuing derivatives contracts on a particular stock is detrimental to the interest of the market, it may compulsorily close all derivatives contract positions in that particular stock.
  • The price of futures contract now is not the expected price of the underlying stock on the maturity date. Futures price is determined by the cost of carry principle. However, empirical evidence on cost of carry is not consistent. Studies have shown that the cost of carry principle does not perfectly hold over a period of time and it keeps changing from week to week or even day to day.
  • There will be three futures contracts available for trade at any given point of time. Theoretically, these contracts would be priced applying the cost of carry principle and hence, the far month futures would be priced higher than the near month futures.
  • Backwardation is not just a theoretical concept. Such scenarios are real. Backwardation conflicts with the cost of carry principle. When other economic factors pre-dominate the markets, such imperfections are possible.
  • The most important use of futures is hedging. Hedging protects investors from adverse price movements. At the same time, it also prevents the hedger from participating in extreme favorable price movements. So, taking decisions on hedging calls for a lot of experience and expertise.
  • You have to pay margin money to enter into a futures contract. Margins are of two types 1. Initial margin and 2. Daily margin. The initial Margin is collected to cover the potential losses for one day. The initial margin percentage may differ from stock to stock based on the risk involved in the stock, which depends upon the liquidity and volatility of the respective stock besides the general market conditions. Apart from initial margin, the difference between the cost of the position held and the current market value of that position, if loss, has to be remitted by the party on a daily basis.
  • There are limits for entering into futures contracts at all levels – at the client level, trading member level and at the market level as a whole. One person cannot enter into as many future contracts he likes. There is a limit to the gross open position, specified by the exchanges every month. Position limits are introduced for controlling excessive speculation.
  • A trader cannot enter any rate for trade. In the case of stock futures, there is a price range which is +/- 20% of the base price. The ‘base price’ is nothing but the daily settlement price. However, on the first day of trading, since there is no previous settlement price, the base price would be the theoretical futures price. Orders below or above this operating range of + / – 20% from the base price would be freezed by the exchange.
  • A trader cannot enter any quantity for a trade. In case of stock futures, there is a maximum quantity specified by the SEBI. In case of Stock Futures the quantity for each stock is specified by exchange from time to time and single order notional value should not normally be beyond Rs. 5 Crores approximately. Notional value is the futures prices multiplied by the lot size.
  • Corporate actions like bonus, rights, dividends, merger, amalgamations and splits would have an impact on the futures contracts and such actions have to be adjusted accordingly. The effect of corporate actions and how it is adjusted would be explained later.
  • NRIs can participate in derivative Contracts (except currency derivatives) out of INR funds held in India on non-repatriable basis (NRO) subject to the limits prescribed by SEBI. An NRI, who wishes to trade on the F&O segment of the exchange, is required to apply for a custodial participant (CP) code. Thereafter he can open a trading account and start trading in derivatives. Position limits for NRIs shall be same as the client level position limits specified by SEBI from time to time.
  • Futures contracts are always cash settled. On settlement, the settlement price would be the underlying asset’s closing price.

You may like these posts:

  1. Types of derivatives 2 – Futures contract
  2. Futures: Understanding the basic terms
  3. Futures: Contango and backwardation

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