Futures: Understanding the basic terms

UNDERLYING ASSET

  • The underlying asset that gives value to a futures contract could be shares, share market indices, commodities, currency, interest rates, weather etc.

LOT SIZE

  • The exchange specifies a particular lot size for each type of derivatives.
  • When you buy or sell futures, you do that in ‘lots’.
  • This lot size is not divisible. For example – the lot size of reliance futures is 250 shares. So, taking 1 lot of reliance futures would involve 250 shares. So if Reliance shares are trading at Rs 1000, then the value of 1 lot is Rs 250,000 (Rs 1000 x 250 Numbers)
  • The exchange specifies the lot size. Lot size would be different for different stocks/commodities.
  • Not all stocks traded in the exchange have equivalent futures contract. Stock are selected on the basis criteria specified by the SEBI


VALUE OF A LOT

  • The value of one lot would be the price of the share x lot size.
  • In most cases, it is approximately Rs 2-3 lakhs.

MARGIN MONEY

  • When a person enters into a futures contract, he need not pay the full value of the contract upfront-only a small percentage needs to be paid. That payment is called margin money. Usually margin money would be a percentage ranging from 10% to as high as 35 or 40% in times of heavy volatility.
  • For example – the margin required for buying 1 lot of reliance futures now is 15.70%. I.e., approximately Rs 29,000.00
  • The actual margin money required to be maintained changes every day, specified by the NSE.

LIFE OF A CONTRACT

  • The life of one contract is 3 months.
  • At any point of time, 3 futures contract will be available for trading with different time limit to expiry – 1month, 2 month and 3 month contract. ( Also called near month, mid month and far  month contracts)

DIFFERENT TYPES OF FUTURES

  • Stock futures and stock index futures – traded on the NSE
  • Commodity futures – traded on MCX / NCDEX
  • Interest rate futures – traded on NSE

OPEN INTEREST

  • ‘Open’ means – yet to be settled. Open interest is the number of ‘yet to be settled’ contracts.
  • The term used to describe ‘a pair of buy and sell’.
  • In live futures market, for each seller of a futures contract there must be a buyer of that contract. Ie, there must be a pair.  Thus, a seller and a buyer combine to create only one contract.
  • For example – if Mr. x buys 5 futures contract from Mr. Y (seller of the contract), then open interest rises by 5.
  • The total number of open contracts x lot size is called open interest. The open interest cannot exceed the number of shares a company has.
  • An increase in open interest may mean that more money is flowing in.

MARKED TO MARKET

  • Futures contracts are monitored regularly by the authorities. Hence, Futures prices are marked to market.
  • It means that every change in value to the investor is shown in the investor’s account at the end of each trading day.
  • The implication is that, if your futures position is in profits on a particular day, your account is credited with that much of profits (which would be taken away, if the prices fall on the next day). This process would keep going until you settle the contract.
  • At the same time, if your position is in loss, the loss will be shown in your account on the end of the trading day and if such loss is beyond your initial margin you’ve given, you will have to pay the difference.

DISPLAY ON THE TRADING SCREEN

Futures are displayed on the trading screen just like equities. Each future contract will be in a coded form just like equities.

  • Future contracts are displayed in alphabetical order.
  • For a particular share / index / commodity, 3 contracts will be displayed. The near month contracts are listed first.
  • The trading screen would also show the open price, high, low, traded quantity etc.

LONG AND SHORT POSITIONS

  • Unsettled or open purchase position at any point of time is called a long position and unsettled sales position at any time point of time is called a short position.

SPOT AND SPREAD.

  • The cash market price is called the ‘spot price’ and the prices of futures contracts are called the ‘futures price’.
  • The term spread used to describe the difference between two prices.   For example – reliance October futures may be trading at Rs 750 per share and reliance December futures may be trading at say, Rs 765. The difference is called spread.
  • In fact, spread is a general term. It should be understood in the context in which it is used. The difference between the ‘bid price’ and ‘ask price’ is also called spread.
  • Futures price will be greater than the spot price in a normal market.

EXPIRY DATE OF A CONTRACT

  • Any futures contract would expire on the last Thursday of a month. On that date the contract ceases to exist and all the obligations must be fulfilled and the rights, if any, become invalid thereafter.
  • Near month contract expire on the last Thursday of that month. For example – Infosys July contract (1 month) would expire on the last Thursday of July while Infosys September contract which is available for trading in July (3months contract) would expire on the last Thursday of September.
  • If the last Thursday happens to be a holiday (like Christmas), the expiry will be fixed for the next day.
  • In case of unforeseen circumstances the maturity date may be shifted to another day by the SEBI through a notification.
  • At the expiry day, all contracts are ‘automatically’ settled.
  • One the next day after the maturity, a new 3 month contract will be introduced.

SETTLEMENT

  • In most futures markets, actual delivery never takes place. Futures are cash settled.
  • Futures are used by traders for hedging price risks or by speculators for betting against price movements. Generally nobody is interested in taking delivery of the underlying asset.
  • For example – let’s take the case of a person who has taken two futures long positions of reliance at Rs 750. At the expiry of a futures contract, if the price of an underlying asset (reliance shares) is more than Rs 750, the exchange will pay the difference plus the initial margin as settlement value. If the price of reliance has dropped below Rs 750, the trader will have to pay the difference to the exchange.
  • So, settlement takes place by taking an opposite position to the one you have. When your contract is settled or liquidated, the initial margin you paid plus or minus any gains or losses will be credited back to your account.

You may like these posts:

  1. Types of derivatives 2 – Futures contract
  2. Futures: Types of contracts
  3. Types of derivatives 1 – Forward contract.

11 Responses to “Futures: Understanding the basic terms”

Rahul

April 2, 2012 at 3:33 pm

Sir, this is a nice post. Thanks for that. Can you explain ‘marked to market’ open interest and it’s relevance a bit more?

J Victor

April 11, 2012 at 7:11 am

Hi rahul ..Open interest is discussed in the next post. marked to market has been already explained.

check this link : http://www.sharemarketschool.com/futures-understanding-%E2%80%98open-interest%E2%80%99/

premsunderdas

April 22, 2012 at 5:06 am

is the marginmoney equal for both buy and sell in derivatives

JiJo joseph

April 23, 2012 at 6:50 am

yes prem ..it’s required.

Ritesh

April 25, 2012 at 9:02 pm

Sir,please tell me who introduces these futures in the market?and what is the benefit to the co. Which owns the underlying assets?

J Victor

April 26, 2012 at 7:59 am

Future contracts are introduced by the exchanges. Derivative contracts,as you would have already understood, are instruments to control risk.The benefit is always for the investor who ‘owns’ the asset.

anand

April 9, 2013 at 8:28 am

hello victor

I read “open interest” definition in some private book. The definition says “open interest is the number of contracts that are held by buyers or are owned by short sellers in a given market on a given date”

my question is: in the definition why it is short sellers? why not a normal sellers? is normal seller called a short seller in the futures market? please fix my confusion.

Ravichandran

July 18, 2015 at 1:28 pm

Good definition and easily understandable.

A.Prasada rao

September 7, 2015 at 8:32 pm

Pl. Refer to Business Line page 9 dated 7.9.2015 regarding futures on Tata Power.what does it mean

Alok ranjan

October 23, 2015 at 3:35 pm

Very best site . I like is very – very much

Neeta

August 13, 2016 at 3:19 pm

Thank you Sir can be easily understood.

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