Types of derivatives 2 – Futures contract

We continue with our discussion on derivatives…

As said in my last article, forward contracts have some de-merits.

  • First, The quantity, the mode of payment, the delivery date, the price, – everything varies from one contract to another and performance of the contract is not guaranteed.
  • Second, to continue the orange juice example, suppose after some days the orange juice company decides to back off since they feel that they don’t need oranges at that price. This would give rise to problems between the buyer and the seller.
  • In short, nothing is regulated in forwards. It’s tailor-made according to circumstances and can be written for any amount and terms.

Quite easy to understand, I guess.

How about a contract that’s regulated in all these aspects? That is, you get a fixed quantity contract, at a fixed rate, for a fixed expiry date. You can buy and sell the contract anytime. Liquidity is ensured and somebody stands in between to regulate and guarantee the performance- That’s futures.

So, there is no much difference between forwards and futures, except that futures are well regulated in all aspects.

A ‘future’ is an agreement between the seller and the buyer to deliver a specified quantity of a share/commodity/forex at a fixed time in the future at a price fixed between the parties NOW. An organization called clearing house stands in between to ensure that both the parties fulfill their obligations.

How does the clearing house ensure that?

Both the parties are required to pay a percentage of the total value of shares/ commodity / forex to the clearing house. This amount is called ‘Initial Margin money’. Since the contract is ‘marked to market’ or linked to market on real time basis, the value changes every now and then. Accordingly, the amount to be maintained by the buyer and the seller with the clearing house also fluctuates on daily basis.

The stock exchange (for stocks futures) or commodity exchange (in case of commodity futures) will take responsibility for collecting the payments and making the settlements. There is no chance of default.

To achieve this, each trade is split into two parts- Buyer with the clearing           house and Clearing house with the seller. So each party has to fulfill their obligation to the clearing house. Even if one party to the trade defaults, the clearing house fulfills performance.

In other words, by virtue of a futures contract, when you have the ‘right to buy’ the clearing house takes a ‘sell’ position against it and when you have the ‘right to sell’ the clearing house takes a ‘buy’ position against it so that the performance is always guaranteed.

So in short, ‘future contracts’ issued by the exchange can be traded just like shares. For example, ‘Reliance October Futures’ may be issued by the exchange. This contract would have the following features:

  • Specific quantity: Each futures contract has a ‘specified quantity’. In this case, let’s assume its 100.
  • Specified share: if you have entered into a futures contract to buy 100 reliance shares, you will have to deliver 100 reliance shares and not 100 Infosys shares.
  • Specified date: the date and month of delivery is determined by the exchange. As of now, the exchange has fixed the last Thursday of every month for settlement of contracts.
  • The clearing house plays an important part in trading of futures contracts. It does all the back office operations. It guarantees performance from either side. Hence there is no risk of default. Thus ‘Reliance October futures contract’ becomes a standard asset like any other asset that can be traded in the market.

MARGIN MONEY

To enter into these futures contract you need not put in the entire money. For example, reliance shares trades at Rs 1000 in the share market.  If you want to enter into one lot of ‘Reliance October futures contract’ which consists of 100 reliance shares, you need not put 100 x 1000. Instead, you would be required to maintain a small deposit (called margin) with the broker. Margin is decided by the exchange. This margin amount will keep varying with changes in daily prices. If the price goes up the buyer’s margin is reduced and the seller’s margin is increased by an equal amount. If the price comes down, the buyer’s margin is increased and the seller’s margin is reduced by an equal amount.

Here’s the link to know the margin money requirements of future contracts

Here’s an example-

Let us assume you bought a Future contract of ‘Infosys October (i .e, 100 shares of INFY at current future price of Rs. 2200 per share, settlement date being last Thursday of October) .Let’s further assume that the margin money required by the exchange is 20%. So, you pay Rs. 44,000.

Now suddenly there is a crash and the price of INFY in the spot market dips to Rs. 1700. So you have lost Rs. 500 per share – which, for 100 shares, is Rs. 50,000! This is greater than your margin of Rs. 44,000 so the broker will ask you to provide the extra Rs. 6,000 as an additional margin to keep your contract afloat.

Futures are actively traded in the market, and the price of the future is not decided by you – so once you have bought the future, you can SELL the contract to someone else. Let’s say the contract you bought at Rs. 2,200 is now trading at Rs. 2,700 instead. You can sell the contract itself, and make the Rs. 500 as profit per share – for 100 shares; that’s  Rs. 50,000 profit. The exchange will also give your margin back, and take a margin from the new owner of the contract.

Before I end this article, here’s a point wise differentiation between forwards and futures:-

  • 1. Size of the contract – In the case of forwards, it’s decided by the parties. In futures, it’s decided by the exchange. In the case of share futures, a ‘lot’ is generally 100 shares.
  • 2. Price of the contract – In the case of forwards, it’s decided by the parties. It remains fixed till the end of the contract. In futures, the price keeps floating according to daily price movements. This is called ‘Marked to market’ in technical terms.
  • 3. Margin money – In the case of forwards, it may or may not be required, depends upon how the party negotiates. In futures, margin money is fixed by the exchange. It is usually a percentage of the value of the contract and it has to be paid by the buyer and the seller to the exchange.  Since it’s marked to market; the margin requirements will have to be settled on a daily basis.
  • 4. Number of contracts – In the case of forwards, there can be any number of contracts. In futures, the number is decided by the exchange
  • 5. Settlement – In the case of forwards, the settlement is through OTC. In the case of futures, the settlement is through exchange.
  • 6. Mode of delivery – In case of forwards – cash settlement or delivery. In the case of futures most of them are cash settled.

I hope you’ve got some understanding about futures and the difference between forwards and futures. It’s important to understand these two instruments clearly.

Till my next article on options…

……. Have a nice time.

You may like these posts:

  1. Types of derivatives 1 – Forward contract.
  2. Introduction to Derivatives.
  3. Types of Charts

6 Responses to “Types of derivatives 2 – Futures contract”

MCX Tips

December 26, 2011 at 9:21 am

HI, I very like your sharing, thank you spend your time to share these. Hope to see you next time the good sharing!!

Dipen

November 16, 2012 at 1:34 am

Hi Victor, I like your articles very much. Just had a doubt in your article about this last example.
As one buys 100 shares of Rs.2200= 2,20,000; but pays just 20% i.e.rs. 44,000.
but as price rises to rs.2700=2,70,000 so money received should also be 20% na,i.e.54,000 so profit is just rs.10,000. Am i right or profit will be 50,000/-

J Victor

November 16, 2012 at 7:32 am

You paid 20% of (2200 x 100 shares). The stock has moved up 22.72% from 2200 to 2700.

The gross profit is 50000 ( 500 x 100) less your initial investment Rs 44,000 – your net profit is Rs 6,000

I think there was a little confusion towards the end. That has been corrected. :)

Dipen

November 16, 2012 at 6:37 pm

Thank you very much Victor.

Kishor

January 27, 2015 at 6:41 pm

HI Victor,

What if the share price has moved up to 2300. In this case
I paid 44000 as Margin.
And the price raises to 2300 means 2,30,000(2300×100).
I have made Rs. 10,000 (100×100) net profit.
Where as you are showing net profit of 6000 when the price has raised by 500.
Am I right???

J Victor

January 28, 2015 at 10:44 am

Noted. That was an editing error. corrected. Thanks a ton for informing.

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