Introduction to Futures Trading

In the previous chapter, we have understood some of the principles related to the futures market. Remember that the futures market is a way for a trader to make money. If a trader has a certain opinion about the direction of the price of an asset, he can use it to make money in the futures market. Now we will try to understand futures trade through some examples. Now instead of gold, we will take the example of shares or stocks.

The country’s well-known software company TCS held an investor meeting on December 15, 2014, where the company’s management said that the company is not very confident about the increase in earnings in the December quarter results. The market does not like such news, especially when the management of the company is saying such a thing. That is why after this statement there was panic in the market and TCS share fell 3.6%. In the picture we have highlighted it with blue color

As a trader, I think TCS has been a bit overbeaten on the stock because if you look closely, no company in the IT sector will generally be able to deliver good results in the December quarter. In fact, the month of December is the last month of the year in USA, the largest market of Indian IT companies. Also, there are many holidays in this month due to which there is less work. This is the reason why the income of IT sector companies is slightly less in the month of December. The market is aware of all this and its effect is already included in the price of IT companies. That’s why I think this 3.6% drop is a buying opportunity for TCS stock. In a few days this stock will again go up again.

You can see that I have a definite and directional opinion about the future price of TCS shares and I think the price of TCS shares will go up in future i.e. I am bullish on the future as compared to its current price.

Now I decide to buy TCS share in futures market instead of buying it in spot market. (Why I am doing this we will discuss in the next chapter) After deciding to buy futures I need to see at what price the TCS futures are doing. All the information related to this contract is available on the NSE website. In fact, the price of the TCS futures contract is given along with the spot market price of TCS. In the above picture I highlighted it with red color.

You must remember that the future price of every asset always moves according to the current price. If the current price of TCS has gone down then the futures price will also have gone down. This is clearly visible in the picture below taken from the NSE website.
The futures prices of TCS have also gone down by 3.77 percent. Now 2 questions arise here-

The spot price of TCS is down by 3.61% while that of TCS futures is down by 3.77%. Why is this difference?
The spot price of TCS is ₹2362.35 while that of the futures is ₹2374.90. Why is this difference?

The answer to both the questions depends on what is the formula to calculate the futures price. We will discuss this further. But the most important thing here is that the futures and spot prices move in the same direction and both fall together. Now before moving ahead, let’s look at some important information related to futures contracts. Look at the picture given below-

If you look at the top of this picture, there are three important information in the box highlighted with red color –

Instrument Type – As you know, the underlying asset here is the company’s stocks. We are bidding on the futures price of that company hence the instrument here is Stock Futures.
Symbol – It denotes the name of the stock as TCS is highlighted here.
Expiry Date – This is the date on which this contract will expire. As you can see here this contract expires on 24th December. Here’s another piece of information you need to know, that all derivative contracts expire on the last Thursday of every month. Next, we will discuss this.

We have already looked at the blue color box which indicates the price of the futures.

We also get some information from the black highlighted box –

Underlying Value – It tells at what price the underlying asset is currently selling in the spot market. I took this screenshot after a while so you will see a slight difference in the price here, earlier the price was 2362.35 and when I took the screenshot then it is 2359.95.

Market Lot or Lot Size – You must remember that futures contracts are of the same standard method, in which everything is pre-determined. For example, it is decided that the minimum number of shares will be the contract. This number of shares is called lot size. The lot size for TCS is 125 shares. You can buy as many lots as you want.

If the lot size is multiplied by the price of the future, then we will know the contract value. You will remember that we talked about the contract value in the previous chapter as well.

Contract Value = Lot Size × Future Price

= 125 × 2374.90

= Rs 296,862.5

Before proceeding further, let us look at one more futures contract, this is the futures contract of State Bank of India i.e. SBI.

Based on this screen shot, you might be able to find answers to some of the questions yourself.

• What is Instrument Type?
• What is the future price of SBI?
• What is the difference between futures price and spot price of SBI?
• What is the expiry of this futures contract?
• What is the lot size and contract value of SBI Futures?

Futures Trade

Back to the futures trade of TCS once again. We have to buy futures contract of TCS as I think its price will increase going forward. I want to buy TCS futures at Rs 2374.9 per share. For that I have to buy at least 125 shares which is one lot of TCS.

For this, I can call my stockbroker and tell me that I want to buy one lot of TCS at Rs 2374.9 per share or I can do it myself at my broker’s trading terminal.

Well, I would like to do this on my trading terminal. For this, I have to load the futures of TCS in my market watch and press the F1 button so that I can buy this contract. If you don’t know how to use a trading terminal then you should read our trading terminal chapter once.

As soon as I press an F1 button to buy TCS futures, a few things will happen in the background.

Margin Validation – When we buy a futures agreement, we have to deposit a margin amount or amount. This amount is a fixed percentage of the contract value or the contract price. If you do not have full margin money or margin amount in your account then you cannot enter into that agreement. That’s why the broker’s risk management system or software first checks whether your trading account has sufficient funds to allow you to enter into futures agreements.

Counterparty Search – After checking the margin, the system looks for a party who can become a counter party to you i.e. can compromise with you. Because I want to buy TCS futures so the system will look for the sellers of TCS futures. There are many people on the stock exchange who have different opinions about an asset. The seller of TCS futures will be of the opinion that going forward, the price of TCS will go down in the future, so he would like to sell the future.

Sign off – When the first and second steps i.e. margin validation and counter party search are completed then both the parties sign a futures agreement. Actually this is not done anywhere, it just happens that both the parties give their consent to fulfill this agreement.

Margin Block – Once signed off, the amount of margin in the trading account from both the parties is blocked. Now you cannot use this amount until this futures contract is completed.

After completing these four steps, I will now have one lot of TCS Futures. Usually all this work is done in a few seconds.

Holding one lot of TCS Futures means that now on 15th December 2014 by buying TCS futures from a counterparty, I have entered into an agreement with that party to buy 125 shares of TCS futures at ₹2374.9 per share And I have to complete this agreement on 24th December 2014.

Three Possible Post-Agreement Situations

After entering into these futures agreements, three conditions can be created on 24th December 2014. The price of TCS may go up, the price of TCS may come down and the price of TCS may not change. Let us see what effect all three of these conditions have:

Scenario 1 – TCS price moves up on 24th December

This is the situation where my opinion turns out to be correct. Suppose the price of TCS increases from ₹2374.9 to ₹2450 per share on 24th December 2014. Because of this, the futures price will also increase. This means that as per the agreement I can still buy TCS shares at ₹ 2374.9 which is much lower than the market price. I am making profit of ₹ 75.1 per share because my trade today is for 125 shares so my total profit will be Rs 9387.5 (2450-2374.9 = 75.1).

On the other hand, the seller will suffer a lot because he will have to sell the shares at the price of ₹ 2374.9 while the market price is ₹ 2450 per share.

Scenario 2– TCS price moves down on 24th December

In this situation my opinion turns out to be wrong, so I will be at a loss. Suppose on 24th December 2014 the price of TCS becomes ₹ 2300 instead of ₹ 2374.9 that means now I have to buy TCS shares at ₹ 2374.9 which is ₹ 75 more than the market price i.e. ₹ 2300. Since the deal is for 125 shares, I will have a loss of ₹9375 (75×125) in this trade.

Whereas the seller of the shares will benefit because he can buy one share from the market for ₹ 2300 and sell it to me for ₹ 2374.9.

Case 3 – There is no change in the share price of TCS as on 24th December

In this situation, there is no profit or loss for both the seller and the buyer.

Taking advantage of trading opportunities

Now just look at this situation, after buying the future of TCS on 15th December 2014 at Rs 2374, the price of TCS increases on the very next day i.e. 16th December 2014. Now it is selling at ₹2460. What should I do next? I am making a lot of profit because of the price increase, ₹85.1 per share i.e. total ₹10637.5 (85.1×125).

Assuming I am happy with this earning, can I exit my agreement? Will my opinion remain the same even after reaching ₹ 2460 that the stock will move further, maybe my opinion will change now and I feel that there is no room for further increase, so should I stay in this agreement ?

As I have said earlier that a futures agreement is tradable i.e. it can be bought and sold. You can sell this entire agreement to someone else i.e. I can take advantage of ₹ 10637.5 by selling the agreement.

Selling such an agreement is called square off. It is also called closing the open position. In the example of TCS, now I have to sell one lot of my shares so that my position can be squared off. Take a look at the chart below to understand it better.

No	Starting Date	Expectation at start	Condition at square off	Expectation at square off
01	Long	Bullish	Sell	Want to get out of the contract
02	Short	Bearish	Buy	Want to get out of the contract

I can again call my broker to square off or do it myself at my trading terminal. To square off, as soon as I place a sell order on a lot of TCS futures, these things will happen-

The broker will find the counterparty through the trading terminal who is willing to buy my futures position i.e. someone who still believes that the price of TCS futures will go up. When he buys the agreement, all the risk associated with it will be transferred to him.

Keep in mind that this transfer will take place at the current future price of TCS i.e. ₹ 2460 per share.
When the deal is done, my position will be squared off.

My blocked margin amount will be unblocked once the deal is done i.e. I will be able to use it now.
The profit or loss from this transaction will be credited to my trading account on the same day.

In this way, a futures trade is completed.

Remember that even at ₹2460, if I feel that the price of TCS will increase further going forward, then I can stay in that agreement. I have the option to hold that agreement till December 24, 2014. In fact, on December 23, just a day before the expiry of December 24, the price of TCS had reached ₹ 2519 i.e. if I had stayed in his agreement, then my profit would have been more. You can see it in the screenshot below:

In fact when on 16th December 2014 when I sold a lot of TCS share futures at ₹2460 and whoever bought that lot from me and took a risk on 23rd December 2014 made a huge profit. Now two questions arise here-

If I had held the TCS Futures share from 15th December 2014 (at ₹2374.9) to 23rd December 2015 (₹2519.25), what would have been my Total Profit and Loss (P&L)?

The one who bought TCS share from me on 16th December 2014 for ₹2460 and held it till 23rd December 2014, what will be his profit loss or profit and loss?

If you do not understand the answer to these questions, then you can write in the comment box below, we will talk about them in the next chapter.

Highlights of this chapter

• If you have an opinion on the direction of the price of an asset, you can make a profit from it by entering into a futures agreement.
• To enter into a futures agreement, you have to pay a token amount called margin.
• When we deal in futures, we have to sign an agreement in which we promise to fulfill this agreement.
• The futures price and spot price of an asset are different and there is a formula to calculate the futures price.
• The minimum number of shares that have to be bought to make this deal is called a lot.
• Even after entering into this agreement, it is not necessary that you remain in that agreement till the expiry.
• Your margin money is blocked as soon as you place a deal.
• You can withdraw from this agreement at any time.
• When you exit or square off the agreement, you transfer your risk to someone else.
• When you square off your position, your margin is unblocked.
• The profit or loss you make after square off is credited to your trading account on the same day.
• In this deal, one of the sellers or buyers gains and the other loses.