Futures contracts enable investors to use various tactics that can prove profitable while trading. One can resort to arbitrage, hedging and speculation depending on one's objectives.
While hedging safeguards against risks due to price variation, arbitrage results in risk-less profit and speculation aims at generating very large profits. However, a futures contract is an obligation and, consequently, the investor must fulfil it even if the asset price on the settlement date is not favourable for him.
So, one needs to understand the mechanism and risks involved before entering the futures market. Here are some terms that can help you.
It is also known as market price and is the one that is quoted for the immediate sale or purchase of an asset.
This is the price at which the futures contract trades in the market. It is determined by the equilibrium between the forces of demand and supply of buy/sell orders on the exchange.
A contract cycle is the period for which the futures contract trades on an exchange. Stock and index futures have one-month (near month), two-month (next month) and three-month (far month) contract cycles. A new contract, which is for three months, is introduced after the expiry of the near month contract. Therefore, at any point, there are three contracts available for trading in the futures market.
This is also known as lot size and is the minimum quantity of an asset (stocks, indices, commodities) that one needs to buy or sell to trade in futures.
It is the last date on which the futures contract trades on the exchange. At the end of the expiry date, the futures contract is no longer valid and ceases to exist. All traders are compulsorily required to settle their positions on the expiry date. In India, equity derivative contracts expire on the last Thursday of every month.
The difference between the futures price and spot price is called basis. Its major determinants are demand and supply, because of which it keeps changing, and can be either positive or negative. If the demand is stronger than supply, the spot price will rise relative to the futures price, which, in turn, will strengthen the basis. On the other hand, if the supply is higher, the spot price will fall and the basis will weaken. The basis tends to reduce as the futures contract approaches its date of expiration.
It is the minimum amount that a participant must deposit in the margin account before initiating trade in the futures market. Margins are levied by the exchanges to ensure that counterparties fulfil their obligations.
COST OF CARRY
The futures price of an asset is determined using the concept of 'cost of carry'. It is the cost associated with holding a position. In case of commodities, such as wheat and rice, there is a cost associated with storage. Similarly, in case of financial assets, the cost of carry includes interest and dividends. The fair futures price of an asset is determined by adding the cost of carry to the spot price.
This is set to ensure that the balance in the margin account does not fall below a threshold level. It is lower than the initial margin. If the balance in an investor's account falls below this level, he receives a margin call. He is then required to top up the balance to the initial margin level before commencing trading on the next day.