What is futures trading?

Futures trading is a type of financial contract that obligates the buyer to purchase, or the seller to sell, an asset like a commodity or a stock index at a predetermined price at a specific time in the future. This contract allows investors to speculate on the price of an asset in the future, either to profit from price movements or to hedge against potential price changes.

How Does Futures Trading Work?

In futures trading, two parties enter into an agreement to buy or sell an asset at a certain price on a future date. These contracts are traded on exchanges like the National Stock Exchange (NSE) or the Bombay Stock Exchange (BSE), and they involve various asset classes, including commodities like oil, gold, and agricultural products, or financial instruments like stock indices or interest rates.

Example of Futures Trading

Imagine you believe that the price of oil will go up in the next three months. You decide to enter into a futures contract where you agree to buy 100 barrels of oil at ₹70 per barrel, to be settled in three months. If the price of oil rises to ₹80 per barrel by the time the contract expires, you can sell your contract for a profit. If the price drops to ₹60, you would incur a loss when you fulfill the contract.

Types of Futures Contracts

Futures contracts can be broadly categorized into the following types:

• Commodity Futures: These are contracts that allow you to trade physical assets like gold, oil, or agricultural products.
• Financial Futures: These are contracts based on financial instruments like stock indices, bonds, and currencies.
• Stock Futures: These contracts are based on individual stocks, allowing traders to buy or sell a specific stock at a set price in the future.

Advantages of Futures Trading

• Leverage: Futures trading allows traders to use leverage, meaning they can control a large position with a smaller amount of capital. This increases the potential for higher profits.
• Hedging: Investors use futures contracts to protect against price fluctuations. For example, a farmer might sell a futures contract to lock in a price for their crop before harvest, reducing the risk of price drops.
• Liquidity: Futures markets are highly liquid, meaning traders can enter and exit positions quickly without affecting the price much.

Disadvantages of Futures Trading

• High Risk: Futures trading can be risky, especially with leverage. A small move in the wrong direction can lead to significant losses.
• Complexity: Futures contracts can be complex, and traders need to understand the market and the underlying asset to trade successfully.
• Margin Calls: If the market moves against your position, you may be required to deposit additional funds (known as a margin call) to maintain the position.

How to Trade Futures?

To begin trading futures, you need a trading account with a broker who provides access to futures contracts. Once you have an account, you can select a contract to trade based on your market outlook. For example, if you expect the price of gold to rise, you would buy a gold futures contract. You can then choose to either hold the position until the expiration date or close it out before the contract expires.

Key Terms in Futures Trading

• Contract Size: The amount of the underlying asset specified in the futures contract. For example, one gold futures contract might represent 100 ounces of gold.
• Expiration Date: The date when the contract expires. After this date, the contract becomes invalid.
• Margin: The initial deposit required to open a futures position. The margin is a fraction of the total contract value and acts as a security deposit.
• Settlement: The process of fulfilling the terms of the futures contract. Settlement can be in cash or by physical delivery of the asset.

Conclusion

Futures trading can be an exciting way to profit from price movements in various markets, but it also involves significant risk. By understanding the mechanics of futures contracts, the advantages, and the potential downsides, traders can make more informed decisions. Futures contracts are widely used for speculation and hedging, and can be a valuable tool for those looking to diversify their investment strategies.