What are Futures Contracts?

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FUTURES CONTRACT: A futures contract is the obligation to sell or buy an asset at a later date at an agreed-upon price & are traded on the stock exchange for different asset classes such as currency, equity, index & commodities.

Example

Let’s demonstrate with an example.
Assume two traders (A & B)  agree to a Rs 880 per share price of HDFC bank on an HDFC Bank futures contract.
A” believes that the HDFC BANK stock price will go up while “B” is betting that HDFCBANK stock will go down.

If the price of HDFC BANK moves up to Rs 990, the buyer of the contract makes Rs 110 Profit.
The seller, on the other hand, loses out Rs 110.

NOTE – It’s not mandatory to have the buy-side futures contract or the underlying shares with you at the time of selling a futures contract & vice versa. When you sell a futures contract you are betting that the stock will go down. While an equity short position has to be squared off the same day, a sell position in a futures contract can be held till the expiry of the contract.

Stock futures can be purchased on individual stocks or on an index like the Nifty 50. The buyer of a futures contract is not required to pay the full amount of the contract up front. A percentage of the price called an initial margin is paid.

Futures contracts tend to be for large amounts of money. The obligation to sell or buy at a given price makes futures riskier by their nature.

IMPORTANT FEATURES OF A FUTURES CONTRACT

TRADED IN LOTS – Lot size specifies the minimum quantity that you will have to transact in a futures contract. Lot size varies from one asset to another.

CONTRACT VALUE – The contract value is the quantity times the price of the asset. We know the futures agreement has a standard pre-determined minimum quantity (lot size). Going by this, the contract value of a futures agreement can be generalized to “Lot size x Price”.

MARGIN – However, in a futures agreement the moment a transaction takes place, both the parties involved will have to deposit some money. Consider this as the token advance required for entering into an agreement. The money has to be deposited with the broker. Usually, the money that needs to be deposited is calculated as a % of the contract value. This is called the ‘margin amount’. Margins play a very pivotal role in futures trading; we will understand this in greater detail at a later stage. For now, just remember that to enter into a futures agreement a margin amount is required, which is a certain percentage of the contract value.

EXPIRY – As we know, all futures contracts are time-bound. The expiry or the expiry date of the futures contract is the date up to which the agreement is valid. Beyond the valid date, the contract ceases to exist. Also be aware that the day a contract expires, new contracts are introduced by the exchanges.



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