Futures for beginners

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Futures are a type of derivative financial product. Let us begin by understanding what derivates are. For the sake of simplicity, we will limit our discussion to equity/share market.

A product derived from some raw material is called the derivative of that raw material. For example, India imports crude oil from oil-rich countries which is a raw material and then derives petrol, diesel, jet fuel etc. at refineries in India. In the above example, petrol, diesel and jet fuel will be called derivatives of crude oil.

Similarly, Future is a type of derivative because they derive their value from the share price. For example, HDFC Bank Futures will derive its value from HDFC Bank share price.

Let us now understand the concept of shorting with the help of an example. Suppose the share of HDFC Bank is trading at a price of Rs. 1500.

Person A is expecting good quarterly performance of HDFC Bank which will lead to an increase in the share price. Based on this logic, he buys shares of HDFC Bank and expects to sell them once the price of the share increases to book profits. Person A is said to be bullish or long on HDFC Bank. If the share price increases to Rs. 1600, then person A has earned Rs. 100 on a share of HDFC Bank. But if the share price decreases to Rs. 1400, then person A would have made a loss of Rs. 100.

Now consider another person B who is expecting bad quarterly results of HDFC Bank and hence a decrease in the share price. Based on this logic, he doesn’t buy the shares of HDFC Bank. Is there any way person B can still make money based on his view? The answer is yes. Person B can sell shares of HDFC Bank first and later buy them after the price has decreased. So, person B sells the share at 1500. Now, if the share price decreases to Rs. 1400, then person A has earned Rs. 100 on a share of HDFC Bank. But if the share price increases to Rs. 1600, then person A would have made a loss of Rs. 100. The process of first selling and then buying the share is called shorting. In effect, person B buys shares at lower price and sells them at a higher price if he is making a profit. Person B is said to be bearish or short on HDFC Bank.

Summary of the example

Having understood derivatives and shorting, let us now understand Futures. Futures are derivative contracts between two parties — person A & person B — having opposite view on the price movement of the stock. For example, person A has a bullish view on HDFC Bank and person B has a bearish view on HDFC Bank. Now person A can either buy HDFC Bank shares or buy HDFC Bank Futures. Similarly, B can either sell (short) HDFC Bank shares or sell (short) HDFC Bank Futures.

Now, consider A & B both have Rs. 15,000 cash to take positions based on the view they hold. In the market, having limited cash is always the case as no one can have infinite cash. Given that both have 15,000 in-hand, this is how both can trade in the spot (normal) market based on the views held by them.

Person A & person B can trade in the Futures market instead of the spot market too. In the Futures market, the trade will be somewhat different. Let us understand how Futures market work. Firstly, one cannot trade in any quantity of shares like in the spot market; there is a fixed quantity decided by the stock exchanges from time-to-time. This quantity of shares is called the lot size. Suppose the lot size for HDFC Bank Futures is 50, so a person has to trade in 50 shares or in multiples of 50 if he/she is trading in HDFC Bank Futures. So, does a trader need 50*1,500 = 75,000 in-cash to deal in HDFC Bank Futures? The answer is no. The trader will need a percentage of 75,000 to deal in HDFC Bank Futures as decided by the exchanges. The percentage required to trade in Futures is called the margin and is different for different companies. Suppose for HDFC Bank, the margin is 20%. So, the trader will need only 75,000*20% = 15,000 to buy a lot of HDFC Bank Futures. So, effectively with an amount of 15,000, the trader is dealing in 50 shares in the Futures market as opposed to 10 shares in the spot market. That is the beauty of Futures market; one can take larger bets with relatively smaller amounts of money.

Having understood the difference between buying shares in the spot market and Futures, we can move ahead to understand the profit/loss on shares in the spot market and Futures. Below are the possible scenarios of price movement for both A & B.

Profit & loss situation for person A
Profit & loss situation for person B

As can be seen in the above example, there are very different outcomes of profit & loss in the spot market and Futures market for the same amount invested. In the spot market, A & B can trade only 10 shares while in the Futures market, they can trade 50 shares. This difference of additional 40 shares that can be bought in Futures market leads to larger profits or larger losses. So in the example, A & B can make a profit of 5,000 on 15,000 invested amount which is a 33.33% gain while they can make only 1,000 on 15,000 invested amount, a gain of mere 6.67%. Similarly, A & B can make a loss of 5,000 on 15,000 invested amount which is a 33.33% loss while they can lose only 1,000 on 15,000 invested amount, a loss of 6.67%. Hence Futures can be a double-edged sword — it can result in large amounts of profit but can also cause losses (if one doesn’t apply a stoploss).

Having understood the idea and the basics of Futures, you can refer to this article written by me to get an in-depth understanding of Futures.