What are Futures?

Feb, 2024
By SmartBulls Team

In simple terms, futures contracts are agreements between two parties to buy or sell something (like stocks, commodities, or currencies) at a specific price on a specific future date. It's like making a deal to buy or sell something in the future, but with a fixed price and date.

In the stock market, futures are financial derivative contracts that oblige the parties involved to buy or sell an underlying asset (such as stocks, commodities, currencies, or indices) at a predetermined price and date in the future. These contracts are standardized and traded on organized exchanges, such as the National Stock Exchange (NSE) or the Bombay Stock Exchange (BSE) in India.

Here's an example how futures work in stock market:

You may buy a futures contract for XYZ Company's stock at Rs. 100 per share, anticipating that the price will rise. If the price increases to Rs. 120 per share, you can sell the contract and make a profit of Rs. 2,000 (Rs. 120 - Rs. 100 per share). Futures trading requires monitoring the market, managing risks, and understanding the factors that influence prices.

The purpose of futures contracts is to provide a way for people to manage risks or speculate on future price movements. For example, farmers may use futures contracts to lock in a price for their crops before they are harvested. Investors may use futures contracts to profit from expected price changes in stocks or commodities.

Features of Futures Trading

1. Contractual Agreement: Futures contracts are binding agreements between two parties to buy or sell an underlying asset at a predetermined price on a specific future date.

2. Standardized Terms: Futures contracts have standardized terms and specifications, including the quantity, quality, and delivery date of the underlying asset. This promotes transparency and liquidity in the market.

3. Leverage: Futures trading involves trading on margin, which means that traders can control a larger position with a smaller initial investment. This amplifies both potential profits and losses.

4. Price Discovery: Futures markets provide a platform for price discovery, as the buying and selling activities of traders determine the market price of the underlying asset. This price discovery mechanism facilitates efficient trading and hedging.

5. Risk Management: Futures contracts allow traders to hedge against potential price fluctuations in the underlying asset. Hedgers use futures to protect against adverse price movements, while speculators aim to profit from price changes.

6. Liquidity: Futures markets tend to be highly liquid, meaning there is a large number of buyers and sellers. This facilitates easy entry and exit from trades and minimizes the impact of large orders on market prices.

7. Variety of Assets: Futures contracts are available for various asset classes, including commodities, currencies, stock indices, and interest rates. This allows traders to diversify their portfolios and participate in different markets.

8. Exchange-Traded: Futures contracts are typically traded on regulated exchanges, ensuring transparency, standardized procedures, and counterparty risk mitigation.

9. Mark-to-Market: Futures positions are marked to market daily, which means that gains or losses are settled daily based on the closing prices. This helps maintain account balances and reduces the risk of default.

10. Trading Hours: Futures markets generally have extended trading hours, allowing traders to access the market beyond regular trading hours.

Advantages of Futures Trading

1. Leverage: Futures contracts allow traders to control a large position with a relatively small amount of capital, thanks to leverage. Traders are only required to deposit a fraction of the total contract value (known as margin), which amplifies potential returns. However, it's essential to remember that leverage also increases the risk of losses.

2. Hedging: Futures contracts serve as effective hedging tools, allowing market participants to manage and mitigate risks associated with price fluctuations. For example, producers can hedge against falling prices by selling futures contracts, while consumers can hedge against rising prices by buying futures contracts. Hedging helps stabilize cash flows and protects against adverse market movements.

3. Price Discovery: Futures markets facilitate price discovery by providing a transparent platform for buyers and sellers to establish prices for underlying assets. The continuous trading and price dissemination in futures markets contribute to price transparency, which benefits all market participants, including investors, producers, and consumers.

4. Liquidity: Futures markets typically exhibit high levels of liquidity, allowing traders to enter and exit positions with ease. The presence of numerous market participants, including institutional investors, speculators, and hedgers, ensures ample liquidity, reducing the risk of slippage and improving execution efficiency.

5. Diversification: Futures trading offers exposure to a wide range of asset classes, including commodities, equities, currencies, and interest rates. This diversification potential allows traders to spread risk across different markets and asset classes, reducing portfolio volatility and enhancing risk-adjusted returns.

6. Accessibility: Futures markets are accessible to a broad range of market participants, including individual traders, institutional investors, and corporations. With the advent of electronic trading platforms, futures markets are more accessible than ever, enabling traders to execute trades from anywhere with an internet connection.

7. Efficiency: Futures markets are known for their efficiency in reflecting available information and incorporating market expectations into prices. This efficiency ensures that prices accurately reflect supply and demand dynamics, providing traders with fair and competitive trading opportunities.

8. Regulatory Oversight: Futures markets are subject to stringent regulatory oversight, which helps maintain market integrity, transparency, and investor protection. Regulatory authorities enforce rules and regulations to prevent market manipulation, fraud, and misconduct, fostering confidence among market participants.

Disadvantages of Futures Trading:

1. Leverage Magnifies Losses: While leverage can amplify potential returns, it also magnifies losses. Since futures trading involves trading on margin, traders can quickly incur significant losses if the market moves against their positions. High leverage increases the risk of margin calls, where traders are required to deposit additional funds to maintain their positions or risk liquidation.

2. Volatility and Price Fluctuations: Futures markets are often characterized by high volatility and rapid price fluctuations. Price movements can be influenced by various factors, including economic data releases, geopolitical events, weather conditions, and market sentiment. Volatility can lead to unexpected losses and make it challenging to accurately predict market movements.

3. Market Timing: Successful futures trading requires precise market timing, which can be difficult to achieve consistently. Traders must accurately anticipate price movements and enter and exit positions at the right time to generate profits. However, timing the market is inherently challenging, and even experienced traders can struggle to predict market trends accurately.

4. Counterparty Risk: Futures contracts are standardized agreements traded on organized exchanges, but they still entail counterparty risk. While exchange-traded futures contracts mitigate counterparty risk to some extent, there is always a risk that the counterparty (usually a clearinghouse) may default on its obligations. However, regulatory safeguards and risk management measures are in place to minimize counterparty risk in futures markets.

5. Overtrading: Futures trading can be addictive, leading some traders to overtrade in pursuit of quick profits. Overtrading can result in excessive transaction costs, increased exposure to market risks, and emotional decision-making driven by greed or fear. It's essential for traders to exercise discipline and adhere to a well-defined trading plan to avoid the pitfalls of overtrading.

6. Market Manipulation: Despite regulatory oversight, futures markets are vulnerable to manipulation and fraudulent activities. Unscrupulous traders or entities may attempt to manipulate prices for their benefit, causing disruptions and distortions in the market. While regulators strive to detect and prevent market manipulation, traders should remain vigilant and report any suspicious activities.

7. Complexity and Learning Curve: Futures trading can be complex, especially for novice traders who are unfamiliar with market dynamics, trading strategies, and technical analysis tools. Mastering futures trading requires time, effort, and continuous learning. Novice traders may face challenges in understanding market intricacies and may make costly mistakes until they gain sufficient experience.

8. Margin Requirements and Costs: Futures trading involves margin requirements, which necessitate traders to maintain a minimum account balance to support their positions. Margin requirements tie up capital and limit the flexibility of traders. Additionally, futures trading entails transaction costs, including commissions, exchange fees, and financing charges, which can erode profits over time.

Precautions for Futures Trading:

1. Education: Before engaging in futures trading, it's crucial to educate oneself about how futures markets work, understand contract specifications, and familiarize oneself with trading strategies.

2. Risk Management: Implement robust risk management strategies, including setting stop-loss orders to limit potential losses and diversifying investments to spread risk.

3. Professional Guidance: Consider seeking guidance from financial professionals or experts experienced in futures trading to gain insights and advice tailored to individual trading goals and risk tolerance.

Futures trading is popular because it provides opportunities for potential gains even if the market is going down. It allows traders to speculate on price movements, hedge against risks, and take advantage of market fluctuations. However, it's important to understand that trading futures involves risks, and it requires knowledge and careful consideration. Before getting involved in futures trading, it's recommended to learn more about how they work and consider seeking guidance from professionals or experts and practice on a paper trading app SmartBulls.