Futures contracts are versatile financial instruments that allow traders and investors to speculate on, hedge against, or gain exposure to various asset classes and commodities. Stock markets comprise different types of futures and options, each tailored to underlying assets and market conditions.
In this blog, let us delve deeper into understanding the different types of futures contracts available to market participants.
You may also like: OTC market – A beginner’s guide to decentralized trading
What is the meaning of a future contract?
Futures are derivative instruments that derive their value from an underlying asset. These contracts facilitate the trading of commodities at a predetermined price today, with delivery set for a future date as outlined in the contract. This arrangement offers investors the opportunity to reap profits if the market price of the traded commodity rises by the agreed-upon delivery date.
It is important to note that futures contracts come with expiration dates. However, there is no obligation to hold them until maturity. Traders enjoy the flexibility to cancel these contracts at any time during their duration.
Futures contracts involve two distinct positions: the short (sell) position, which entails delivering the asset on the specified date, and the long (buy) position, which obligates the acceptance of delivery on the maturity date. Investors may opt to initiate a short position while holding a long position in the same contract, nullifying the original long position.
Forward Contract Vs Future Derivative Contract
A forward contract is an over-the-counter (OTC) contract and concludes only once, typically at the contract’s end. The parties engaged in this agreement negotiate and determine the specific terms privately. Forward contracts carry a certain level of default risk as it is the counterparty’s responsibility to make the payment on time as agreed upon.
In contrast, futures contracts are standardised agreements traded on stock exchanges. They involve daily settlements, fixed maturity dates, and uniform terms. Futures contracts are low-risk since they provide a guarantee of payment on the specified date, reducing the risk associated with default.
Functions of future markets
Hedging
They provide a platform for businesses and producers to mitigate price risk by locking in prices for future transactions, ensuring cost stability and income protection.
Speculation
Speculators enhance market liquidity, aid in price discovery, and seek profit opportunities by actively participating in trading. Their activities create price volatility and depth, allowing for more complex trading strategies and risk management.
Also read: How to trade in options and maximise your profit?
Different types of future contracts
Futures markets offer a range of contract types, with the most common being forex, indices and commodities, particularly oil.
Forex futures
Forex futures are also known as currency futures. They establish a future date’s price for purchasing one currency using another. These contracts are exchange-traded, which differentiates them from the over-the-counter nature of regular foreign exchange (FX) trading. While the forex futures market is relatively smaller and less flexible, it provides a gateway for individuals accustomed to trading more regulated products like stocks.
When trading forex futures, it is crucial to consider the liquidity of the currency pair, with major pairs typically offering higher daily trading volumes. Currencies like the USD, GBP, EUR, and JPY are among the most liquid currencies. Forex futures are used for hedging and speculative purposes rather than physical settlement.
VIX futures
VIX futures contracts are associated with the NIFTY Volatility Index (VIX), a gauge reflecting market expectations regarding future volatility. NSE VIX futures are traded on the NSE under the symbol NVIX.
NVIX is viewed as an indicator of market uncertainty. Traders utilise NVIX futures to speculate on potential shifts in market volatility. If a trader anticipates an uptick in market volatility, they may opt to purchase NVIX futures as a safeguard against potential market declines.
Oil futures
Oil futures allow market participants to fix a future oil price. While no one can predict the exact future market price, traders can choose a level they believe the market will reach. Unlike some other commodity futures, oil contracts have monthly settlements due to the high volatility of oil markets. This frequent expiration schedule makes it easier for traders to speculate on oil prices.
Equity futures
Equity futures represent standardised agreements that require the trader to purchase or sell a specific quantity of shares from a specific company’s stock at a predetermined price for a future date. These contracts are actively traded on exchanges, offering traders a means to participate in the price fluctuations of individual stocks without actual ownership of the shares.
Equity futures are popular among market participants like speculators, hedgers, and arbitrageurs. These contracts enable traders to capitalise on upward and downward movements in stock prices, offering a versatile tool for managing risk and seeking profits.
Index futures
Index futures contracts are based on specific stock market indices, which are representations of a collection of stocks chosen to mirror a particular market or sector. Examples include Nifty 50 and BANKNIFTY. When engaging in index futures trading, traders are essentially making predictions about the direction of the overall market, as opposed to focusing on individual stocks. These contracts are widely used for managing portfolio risk and capitalising on broader market trends.
Also read: What is Short-Selling, and how does it work?
Futures Option Vs Futures Contract
Understanding the world of trading can be a bit intimidating, especially with terms like “futures options” and “futures contracts” flying around. Futures contracts and options on futures both play vital roles in trading strategies, but they serve different purposes and come with unique features. Let’s jump straight into the differences between these two important concepts.
| Futures Contract | Futures Option | |
| Definition | A legally binding agreement to buy or sell an asset at a predetermined price on a specified future date. | A contract that gives the buyer the right, but not the obligation, to buy (call option) or sell (put option) a futures contract at a specified price before the option expires. |
| Obligation | Both parties are obligated to fulfill the contract on the expiration date. | The buyer has the right to exercise the option but is not obligated to do so. |
| Risk | Higher risk as both parties must fulfill the contract regardless of market conditions. | Lower risk for the option buyer since they can choose not to exercise the option. |
| Premium | No premium is paid; the contract value is based on the asset price. | A premium is paid to acquire the option, which is the cost of having the right. |
| Profit Potential | Profit or loss is directly tied to the price movement of the underlying asset. | Profit potential can be limited to the premium paid, depending on the option’s market movement. |
| Market Participation | Requires a more significant capital investment due to margin requirements. | Allows participation with a smaller capital outlay due to the premium. |
| Settlement | Typically settled by physical delivery of the asset or cash settlement. | Settled by exercising the option or letting it expire worthless. |
Knowing these terms is the first step to successful futures trading. It’s also important to understand how futures trading works to make smart choices in the market. Let’s go over the basics of futures trading to help you get ready for your journey.
How Does Futures Trading Work?
As you now know that futures trading involves buying or selling a contract that obligates the buyer to purchase, and the seller to sell, an asset at a predetermined price on a specified date in the future. This form of trading is commonly used for commodities, currencies, or financial instruments.
So, traders simply use futures to hedge against price fluctuations or to speculate on price movements. For example, a farmer may sell futures contracts for wheat to lock in a price before harvest, protecting against potential price drops. On the other hand, an investor might buy futures contracts on oil, betting that prices will rise before the contract’s expiration.
Futures contracts are standardized and traded on exchanges, which helps ensure transparency and liquidity. Because of the leverage involved, profits and losses can be magnified, making it essential for traders to manage risk effectively.
So basically, futures trading plays a crucial role in price discovery and risk management in financial markets.
Conclusion
To engage in futures trading successfully, it is essential to possess a comprehensive grasp of the functions of the futures market and the behaviour of the underlying asset. This knowledge is crucial for making informed decisions regarding trading positions and timing entry and exit points. Although futures trading has witnessed significant growth in trading volumes on stock exchanges, traders must be mindful of the potential pitfalls and exercise caution in their trading endeavours.
