Understanding the "Futures Trading"

Lesson -> Future Trade

3.1 - Before Trade

We have learned many concepts about the futures market in the last chapter. The motivation of any trader who enters into a futures contract is to gain financial benefits. A trader must have a directional view on the price of the underlying assets. It might be time to look at a real-world example of a futures trading trade. Let's look at a stock example instead of the Gold example.

Today (15 th December 2014), Tata Consultancy Services' (TCS) management met with investors. The TCS management stated that they are cautious regarding the December Quarter revenue growth. Markets don't like such cautious statements, particularly from the company management. The markets responded to the statement and the stock fell by more than 3.6%, as you can see in the TCS spot market quote. The price per share is highlighted blue in the image below. The price per share is highlighted in blue in the snapshot below. We will talk about it soon. 

TCS stock price reaction is exaggerated according to me as a trader. My reasoning is: If you are a trader and follow TCS, or any Indian IT sector company generally, then you'll know that December is often a slow month for Indian IT companies. December marks the end of the US financial year (which is the largest market for Indian IT companies), and it also marks the holiday season. This means that business slows down for these companies. The IT sector revenues suffer from this furlough. This information is already known by the market and it has taken it into consideration. Accordingly, I think the stock's plunge of 3.6% is not justified. This could also be an opportunity for me to purchase TCS as I believe that the stock will rise in the future. This announcement would make me a buyer of TCS.

You will notice that I have created a ' directional ' view on the asset's value (TCS) based on my thoughts. Based on my analysis, I believe that the TCS (underlying assets) stock price will rise in due time. Also, TCS is my top pick at the current market price.

I decided to purchase TCS Futures instead of buying TCS shares on the spot market. I will explain why in the next chapter. Once I have decided to purchase futures, all that is required is to know the current price of the TCS Futures. You can find the contract details on NSE's website. The spot market quotes actually has the link to access details about a TCS futures agreement. In the above image, I highlighted the same in red.

Remember that the spot price must always be the same as the futures price. If the spot price goes down, then the futures should follow suit. Here's a snapshot of the TCS Futures Price from NSE.

The spot price has been imitated by the futures prices, so the TCS Futures is also down 3.77%. Two questions may be asked at this point.

  1. TCS spot market is down 3.61% TCS futures are down by 3.77%. What is the reason for this difference?
  2. TCS spot price is Rs.2362.35, Futures price at Rs.2374.90 What is the difference?

These are valid questions. The answer depends on the "Futures Pricing Formula", which we will discuss at a later time. The most important thing to remember at this point is that both the spot and futures prices have moved in the same direction. Both are currently down. Let's take a look at the futures contract again and examine a few key components before we move on. Let me now repost the futures agreement with some important elements highlighted.

The box highlighted in red at the top contains three key pieces of information.

  1. Type - The underlying asset is the stock in a company. We are interested in its future contract. The'stock futures' instrument type is used here.
  2. Symbol This shows the name of the stock. In this case, TCS.
  3. Expiry date - This indicates the date that the contract ends. The TCS futures contract stipulates that the expiry date is 24 December 2014. All derivative contracts in India expire the last Thursday of each month. We'll discuss the expiry date in detail at a later time.

The blue box was something we had seen earlier. It just shows the future price.

The black box also highlights two key parameters: the underlying value as well as the market lot.

  1. Underlying Value - This refers to the spot market price at which the underlying trades. TCS traded at Rs.2362.35 per shares; however, TCS dropped a few points when I took this snapshot. The price you see is now Rs.2359.95. Per share
  2. Market Lot (lot size) - A futures contract is a standard contract. These parameters are prefixed. If we agree to purchase/sell shares, the lot size is the minimum amount of shares we must buy/sell. TCS futures have a lot size of 125. This means that a minimum of 122.5 shares or a multiple of 125 must be traded while trading the TCS options.

Recall covered the 'contract worth' in the previous chapter. This is the result of the 'Lot size' multiplied with the futures price. The following formula can be used to calculate the TCS futures contract value:

Contract Value = Lot Size x Futures Price

= 125 x Rs.2374.90

= Rs. = Rs.

Let's take a quick look at the 'Futures Contract' before we get into the TCS futures trade. Here's a snapshot of the futures contract of "State Bank of India" (SBI).

The above snapshot may help you answer these questions.

  1. What type of instrument is it?
  2. What is the futures price of SBI?
  3. What does SBI's spot price and its future price look like?
  4. What is the expiry of the Futures contract's Futures contract?
  5. What is the lot size and contract value for SBI futures contracts?

3.2 - Futures Trade

To return to the TCS Futures Trade, my idea is to purchase a futures contract because I expect TCS stock prices to rise. TCS Futures would cost Rs.2374.9/share. The minimum number of shares I must buy is 125. Commonly, the minimum number of shares is called "one lot".

How do we purchase the 'Futures Contract? It's easy. We can either call our broker to ask him for 1 lot of TCS Futures at Rs.2374.9/, or we can purchase it ourselves using the broker’s trading terminal.

I prefer to trade directly through the trading terminal. If you're new to trading terminals, I recommend that you read the chapter on Trading Terminal. Once TCS Futures has been loaded onto my market watch, I can simply press F1 to buy the contract.

A few things take place in the background when I press F1 on my trading terminal to express my interest in buying TCS futures.

  1. Margin Validation- We need to deposit a margin amount, which is a type of token advance, when we enter into futures agreements. This is simply a percentage the contract value. We'll soon discuss margins. We cannot agree if there is not enough margin. As a first step, the broker's Risk Management System/ Software checks whether I have enough money in my trading account (to meet the margin requirement) before entering into a futures contract.
  2. The counterparty searching - After validating margins, the system searches for a suitable counterparty match. The match must be between me, the buyer of TCS futures, and the TCS forwards seller. The stock exchange is a "Financial Supermarket" where many people have different opinions on the price of an asset. TCS futures seller clearly believes that TCS futures prices will fall further. The seller's view on the direction of TCS stock prices is similar to my reasoning. He wants to be a vendor.
  3. Signoff -Once steps 1 and 2 have been completed, i.e. The margin validation and finding the counterparty are completed. This is mainly symbolic. One agrees to buy or sell the futures contract and the other agrees to follow the contract specifications.
  4. The margin Block - Once the signoff has been completed, the required margin will be blocked from our trading account. The margin cannot be used for any other purpose. As long as the futures contract is in force, the money will remain blocked.

After completing these four steps, I now have 1 lot of TCS Futures contract. Surprisingly, the actual markets have all of the steps above in just a few seconds.

This is the critical question: What does "I now own 1 lot" of TCS Futures Contract mean? It simply means that I purchased TCS futures on the 15 December 2014 and digitally signed a contract with a counterparty to purchase 125 TCS shares at Rs.2374.9/share. The futures agreement between me (the counterparty) expires on 24 th December 2014.

3.3 - The 3 possible outcomes after the agreement

After agreeing, 3 possible scenarios can pan out by 24th Dec 2014. These scenarios are known (we have studied them in chapter 1). The price of TCS may go up or fall, or it could remain the same. Let's look at the impact of price on each party.

Scenario 1: TCS stock price rises by 24 th December.

Here is where my directional view of TCS shares comes to fruition. Thus, I stand to gain.

Let's say that the stock price for TCS rose from Rs.2374.9/– to Rs.2450/– per share on the 24th December 2014. The futures price would rise due to the increase in spot prices. According to the agreement, I have the right to purchase TCS shares at Rs.2374.9/share, which is much less than what is on the market. My profit will be Rs.75.1/share (Rs.2450-Rs.2374.9). My total profit (Rs.75.1/* 125) will be Rs.9387.5/=

As a result, the seller suffers a loss as he has to sell TCS shares at Rs.2374.9 per unit instead of selling them in open market at Rs.2450/- per unit. The seller's loss is clear.

Scenario 2: TCS stock price drops by 24 th December.

Here is where my directional view of TCS shares went wrong. Also, I stand to lose.

Let's say that the stock price at TCS drops from Rs.2374.9 to Rs.2300/share on the 24th December 2014. The futures price will be approximately the same. According to the agreement, I am required to purchase TCS shares at Rs.2374.9/share, which is much more than what is on the market. My loss will amount to Rs.75./share (Rs.2374.9-Rs.2300). My total loss due to the deal for 125 shares will be Rs.9375/ (Rs.75/ * 125).

As I am forced to purchase the TCS shares at Rs.2374.9/share instead of buying them in the open market at Rs.2300/share, I will undoubtedly incur a loss. The seller's gain is clearly the buyer's lose.

Scenario Three - TCS stock price remains unchanged.

In such a scenario, neither buyer nor seller benefits, so there is no financial impact for either.

3.3 - Exploiting trading opportunities

Here's an example: TCS futures were purchased on December 15, 2014 at Rs.2374.9/day. 16th Dec 2014, TCS price shot up. It now trades at Rs.2460/+ What can I do? The price rise will clearly benefit me. As an overall profit, I have a profit of Rs.85.1/share or Rs.10637.5/- (Rs.85.1/– * 125).

Let's say I'm happy with the overnight money I made. Can I end the agreement? What if my opinion changes at Rs.2460 per shares? What happens if my view changes about TCS at Rs.2460. Is it really necessary to keep the agreement in place until the contract expiry date (i.e. 24 th December 2014, at which point a drop in price could result in a loss.

As I mentioned in the previous chapter the futures agreement can be traded. This means that I can easily cancel a futures contract by simply transferring it to another person. This allows me to close my existing TCS futures position, and make a profit of Rs.10637.5/-. This is a great job for a one-day job. J

Square off is the term used to close an open futures position. Square off is the process of reducing an open position. For example, in the TCS case, I bought 1 lot TCS futures. When I square off, I must sell 1 lot TCS futures so that my original buy position is offset. The following table summarises the idea of square off.

Serial NoInitial LegView at the initial legSquare off the legTake a look at the time of squarering off
01Buy / PurchaseBullish: Expect the price of gold to rise -SellOne can't expect the price of the product to rise or want to exit the current position (for whatever reason).
02Shorten/SellBearish: Expect the price to fallBuyOne cannot expect the price of the product to drop or want to exit the current position (for whatever reason).

If I want to square off a position I have two options: call my broker and ask him to do so, or I can do it myself via the trading terminal. The example shows a buy-open position in TCS futures (1 lots). This open position can be offset by the square-off position of "selling 1 lot" TCS futures. When I square the TCS position, these are what happen:

  1. Through the trading terminal, the broker searches for a counterparty willing to purchase my futures position. Simply put, my existing buy position will be transferred to another person. The risk of the TCS price going up or down is now borne by the "someone else" who bought the contract from me. This is known as the "Risk transfer".
  2. The transfer will take place at the current market futures price, i.e. 2460/- per Share
  3. After the trade is completed, my position will be considered to be offset (or squared off).
  4. After the trade is completed, any margins that were previously blocked will now be open. This cash can be used for other transactions.
  5. My trading account will be debited or credit with the profit or loss from the transaction that evening.

The futures trade is now complete.

If I have a view at Rs.2460 that the price will rise, I can continue to hold stock futures. The fact is that I can keep the futures until the contract expires, i.e. 24th Dec 2014. I will continue to own the futures as long as the price fluctuation of TCS continues to be a risk. Here is the snapshot of TCS Futures, taken just one day before expiry. My profits would have been higher if I had held the futures until 23 December. TCS futures are trading at Rs.2519.25/share.

In reality, the TCS futures were purchased by someone else on the 16th December 2014. This means that I sold my buy position to someone else and the counterparty would have also made money by purchasing the TCS futures contract at Rs.2460/= from me. The contract was held until 23 December 2014. Here are two questions:

  1. How much would my Profit & Loss (P&L), per share, and overall, if I had held the TCS futures between 15 th December 2014 (Rs.2374.9) and 23 rd December 2015 (Rs.2519.25).
  2. I squared my position at Rs.2460/– on 16 th December 2014. This was evidently after the contract's square was transferred. If the counterparty kept the TCS futures position up to 23 rd December 2014, how much profit and loss would he make on a per-share or overall basis?

If you are unable to answer the questions above, please leave a comment below and I will gladly answer your question. I hope that you find the answers to these questions yourself.

We will be discussing margins in the next chapter. They are an important aspect of futures trading.

To Summarize

  • A futures agreement can be a financial benefit if you have a directional outlook on the asset price.
  • A token advance, also known as the margin, is required to transact in futures contracts.
  • We digitally sign a futures contract agreement when we transact; we are legally bound to honor the contract.
  • Spot and futures prices for an asset differ. This is due to the futures pricing formula.
  • One lot is the minimum number required to transact shares.
  • We are not required to keep the futures agreement in force until it expires once we have entered into one.
  • A margin amount is required for every futures trade. If you enter a futures trading, the margins will be blocked.
  • You can end the agreement at any time. This means that you can do so within seconds of signing it.
  • By signing an agreement, you are effectively transferring risk to another party.
  • Margins can be unblocked once we have squared the futures position.
  • Your trading account is debited or credited with the money you lose or make in a futures trade on the same day.
  • A futures contract is a contract where the seller loses and the buyer gains.