Trading Stocks & Index Futures in
the Indian Stock Market
Futures trading is a business that gives you everything you've ever wanted from a business of your own. Roberts (1991) calls it the world's perfect business. It offers the potential for unlimited earnings and real
wealth. You can run it working at your own hours as well as continuing to do whatever you're doing now.
You can operate this business entirely on your own, and can start with very little capital. You won't have any employees, so you wouldn't need attorneys, accountants, or bookkeepers.
What's more, you'd never have collection problems because you won't have any "customers," and since there is no competition, you won't have to pay the high cost of advertising. You also won't need office space, warehousing, or a distribution system. All you need is a personal computer and you can conduct
your business from anywhere in the world.... Interested?...
read on!
What does Futures Trading apply to
Indian Stocks & Indices
Futures Trading is a form of investment which involves speculating on the price of a
security going up or down in the future.
A security could be a stock (RIL, TISCO, etc), stock index (NSE
Nifty Index), commodity (Gold, Silver, etc), currency, etc.
Unlike other kinds of investments, such as stocks and bonds, when you trade futures, you do not actually buy anything or own anything. You are speculating on the future direction of the price in the
security you are trading. This is like a bet on future price direction. The terms "buy" and "sell" merely indicate the direction you expect future prices will take.
If, for instance, you were speculating on the NSE Nifty Index, you would buy a futures contract if you thought the price would be going up in the future. You would sell a futures contract if you thought the price would go down. For every trade, there is always a buyer and a seller. Neither person has to own anything
to participate. He must only deposit sufficient capital with a brokerage firm to insure that he will be able to pay the losses if his trades lose money.
What is a Futures Contract?
A futures contract is a standardized contract, traded on a
futures exchange, to buy or sell a certain underlying
instrument at a certain date in the future, at a specified
price. The future date is called the delivery date or final
settlement date. The pre-set price is called the futures
price. The price of the underlying asset on the delivery
date is called the settlement price.
A futures
contract gives the holder the obligation to buy or sell,
which differs from an options contract, which gives the
holder the right, but not the obligation. In other words,
the owner of an options contract may or may not exercise the
contract. Whereas in a futures contract, both parties of a
"futures contract" must fulfill the contract on the
settlement date.
In a futures contract the seller delivers the
shares/commodity to the buyer, or, if it is a cash-settled
future, as in the case of stock futures in India, cash is
transferred from the futures trader who sustained a loss to
the one who made a profit. To exit or close your position in
an existing futures contract prior to the settlement date,
the holder of a futures position has to offset his position
by either selling a long position or buying back a short
position, effectively closing out the futures position and
its contract obligations.
The futures contract is a standardized forward contract,
which is an agreement between two parties to buy or sell an
asset (which can be of any kind) at a pre-agreed future
point in time specified in the futures contract. Some key
features of a futures contract are:
Standardization
A futures contract is highly standardized contract with the
following details specified:
- The underlying asset or instrument. This could be
anything from a barrel of crude oil, a kilo of Gold or a
specific stock or share.
- The type of settlement, either cash settlement or
physical settlement. Currently in India most stock
futures are settled in cash.
- The amount and units of the underlying asset per
contract. This can be the weight of a commodity like a
kilo of Gold, a fixed number of barrels of oil, units of
foreign currency, quantity of shares, etc.
- The currency in which the futures contract is
quoted.
- The grade of the deliverable. In the case of bonds,
this specifies which bonds can be delivered. In the case
of physical commodities, this specifies not only the
quality of the underlying goods but also the manner and
location of delivery.
- The delivery month.
- The last trading date.
Trading in futures is regulated by the Securities & Exchange Board of India (SEBI). SEBI exists to guard against traders controlling the market in an illegal or unethical manner, and to prevent fraud in the futures market.
How does Futures Trading Work?
There are two basic categories of futures participants:
hedgers and speculators.
In general, hedgers use futures for protection
against adverse future price movements in the underlying
cash commodity. The rationale of hedging is based upon the
demonstrated tendency of cash prices and futures values to
move in tandem.
Hedgers are very often businesses, or individuals, who at
one point or another deal in the underlying cash commodity.
Take, for instance, a major food processor who cans corn. If
corn prices go up. he must pay the farmer or corn dealer
more. For protection against higher corn prices, the
processor can "hedge" his risk exposure by buying enough
corn futures contracts to cover the amount of corn he
expects to buy. Since cash and futures prices do tend to
move in tandem, the futures position will profit if corn
prices rise enough to offset cash corn losses.
Speculators are the second major group of futures
players. These participants include independent traders and
investors. For speculators, futures have important
advantages over other investments:
If the trader's judgment is good. he can make more money
in the futures market faster because futures prices tend, on
average, to change more quickly than real estate or stock
prices, for example. On the other hand, bad trading judgment
in futures markets can cause greater losses than might be
the case with other investments.
Futures are highly leveraged investments. The trader puts
up a small fraction of the value of the underlying contract
(usually 10%-25% and sometimes less) as margin, yet he can
ride on the full value of the contract as it moves up and
down. The money he puts up is not a down payment on the
underlying contract, but a performance bond. The actual
value of the contract is only exchanged on those rare
occasions when delivery takes place. (Compare this to the
stock investor who generally has to put up 100% of the value
of his stocks.) Moreover the futures investor is not charged
interest on the difference between the margin and the full
contract value.
Settling Futures Contracts in India
Futures contracts are usually not settled with physical delivery. The purchase or sale of an offsetting position can be used to settle an existing position, allowing the speculator or hedger to realize profits or losses from the original contract. At this point the margin balance is returned to the holder along with any additional gains, or the margin balance plus profit as a credit toward the holder's loss. Cash settlement is used for contracts like stock
or index futures that obviously cannot result in delivery.
The purpose of the delivery option is to insure that the futures price and the cash price of good converge at the expiration date. If this were not true, the good would be available at two different prices at the same time. Traders could then make a risk-free profit by purchasing
stocks in the market with the lower price and selling in the
futures market with the higher price. That strategy is called arbitrage. It allows some traders to profit from very small differences in price at the time of expiration.
Advantages of Futures Trading in India
There are many inherent advantages of trading futures over other investment alternatives such as savings accounts, stocks, bonds, options, real estate and collectibles.
1. High Leverage. The primary attraction, of course, is the potential for large profits in a short period of time. The reason that futures trading can be so profitable
is the high leverage. To ‘own’ a futures contract an investor only has to put up a small fraction of the value of the contract (usually around
10-20%) as ‘margin’. In other words, the investor can trade a much larger amount of the
security than if he bought it outright, so if he has predicted the market movement correctly, his profits will be multiplied (ten-fold on a 10% deposit). This is an excellent return compared to buying
and taking physical delivery in stocks.
2. Profit in both bull & bear markets. In futures trading, it is as easy to sell (also referred to as going short) as it is to buy (also referred to as going long). By choosing correctly, you can make money whether prices go up or down. Therefore, trading
in the futures markets offers the opportunity to profit from any potential economic scenario. Regardless of whether we have inflation or deflation, boom or depression, hurricanes, droughts, famines or freezes, there is always the potential for profit
making opportunities.
3. Lower transaction cost. Another advantage of futures trading is much lower relative commissions. Your commission
for trading a futures contract is one tenth of a percent
(0.10-0.20%). Commissions on individual stocks are typically as much as one percent for both buying and selling.
4. High liquidity. Most futures markets are very liquid, i.e. there are huge amounts of contracts traded every day. This ensures that market orders can be placed very quickly as there are always buyers and sellers
for most contracts.
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