Future Pricing Insights

Introduction

Futures contracts are financial agreements to buy or sell an underlying asset on a future date and at a predetermined price. These are primarily used for hedging (protecting against losses from significant price changes) and speculation (trying to profit from potential price movements) in the financial markets.

Unlike stocks, whose prices depend on current market supply and demand, Future share price is intricately linked to the underlying stock’s price and various other factors. Understanding the pricing of Futures contracts is crucial because it directly impacts trading decisions, risk management, and investment strategies. 

For traders and investors, comprehending how Futures prices are determined can provide a competitive edge, help mitigate risks, and enhance profitability in the volatile futures markets. Let’s understand the key factors influencing Futures pricing and how you can leverage this knowledge for more informed trading.

Understanding Pricing of Futures Contracts

The prices of futures contracts are determined using a straightforward formula that links the underlying asset's price to the futures price. Let's understand the formula for futures pricing:

Futures price = Spot price * (1 + rf) - d

Where:

rf is the risk-free interest rate

d is the expected dividend

Now, let's understand this with an example:

Suppose Nisha is looking at Stock ABC, which is currently priced at ₹1000. She wants to know the fair price of a futures contract for this stock.

Assuming a risk-free interest rate of 5% and an expected dividend of ₹20, the futures price will be:

Futures Price = ₹1000 * (1 + 0.05) - ₹20 = ₹1050 - ₹20 = ₹1030

Now, if the contract expires in 30 days, the formula adjusts for the exact duration:

Futures Price = Spot Price [1 + rf (X/365)] - d

Here, X is 30 days (which is the number of days to expiry

So, Futures Price = ₹1000 [1 + 0.05 (30/365)] - ₹20 = ₹1004.11 - ₹20 = ₹984.11

By using this formula, Nisha can see the fair value of a futures contract based on today's price, interest rates, and expected dividends.

Also read - Futures & Options Trading for Beginners 

Which Factors Impact Futures Pricing?

Now that you’ve understood the basics of a Futures contract, it is important to understand some key factors that may impact their pricing. 

Spot Price of the Underlying Asset

The spot price is the asset's current market price based on the futures contract. It serves as the starting point for calculating the futures price. 

For example, if the spot price of Reliance Industries stock is ₹2,500 today, this price is the foundation upon which the futures price will be built. Any fluctuations in the spot price directly impact the futures price, so keeping an eye on the spot price is crucial for traders.

Interest Rates (Risk-Free Rate)

Interest rates, particularly the risk-free rate, play a significant role in futures pricing. The risk-free rate is the return expected from an investment with no risk, such as government bonds. This rate is used to calculate the cost of carrying the asset over the duration of the futures contract. The cost of holding the asset increases when interest rates rise. This leads to higher futures prices. On the other hand, if interest rates fall, then the carrying cost falls too, and this results in lower futures prices.

In simple words, if interest rates are high, it costs more to hold the asset, so futures prices go up. If interest rates are low, holding the asset is cheaper, so futures prices go down.

Things to Note While Trading Futures

Trading futures can be rewarding, but you must consider several factors to navigate the market successfully.

Liquidity of the Futures Contract

Ensure the futures contracts you trade have high liquidity. High liquidity allows you to quickly buy or sell a contract without causing a significant price change. For example, Nifty 50 futures are highly liquid because many traders participate in this market. High liquidity lets you enter and exit positions easily and at favourable prices. In contrast, low liquidity futures contracts might be harder to trade and could lead to less desirable pricing.  

Transaction Costs and Commissions

Always account for transaction costs and commissions when trading. These costs, charged by brokers for facilitating trades, can add up over time. For instance, if you trade S&P BSE Sensex futures, you incur brokerage fees each time you buy or sell a contract. These costs impact your overall profitability, so choose a broker with competitive rates to minimise expenses.

Margin Requirements and Leverage

Understand and manage margin requirements and leverage. Margin is the amount of money you need to deposit to open a futures position. With leverage, you can control a larger position with less capital.

For example, if you trade Infosys futures with a margin requirement of ₹50,000 and the leverage provided is 10x, you can control shares worth upto ₹5,00,000 with this investment. However, you must note that leverage amplifies both gains and losses. If the market moves against your position, you could incur significant losses, potentially exceeding your initial margin. Therefore, always use leverage wisely to manage risk effectively.  

Top Effective Strategies for Futures Trading

If you are new to futures trading, here are some effective strategies that can help you navigate the market more confidently:

Hedging Strategies (Long and Short Hedges)

Use hedging strategies to protect your investments against price fluctuations. If you own an asset and worry about its price dropping, you can use a long hedge by buying futures contracts. For example, if you hold shares of a company like Reliance Industries and fear a price drop, buying futures contracts for Reliance can help lock in the current price. This means you can sell the shares on a future date, using today's price, even if the market price of the stocks drops in the future.

On the other hand, if you plan to buy shares in the future and want to protect yourself from price increases, you can use a "short hedge". This involves selling Futures contracts. Let's say you plan to buy shares of Tata Motors in six months, and you fear that the price might go up. So, you sell futures contracts for this stock now and lock in the current price. This way, if the price of Tata Motors stocks rises, the profit from the futures contracts offsets the higher price. This strategy allows you to buy the shares at today's price and protects your capital from potential hikes.  

Speculative Strategies (Long and Short Positions)

Speculative strategies allow you to profit from market movements by entering into contracts to buy or sell an asset at a future date and price.

Suppose you believe that the price of Infosys stocks is going to rise. You can buy a futures contract, which can also be referred to as entering into a 'Long Position'. This will allow you to benefit if the stock's price increases.

Conversely, if you think that the stock's price will drop, you can take a 'Short Position' or sell a futures contract for this stock.

Spread Trading 

Spread trading in Futures lets you profit from price differences between contracts of the same stock with different expiration dates.

Suppose you expect the price gap between Reliance futures expiring in June and those expiring in September to change. To benefit from this change, you can buy the June futures and sell the September futures. Now, if the price gap changes as you predicted, you make a profit from the difference between the two contracts.