A Guide to Futures Contracts: Understanding Their Function and Usage

Introduction

Imagine a farmer from the olden days who wants to ensure that, later on, his crops will fetch reasonable prices. He deals with a trader and sells his produce at a fixed price months before harvest. In this way, he and the trader know what to expect, no matter what the market is doing. The simple concept that underlies futures contracts is what it is based on.

A futures contract is an agreement to buy or sell something (like stocks, gold, or even wheat) at a specific price on a future date. These contracts are traded on exchanges, making them regulated and standardised.

Understanding Futures Pricing

Think of future pricing as the cost you agree to pay today for something you'll get in the future. This price is influenced by:

1. The current price of the item (like a stock or gold)
2. Interest rates (the cost of borrowing money)
3. How long until you get the item
4. Expected dividends (if it's a stock)

Here’s a simple way to think about it:

Futures Price = Current Price + Cost of Carry

The "cost of carry" includes things like interest rates, storage costs, insurance, dividends, and other expenses incurred while holding the underlying asset.  

Also Read: 8 Best Stocks for Entering the F&O Market

Types of Futures Contracts

In India, futures contracts are popular financial instruments for hedging and speculation. Here are the main types:

1. Commodity Futures involve physical commodities ranging from gold, silver, and crude oil to agricultural products such as wheat and soybeans. They are traded on exchanges such as MCX and NCDEX, which helps farmers and producers manage price risks.
2. Equity Stock Futures: These contracts are based on individual Indian company stocks. Traded on the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE), equity futures allow investors to hedge their positions in the stock market or speculate on future stock prices.
3. Index Futures: These futures are focused on indices like the Nifty 50 and BSE Sensex. Traders use them to gain broader market exposure or hedge their portfolios against market volatility.
4. Currency Futures: These contracts are on the US Dollar (USD), Euro (EUR), and Japanese Yen (JPY) against the Indian Rupee (INR). They are traded in exchanges such as NSE and BSE, which help businesses and investors hedge foreign exchange positions.

Each type of futures contract in India provides unique opportunities for managing risk and capitalising on market movements, making them essential tools for investors and traders.

How to Trade Futures with Small Capital

You may assume that trading in futures requires a huge amount of money, but it is not impossible to start with little capital. Here is how you can do it: 

Meet Raj.

Raj is a software engineer from Mumbai who wants to try trading futures even though he has only ₹10,000. Futures are contracts that obligate you to buy or sell an asset at a predetermined price on a future date. Raj opted to trade the Nifty 50 futures, which incorporates the top 50 companies in India.

1. Margin: Raj deposits ₹10,000 as margin, a fraction of the contract's total value.
2. Leverage: With his ₹10,000, Raj controls a larger position, for example, ₹1,00,000.
3. Profit/Loss: If the Nifty 50 index rises, Raj makes a profit; if it falls, he incurs a loss.

Starting with a small investment, Raj controls more shares at a good price, multiplying his returns. Obviously, this can also lead to losses.

Grey Market and IPO Futures

The Grey market is an unofficial system in which IPO shares are traded before their official listing on the stock exchange. IPO futures are contracts based on these IPO shares' expected future price. They enable you to guess how the stock will do after it’s listed. 

Example:

Vikram hears about a new stock entering the market. He trades in the Grey market to acquire shares before the official listing and buys IPO futures that take a position on the price once it is listed. It's risky, but Vikram hopes to profit if his prediction is correct.

Caution: Trading in the Grey market isn't regulated by SEBI, which can lead to big financial risks. To keep your investments safe, stick to official trading rules and regulations.