- Familiarise yourself with key terms of the future markets and their uses
In the previous chapter, we learned the basics of futures contracts. In this chapter, we will discuss key jargons used in the futures market that will allow you to complete your understanding of the futures market.
A futures contract is a legal agreement to buy or sell a specific underlying asset at the expiry date for a predetermined price. It is primarily used for hedging and speculation in the financial markets globally. In India, all major exchanges: NSE, BSE and MCX, facilitate futures trading.
The expiry date is the predetermined date on which the final settlement of the contract takes place. Put simply, this is the date on which the two parties are supposed to fulfil their obligations, i.e. the buyer of the contract is supposed to buy the underlying asset, and the seller must deliver the underlying asset. Note that it is not necessary to hold the futures contract till expiry. In practice, most traders exit their position before the expiry date.
Most of the futures contracts traded in India on the NSE and BSE expire on the last Thursday of the expiry month. If the last Thursday of the expiry month is a holiday, the contracts are settled on the trading day immediately preceding the last Thursday.
Futures price is the predetermined price at which the contract will settle on expiry. This is the price at which the buyer will buy the underlying asset on expiry and the seller will sell the underlying asset on expiry.
The spot price is the current market price of a security. For example, if you look up a stock, this is the price you will see. Note that you may not always be able to buy/sell the stock at this price. The spot price merely indicates the last price at which the security was traded between the buyer and the seller.
Lot size refers to the minimum number of units that have to be bought/sold in a futures contract.
For example, one lot of Tata Consultancy Services (TCS) corresponds to 150 shares. If you were to buy 1 futures contract of TCS, you would have to purchase the entire lot (150 shares) of TCS at the expiry date unless the position is squared off before expiry.
Lot sizes vary across securities. In India, SEBI has defined the lot size of all stocks that trade in the F&O segment.
Futures margin is the amount a trader must deposit with the broker at the time of entering a futures contract. It is a set percentage of the overall contract value that traders much deposit with the broker at contract initiation.
For example, assume that the margin requirement for purchasing a NIFTY50 futures contract is 10% of the notional value, and the notional value is INR 10,00,000. In this case, a trading member can purchase the futures contract by holding only 10% * 10,00,000 = INR 1,00,000 in the trading account. We have explained the concepts of initial margin and maintenance margin in the later chapters of this module.
In futures contracts, profits and losses are settled on a daily basis using the MTM mechanism. MTM prevents counterparty risk in futures trade. To know how, read chapter 8.5.
The asset on which the futures contract is based is called the underlying asset. For example:
- In the case of equity futures on Tata Consultancy Services (TCS) shares, the underlying will be the equity shares of TCS.
- In the case of futures on the NIFTY 50 index, the entire NIFTY 50 index will be the underlying.
- In the case of commodity futures on crude oil, crude oil will be the underlying.
The underlying asset in a futures contract could be commodities, stocks, currencies, interest rates and bond.