What is Futures Pricing & How to Calculate it?
A futures contract is nothing but an improvised forwards contract. It is designed to retain the fundamental transactional structure of a Forwards market. Futures Contracts also eliminate the risks that are generally associated with a Forwards Contract.
In futures trading, you may come across different sets of traders. There will be some technical traders who will be well-aware of the pricing formulae. On the other hand, there will be intuitive traders who would decide their trading based on their hunches.
However, in order to be a successful trader in futures trading in the stock market, you need to have the needed knowledge and skills, along with experience to gain profit. Moreover, you also need to have a fair understanding of how to calculate the futures pricing to be able to wade smartly through the choppy waters!
In this blog, we will delve deeper into the base of Futures pricing. But before that, let’s learn a bit more about what actually forms the base of the Futures price.
About Futures Pricing
Technically speaking, the price of Futures will be determined by the value of its underlying asset. This price will move in sync with any changes in the asset value. For instance, if the cost of the underlying asset increases, the cost of futures will also rise, and it will fall when the former’s price falls.
However, the value of Futures and their underlying asset may not be equal to one another. This means both of them can be traded in the market at different prices. So, an asset’s spot price may vary from its futures price. And this price difference is called ‘Spot-Future’ parity. Basically, dividends, interest rates, and the expiry dates cause the difference in the prices of the two.
Also Read: Different Types of Futures Trading
The Formula for Calculating Futures Pricing
The futures price is the price at which a buyer commits to buy the underlying asset. You can calculate using this below-mentioned formula –
Futures Price = Spot price x (1+ rf – d)
In this formula,
rf stands for risk-free rate
d is the dividend
A risk-free rate is something that can be earned throughout the year in an ideal environment. One can adjust according to the number of months till the expiration date of the futures.
The adjusted formula is,
Futures Price = Spot price x [1+ rf x (X/365) – d]
X stands for the number of days till the expiration date
Understanding Futures Pricing Quotes
The ones who get involved in the active stock market are known as investors. They do not expect any physical delivery of the asset or commodity. However, they bet on stock market trends for securing their profit from a deal. They base their prejudices on Futures quotes for predicting the Futures price movements on the exchange.
The exchanges usually have a Futures quote chart where every single piece of information related to the Futures Contract is shared along with their periodical price movements. At the top of the chart, the commodity name is mentioned along with its expiration date. At the corner of the chart, investors can check the current value and index of the Futures price movements. At the bottom of the chart, the open prices and settlement prices are mentioned.
Also Read: What is Indian Stock Market Trading & Its Settlement Process?
For beginners in stock market investments, futures and options trading needs some basic practice and understanding. It is also important to be aware of the formula to calculate the price of Futures in order to be on the safe side when investing. Market variables influence the Futures pricing in the market. However, knowing this formula could be a great start for an investor like you. Simply put, it will guide you better in understanding the Futures quote so that you are able to plan your investment position in a better way.
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Frequently Asked Questions
A futures contract in a stock exchange is a standardized agreement that is set by the market to sell or buy an underlying asset or commodity at a predetermined price at a future date.
It is a method to settle prices of futures on a daily basis. The futures pricing may rise or fall every day due to active trading. Clearing houses consider a few means to pay for the price difference of Futures after each trading. It either debits or credits the differential amount from the margin amount that is deposited by both parties.
Futures, unlike forwards, are traded in an active market through an exchange. These exchanges are also termed as a ‘clearing house’. In India, the National Stock Exchange of India Limited (NSE) takes part in Futures trading through the Futures index.
Index Futures are the contracts where an investor can sell or buy a financial index on the present day to be settled at a future date. With an index future, investors or stock market traders can venture in the direction of the index's price movement.