Futures Trading - Know the Basics of Futures Trading Online | My Espresso

What is Futures Trading

Have you ever booked a car at a car dealership for the vehicle to be delivered at a pre-decided date and an agreed-upon rate? If you have, then you know the fundamentals of how a futures trading contract in securities and commodities works. A futures trading contract is akin to a regular buy or sell contract, albeit with an execution or delivery time that lies in the future.

Published on 31 January 2022

Futures Trading Meaning

Futures trading, as is clear from the name, is making trades for securities and commodities with a future settlement date but at the current price. Futures are derivatives contracts, and the underlying asset can be either financial assets or physical commodities. The types of assets that commonly constitute the underlying assets for futures trading contracts are:

  1. Stocks;
  2. Commodities;
  3. Currencies;
  4. Bonds.

Futures trading happens on highly regulated futures exchanges and is one of the most widely applied hedging strategies in trading.

Futures Trading Basics

Suppose you have entered into a futures trading contract to, say, buy a certain number of shares of a specific stock today, you will have to honour said contract on or before the expiration date. If the price prevailing at the time of the settlement of the contract is higher than the price you booked your futures contract at, you can profit from the sale of the shares at a higher price. In such a scenario, your profit would be the difference between the two prices multiplied by the number of shares after accounting for the margin money paid by you.

On the other hand, in a stock futures trading contract involving sale, you are obligated to sell a certain number of shares of a particular stock at a predetermined price at a fixed future date. Therefore, should the market price of the stock at the time of the execution of the contract be lower than the price agreed upon in your futures contract, you will have made a profit.
Also Read: How to make profit in F&O Trading?

Pros and Cons of Futures Trading

Before trying your hand at futures trading, you must understand the pros and cons associated with entering into a futures contract:

Parameter

Pros of Futures Trading

Cons of Futures Trading

Speculation

A futures trading contract can be used to speculate the direction in which the price of an underlying asset may be headed.

If the price of the underlying asset in your futures trading contract moves in the opposite direction than what you had anticipated, you may end up losing more than the initial margin amount.

Leverage

With a futures trading contract, you do not need to pay the entire amount at the time of making the contract, thereby enabling you to have higher leverage.

The high leverage available in futures trading owing to minimal margins can prompt you to take positions of high magnitude. Although this can lead to gains, the flip side is that it can lead to huge losses as well.

Hedging

Futures trading can be effectively used as a hedging strategy to restrict your potential losses owing to the fluctuations in the prices of the underlying assets. It can also be used by companies to lock the selling prices of the commodities they produce or the products they manufacture.

If the price of the underlying asset in a futures trading contract for sale entered into for hedging rises above the locked-in price, the party who has the selling obligation will be forced to miss out on a favourable price movement.

Intraday Futures Trading

Akin to the regular mechanism of intraday trading, intraday futures trading is futures trading, albeit with an execution time frame that is shorter than a day. Therefore, the positions acquired in intraday futures trading are usually minutes or hours long and are settled on the same day.

As is the case with all futures trading contracts, an intraday futures trading contract can be used for hedging as well as speculation. However, since your futures position has to be executed the same day, there is no overnight risk involved in such a trade.

Futures Trading - Things You Should Keep in Mind!

While trading in futures may seem enticing, particularly considering the leverage such trades allow you to enjoy, it is important to keep certain important things in mind:

  1. Understand How Futures Trading Works: Before engaging in futures trading, it is critical to have a clear understanding of how futures contracts work, what the risks involved are, and what is your obligation owing to such contracts. Only once you have clarity on these facets of futures contracts should you entertain the thought of entering into one.
    Also Read: Options Trading
  2. Ascertain Your Risk Appetite: Futures trading can allow you to benefit from accurately speculating the prices of securities as well as hedging the amount of risk you are exposed to owing to the fluctuations of asset prices in the market. However, since you are merely speculating the movement of the market price of an asset, you are susceptible to speculating wrongly and, therefore, vulnerable to losses. You must, thus, ascertain your risk appetite before wading into the waters of futures trading.
  3. Understand How Margins in Futures Trading Work: The small margins on futures contracts allow you a high amount of leverage. However, margins are double-edged swords and should you end up on the wrong side of price speculation, you may have to bear significant losses in terms of margin payments.

In Conclusion

Futures trading is filled with opportunities, but before entering into a futures contract, you must have a clear understanding of how they function and how much risk you are willing to undertake.

 

Chandresh Khona
Team Espresso

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