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All You Need to Know About Futures Contracts: What are Futures and How to Trade in them?

Founder and CEO, Transfin.
May 4, 2020 7:19 AM 6 min read
Editorial

The recent ‘scary’, ‘unprecedented’, or ‘visceral’ days seen in Global Oil markets, all thanks to an Oil Futures contract delivering in May gone negative,  has suddenly brought mainstream attention to these Derivatives and Futures in particular.  

 

Wait, what? “Oil Futures”? Delivering what in May?! Derivatives? 

 

We hear you. Why don’t we use this interesting backdrop to understand these fascinating financial contracts. 

 

 

What Are Derivatives and Its Types 

A Derivative is a financial contract which carries value ‘derived’ from an underlying asset. The underlying assets are nothing but stuff like stocks, bonds, currencies or even commodities such as oil, gold, corn, or wheat. 

 

There are four common types of Derivatives: 

 

1) Futures 

2) Forwards (structurally like Futures) 

3) Options – Call and Put and 

4) Swaps 

 

Derivatives were originally created to “hedge” or protect commodity traders and farmers against possible losses due to price volatility. Think of a coffee farmer who can have his demand and price locked in advance, without being hostage to the vagaries of price volatility thanks to global coffee supply and demand shifts. But they have increasingly become a tool for speculators to bet on the directional price movement of the underlying assets. 

 

What Are Futures Contracts?

A Futures Contract or a Future is an agreement between two parties for the delivery of the underlying asset at a pre-determined price and time (marked by the contract expiry and delivery dates). That is it!

 

Let us take an example:

 

Futures Price Quotes
Source: Moneycontrol

 

Look at the graphic above. It shows the Futures contract for delivery of an HDFCBANK share. The Futures is trading at ₹943 (item 1) and is set to expire on June 25th 2020 (item 2). HDFC Bank share’s current trading or spot price is ₹948.20 (item 3). 

 

By buying this Futures contract for ₹943, an investor is essentially locking in ₹943 as the price to pay in exchange of an HDFCBANK stock to be delivered on June 25th 2020 (delivery and expiry for shares is typically the same day or +/- one day as there’s no aspect of “physical” delivery – more on that later). The contract expires after June 25th 2020. That is why you see sizeable movement in the stock on expiry date as people tend to close out positions! 

 

Now typically Futures are sold in lots and the above contract is sold in lots of 500 (item 4). However, for illustration let’s assume one future contract for one underlying share.

 

Say on June 25th 2020: 

 

  1. HDFCBANK is trading at  ₹1,000. It would mean that as per the contract the investor can buy the stock at ₹943 thus resulting in an ₹57 profit (pre-tax). 
  2. On the flipside, if HDFCBANK goes down to ₹900, the investor is still obliged to buy HDFCBANK at ₹943 thus resulting in an ₹43 loss. 

 

It is worthwhile to note that Futures are rarely held till expiration as they trade freely in the market. It means that if the price of this contract actually jumps up on May 10th to say ₹960 (which would usually happen in conjunction with a similar upswing in the price of the underlying asset i.e. HDFCBANK), one can sell the contract itself for a profit of ₹17 and close the position. Buying or selling of Futures is extremely common in an actively traded market. As a side-note, at the time of expiry, the future price and the spot price converge. Think about it!

 

 

What About Oil Futures Turning Negative?

In the prior example HDFCBANK was a share and its physical delivery would be quite seamless i.e. It just sits in your demat account. However, when the underlying asset is a commodity such as Crude Oil, their physical delivery is a thing i.e. One would have to account for the time to delivery and one’s got to pay a fair bit for the storage! This adds another layer of complexity. 

 

For instance, the Oil Futures contract which recently went negative had as its underlying asset barrels of WTI Crude Oil (one of the prevalent benchmarks of Oil). The contracts were supposed to expire on April 21st 2020 with delivery due in May 2020. Investors would have ideally sold the contract and closed out the position either at a profit or a loss before the expiry. However, this time around there were no ready buyers. While this seems counterintuitive, there were multiple factors at play and each one leading to another: 

  1. COVID-19 has caused a sharp decline in demand for Oil as across the world the economic activity has come to literal standstill
  2. Given the demand for Oil had fallen off coupled with no real transportation happening, the warehouses have been sitting on full capacity (interestingly: WTI contracts requires delivery to happen at Cushing, Oklahoma i.e. one location. Brent crude futures allows delivery in several offshore locations and hence was less under pressure) with barrels and barrels of oil and no buyers. In such a situation, storage of this oil becomes a massive challenge (and an expensive one)

In that context, futures contract owner has got to not only find storage space but also pay an elevated price to actually pick it up and store it (these storage costs are known as cost of carry and are typically built into the price of the contract). Hence, it was only at a negative level (i.e. sellers paying buyers to take the delivery!) that someone was willing to buy the contract. A truly unprecedented and counterintuitive occurrence. 

 

If this was not helpful, here’s a simpler and more colourful explanation that was floating around on Twitter.

 

How to Trade in Futures?

Trading in Futures is similar to trading any stock and can be executed with a broker. However, there are some key differences and interesting nuances that one might want to note:

  1. Margin Money: Before entering a Futures trade, the trader needs to put up a certain margin amount. Said another way, there needs to be certain cash amount in the trading account before executing the trade. It could typically vary between 5%-15% of order value and can be intuitively thought of as a form of down payment. 
  2. Liquid Only: Not all underlying stocks will allow a Futures trade. There are certain criteria that the stock needs to meet such as liquidity volume etc. But Futures can be also be traded on entire indices e.g. NIFTY Futures are a highly traded product class. 
  3. Daily Settlement: All Futures positions are settled daily. The profit or loss made each day is calculated and then subsequently debited or credited from your account every day. This is called Mark-to-Market. What this also means is that the margin requirement alluded to earlier will be revisited every day and if there is not enough margin (cash) in the account, there is need to put up more cash what is known as “margin call”. For illustrative purpose, below is a table of what the cash settlement would look like when done daily. Note that the total profit/loss is obviously unchanged, it is just settled daily. 
  4. Square-Off: Finally, just like a stock, a Future’s trade can also be “squared-off” before expiry. In fact, most Futures contract are squared-off and very few do make it to the expiry. This just means that the trader can close the position and realize the profit or loss from the trade anytime until the contract expires. 

FIN.

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