Predicting future accurately is a very rare art. This statement is also correct in context of stock market. One, who is able to correctly predict the movement of stock price, earns money from stock market and one who can’t, loses money. Almost all of us have heard about futures trading. Here in this article we will know about the basics of futures trading.
As the name suggests futures trading involves agreement between two parties, one buyer and the other seller, to execute a trade on a specified future date and price. Every futures contract signifies a specific amount of given scrip or commodity. The most commonly traded futures contract is generally of crude oil, which has a contract unit of 1000 barrels.
Futures contracts are legal agreements to buy or sell a product or service at a pre-determined price and also at a specified date. Futures contracts were initially made to protect the farmers from changes in prices of crops between two specific time intervals, as the price of crops can change planting and harvesting.
HOW FUTURES WORKS:
A derivative is a contract whose value is derived on the performance of an entity present in the contract. The entity present can be an index, asset or commodity. In other words, the value of derivative is not an intrinsic function but it depends on the price of entity, which the contract tracks. For example the value of a derivative linked to Nifty 50 is a function of the price movement of Nifty 50. Futures trading also involve the concept of derivatives.
All futures contracts are bounded to their respective entities and expiration date. The prices of all the contracts keep on fluctuating during the trading session in response the economic activities occurring around the globe.
Every futures contract has an expiration date. Expiration date of a futures contract refers to the date after which it no longer remains functional. The expiration date of a futures trade is similar to the expiry of medicines. As the medicines also are useful till a certain date, similarly a futures contract becomes useless after the expiration date. If you don’t wind up your contract before the expiration date then you will have to deliver the physical entity or take delivery. The contracts based on stocks have to be settled in cash as there would be nothing to deliver.
The month in which the futures contract expires is referred to as the contract month. Some contracts trade every month while the others trade only during some specific months of the year.
WHAT DOES THE FUTURES CONTRACT CONSIST OF?
Just like the other contract papers, futures contract also contain some crucial information. They are:
HOW IS FUTURES TRADING DIFFERENT FROM OTHER FINANCIAL INSTRUMENTS:
Stock market alone offers a large bouquet of different financial instruments. One among them is futures trading. It differs from other available instruments in many ways. So let’s know about the differences:
1. TIME INVOLVED:
Unlike financial instruments like stocks, futures have a fixed life span. In case of stocks the buyer has the freedom to sell whenever he/she wants whereas in case of futures the buyer has to waive off his/her trades before the expiry. After expiry the futures contract cease to exist.
Futures trading are considered more risky than others because of the involvement of high leverage. Leverage allows the trader to buy more than what he/she is actually paying for. Futures trades involve high leverage as the initial margins decided by the exchange are considerably less than the cash value of contracts. The high leverage is one of the primary reasons for the futures market being so popular.
While performing futures trades the trader gets many choices or rather should I say many traps are laid in front of them. Why I am calling these choices as trap?
One of the choices that the trader gets is choosing how long he/she wants to make a wager for. For example there might be a futures contract on a stock with expiry date provided every month for the next 6 months. This is very good for the traders who have some experience and knowledge. But for the ones, who lack those, will easily fall into the trap. As the different time intervals might create a new perception in the mind of the trader.
There are many more choices which are very well used by the big players of the market to trap the retail traders. As stock market is the place where different traders see different future and act accordingly.