Basic Understanding Of Futures Market
FUTURES MARKET is a place where standardized FUTURES CONTRACTS are traded. So let us know what is a FUTURES CONTRACT all about.
It is a contract to BUY OR SELL a financial instrument or a commodity, price, quantity, and date fixed WHEREIN the quantity is dealt with only in LOTS (each stock may have different LOT size).
For instance, lets buy RELIANCE STOCK FUTURES, 1 lot which counts to 500 shares, today (March 9, 2019) at the prevailing market price at 1292 rupees, Expiry date is fixed as I told u already, say March 30, 2019, we usually term this case as we are buying March 30 expiry 1 lot reliance futures .
Let me clearly break down into a simple understanding layman language of what we did in the above case . We bought a contract by paying an initial margin which is a small percentage ( say 20% of the total amount required to buy 500 shares of RELIANCE at 1292 rupees ). We can either sell this futures contract any time from now or wait till the expiry date, which is March 30.
How They Operate
Let’s discuss how these futures work now. Say after a few days, the price of the futures quote at 1300, we can decide to sell the contract in the market and cash settlement will be made. DON’T get confused with the word CASH SETTLEMENT, it is just the
- Difference between our cost and sale values
- Could also be understood as gain or loss
- AND we get our gain or loss in the form of cash,
- That is, it will be credited to our trading account,
- TO ENABLE US TO ENJOY THE OPTION OF TAKING DELIVERY in the spot market
- IF WE HAVE THE INTENTION TO TAKE SUCH STOCK or
- TO ENABLE US TO ENJOY THE GAINS OR SUFFER THE LOSSES, IF WE ENTERED INTO A SPECULATIVE TRANSACTION,
Effect Of Futures Contract
HENCE, we get (1300-1292) *500 shares as profit in the transaction(profit ,if we are a speculator, BUT if we have intentions to take delivery, this profit amount of 8 per share and 1292 entered price will be available to purchase stock in spot market which quotes price close to 1300 BUT NOT EXACTLY 1300 , HENCE OUTFLOW TO PURCHASE SHARES is 1292 which is OUR money and 8 the PROFIT money because of futures contract) .
We usually do the above, if we think that the price will not move higher than this, EVEN IF WE WAIT until the expiry date(I am telling you from the shoes of a speculator or a person who decides to take delivery now itself and changed his date of purchase, the point here is, this person would be able to buy shares at the cost of 1292 per share, irrespective of the date).
HOWEVER, being a speculator, if our expectations ARE that THE PRICES will still go higher and higher till the expiry date, we would wait until the expiry date, and cash settlement will be done at that point with the difference between your cost price and sale price as we have already discussed.
Now you might be getting confused as to what is happening in our transaction. We are told that cash settlement is made. Let’s talk about numbers, say in our example, the price on March 30 is 1305. We will be given the difference in purchase price and sale price, that is (1305-1292)*500 =6500. Now, how about the delivery of shares is YOUR BIG SIZED QUESTION.
Let us now understand as to how FUTURES MARKETS work. In the above case, the futures market will not give us shares if we give money. We simply get 6500 plus the amount that has been given as initial margin, BACK TO OUR TRADING ACCOUNT.
FUTURES MARKET will not provide delivery; they do cash settlement for the gain or loss.
So now, we can go to the spot market and buy RELIANCE SHARES if we want delivery.
SPOT MARKET price would be 1305 that day, and we can buy reliance shares with the money from our pocket and the money which we got (6500). So the summary is we bought shares at 1292 only on March 30, and we could take delivery. Money from us is 1292 per share, and 13 per share is the money that we got from FUTURES MARKET.
THIS IS FINAL EFFECT in our case.
In the same way, we can ALSO first SELL FUTURES which is referred to as SHORTING.
To complete the flow of understanding, we would be left out with a crucial question as to how the price of 1300 would be there in the futures market and how it matches with spot price and thereby enabling us to take delivery.
THIS REQUIRES US TO UNDERSTAND THAT FUTURES PRICE AND THE SPOT PRICES WILL COME TO A SINGLE POINT ON THE EXPIRY DATE and will not have the usual difference, that they have on other dates.
If you closely observe our example, we bought at 1292 futures price wherein the spot price was few rupees lower i.e., 1287. The difference symbolizes the expectations built upon a stock. These expectations will become lesser and lesser as we are drawing close to the expiry date. LETS close with a basic understanding with our common sense as to why expectations will meet actuals on the expiry date.
Let me tell you what happened last night. We are expecting our friend a 25 yr old young man to reach his dream of climbing Himalayas. Let I tried to convey my intentions with some numbers . last night, 10 of us in the party have high expectations that our friend will reach that dream. We all USUALLY have an idea or an expectation that climbing Himalayas is possible for someone of age not more than 35 yrs age.NOW, LET ME LINK AND SYNCHRONIZE WITH OUR FUTURES CONTRACT.
When our friend couldn’t reach his dream of climbing in the first year, 2 of our friends might lose expectations, AND when he couldn’t wait for next 3 yrs, another 5 of our friends might lose their expectations , AND when he reaches 35, and still he doesn’t climb, almost ALL our friends expectations would reach to the point of “no expectations”, since all of us would feel that it is very tough for someone to climb the Himalayas once age crosses 35.
The expiry date for all our expectations is our friend’s age of 35 years. EXPIRY DATE, in our example, is March 30. People build up expectations on reliance that it will move further and further and they increased the price to 1292 in futures market while the spot market was at 1287, AT THE TIME OF OUR PURCHASE OF RELIANCE FUTURES. These expectations will come into a “no expectations stage” at the end of the expiry date, and the prices would come to a single point on March 30. I hope you learned what’s happening in the FUTURES MARKET WITHOUT READING BIG BIG WORDS AND BIG BIG DEFINITIONS.