Futures Trading: Meaning, Functions, Benefits, Risks

Futures trading is one of the most popular segments of the derivatives market. Traders make bets on what they think will happen to prices in the future. These contracts can be traded on several underlyings, including equities, indexes, and commodities.

This article explains what futures trading is and its functions, benefits, and risks.

Key Takeaways

• Futures are standardized derivative contracts that are tied to an underlying asset.
• Traders might take long or short positions depending on their views on the market.
• Futures contracts have fixed lot sizes and expiry dates.
• Traders need to hold a margin rather than pay the full contract value upfront.
• Leverage is a double-edged sword that magnifies both earnings and losses.

What is Futures Trading?

Futures trading is the purchasing and selling of a futures contract on a certified derivatives exchange. The contract gives traders exposure to the price swings of the underlying asset without requiring direct ownership.

Every contract has specific parameters, including its lot size and expiry date. Traders can take a position based on their market outlook, then close it before expiry or go through the relevant settlement process. For example, a trader anticipating rising prices may go long, while a trader anticipating falling prices may go short.

How Futures Trading Works?

Unlike stock trading, futures use high leverage, meaning you only need to deposit a fraction of the total contract value to open a position. Every futures contract operates on standardized parameters, including specific lot sizes and fixed expiration dates.

• Initial margin: The minimum cash amount required in your account to open a futures position.
• Maintenance margin: The minimum balance you must maintain to keep the position open.
• Margin call: A demand for additional funds if your account balance falls below the maintenance margin.
• Mark-to-Market: Daily settlement where gains or losses are calculated and adjusted in your account at the end of each trading day.

Impact on Long and Short Positions

• Long positions: Investors buy and hold a stock expecting the price to rise over time, benefiting directly from upward market movements and capital appreciation. In a reverse stock split, a long position experiences a reduction in total share count offset by a proportionate increase in share price, leaving overall equity value neutral.
• Short positions: Traders borrow shares to sell immediately on the open market, aiming to buy them back later at a lower price to return to the lender, profiting from a downward price trend. During a reverse split, short positions face automated adjustments where the number of borrowed shares decreases and the short price liability scales up proportionally to maintain neutral position value.
• Margin and options impact: Both long and short positions involving derivatives or margin accounts require contract adjustments managed by clearinghouses to reflect the new share quantities and strike prices without altering total risk exposure.

How a Futures Contract Functions?

• Underlying security: The asset that establishes the value of the futures contract (e.g., a stock, index, or commodity).
• Contract size (Lot Size): A defined quantity of the underlying asset that dictates the overall exposure of the contract.
• Expiration date: A set end date by which traders must close, roll over, or settle their position.
• Futures price: The current trading price of the contract. It is typically influenced by the underlying asset's spot price and the cost of carrying the position until expiry, including factors such as interest rates, dividends, storage costs, time to expiry, and market expectations.

Margin and Leverage in Futures Trading

Futures traders do not normally pay the full value of the contract upfront. Instead, they must maintain a required cash buffer known as margin.

Example: A futures contract can provide ₹10 lakh of market exposure while requiring only a fraction of that amount as a margin deposit. This creates leverage, allowing traders to take substantial positions with less capital.

Mark-to-Market (MTM) Settlement in Futures Trading

A critical element of futures trading is mark-to-market (MTM) settlement.

A futures position is marked-to-market daily, meaning profits or losses are calculated based on daily price shifts and adjusted through the settlement process. If a position moves adversely and available margins fall below the required thresholds, additional funds (a margin call) will be required.

Mark-to-Market (MTM) Example

• Pre-split position: You hold a short position of 500 shares, borrowed and sold at ₹50 per share. Your initial liability is ₹25,000, and the daily Mark-to-Market (MTM) tracks the unrealized gain or loss based on the current market price.
• Corporate action: The company implements a 1-for-10 reverse stock split.
• Post-split position: Your borrowed share quantity is divided by 10, leaving a short position of 50 shares. Simultaneously, the market price multiplies by 10, moving from ₹50 to ₹500 per share.
• Post-split MTM value: Multiplying your new share count by the new price (50 * ₹500) results in a current liability of ₹25,000.
• Result: The MTM calculation remains completely balanced at ₹25,000, proving that the corporate action alters the underlying share metrics without creating any immediate profit or loss for the short seller.

Who Uses Futures Contracts

• Hedgers: Producers, manufacturers, and institutional asset managers use futures to lock in future prices and protect themselves against adverse market volatility (e.g., a farmer locking in a sale price for crops or an airline locking in jet fuel costs).
• Speculators: Day traders and individual investors who take on price risk without intending to take physical delivery of the underlying asset, aiming to profit from short-term price movements and market momentum.
• Arbitrageurs: Traders who exploit temporary price discrepancies between the spot market and the futures market, or across different exchanges, locking in risk-free profits.
• Institutional Investors and Mutual Funds: Large entities that use futures for efficient portfolio rebalancing, asset allocation, and managing broad market exposure without constantly buying or selling physical underlying assets.

Futures Trading vs Cash Market: How Are They Different

Basis	Futures Trading	Cash Market
Ownership	Contract-based exposure	Direct ownership in delivery-based investing
Capital	Margin is generally required	Full purchase value is generally required
Expiry	Has a fixed expiry date	Shares do not have an expiry
Positions	Both long and short are readily available	Short selling is subject to specific intraday/segment rules
Leverage	Commonly available	Generally lower for delivery investing
Main Risk	Leverage and market movement	Market movement and investment risk