How to perform a trade using futures

Alright then, so you’re up to date with the key terms related to futures trading. But what about the actual trade itself? How does that come about? That’s just what we’re going to see in this chapter on futures trading basics. Now, when you’re looking to trade in futures, you’ll realize that it’s quite like options trading. 

However, there are certain differences between these two. 

• Firstly, in futures trading, if you hold a futures contract till expiry, you’re obligated to go through with it irrespective of whether you’re the buyer or the seller of the contract.
• Secondly, in futures trading, you pay a margin, as we saw in the previous chapter. But in an options contract, you pay a premium, as you’ll recall from the earlier chapters.

Trading in futures: What happens if you’re the buyer?

When you expect prices to go up in the future, it makes sense to buy a futures contract. So, suppose that you’re the contract buyer, and you purchase the future and wait till expiry for settlement. Here’s a theoretical scenario to understand this better.

Purchasing the futures contract 

Rakesh is a frequent trader. He tracks the markets diligently, and he believes that the share price of Tata Power, currently at Rs. 90 in the spot market, may most likely go up within the coming month or two. So, he decides to take a long position by buying a Tata Power futures contract with the following specifications.

• Price of the futures contract: Rs. 100
• Lot size: 10 shares
• Contract value: Rs. 1,000 (Rs. 100 x 10 shares)
• Margin money: Rs. 330

For the sake of easier understanding, we’ll exclude the margin money from our calculation of profit or loss. This is because the margin money, as you’ll recall, is akin to a security deposit that will be returned to you at expiry or when you square off your position (after deducting losses, if any).

Holding the futures contract until expiry 

On expiry, Rakesh’s profit or loss will be calculated depending on the spot price of the shares of Tata Power. Say, for instance, that the share price of Tata Power on expiry is Rs. 150. But as per his futures contract, Rakesh can buy 10 shares of Tata Power at Rs. 100 each. He can then sell them for Rs. 150 in the spot market, making a profit of Rs. 50 per share. 

Alternatively, suppose the price of the shares falls to Rs. 80 on expiry, Rakesh will suffer a loss of Rs. 20 per share. 

Let’s take different spot prices and calculate the profits or losses that Rakesh would experience at those levels.

Plotting this on a graph, we get the following pattern.

Trading in futures: What happens if you’re the seller?

When you expect prices to go down in the future, it makes sense to sell a futures contract instead. If you’re the contract seller, say you sell a future and wait till expiry for settlement. Here’s a theoretical scenario to understand this better.

Selling the futures contract 

Suman, who is also a seasoned trader, believes that the share price of Tata Power, currently at Rs. 90 in the spot market, may most likely go down within the coming month or two. So, he decides to take a short position by selling a Tata Power futures contract with the following specifications.

• Price of the futures contract: Rs. 100
• Lot size: 10 shares
• Contract value: Rs. 1,000 (Rs. 100 x 10 shares)
• Margin money: Rs. 330

Again, to make understanding easier, we’ll exclude the margin money from our calculation of profit or loss. 

Holding the futures contract until expiry 

On expiry, Suman’s profit or loss will be calculated depending on the spot price of the shares of Tata Power. Say, for instance, that the share price of Tata Power on expiry is Rs. 150. But as per his futures contract, Suman must sell 10 shares of Tata Power at Rs. 100 each. So, he ends up with a loss of Rs. 50 per share. 

Alternatively, suppose the price of the shares falls to Rs. 80 on expiry, Suman will enjoy a profit of Rs. 20 per share. 

Let’s take different spot prices and calculate the profits or losses that Suman would experience at those levels.

Plotting this on a graph, we get the following pattern.

Wrapping up

So, you see how the payouts from a futures contract resembles the payouts from an options contract? This covers your in futures trading basics. Interestingly, both options and futures contracts can be used to minimize losses from other financial investments. That’s what the financial world calls as hedging. Curious to know how it works? Head to the next chapter to find out.

A quick recap 

• Performing a trade using futures is quite like options trading. However, there are certain differences between these two. 
• Firstly, if you hold a futures contract till expiry, you’re obligated to go through with it irrespective of whether you’re the buyer or the seller of the contract.
• Secondly, in a futures contract, you pay a margin. But in an options contract, you pay a premium.
• When you expect prices to go up in the future, it makes sense to buy a futures contract. 
• If you’re the contract buyer, you purchase the future and wait till expiry for settlement.
• When you expect prices to go down in the future, it makes sense to sell a futures contract instead. 
• If you’re the contract seller, you sell a future and wait till expiry for settlement.