Key terms to know in futures trading

In this module, so far, we’ve covered options extensively. Now, it’s time for us to shift our focus to the other type of derivative contract - futures. Before we take a look at how to trade in futures, let’s first try to understand the various key terms used in futures contracts.  

Particulars of a futures contract 

Here’s how a futures contract of Tata Motors Limited looks like. 

You see how different it is from a typical options contract? Let’s dissect this even further. 

• TATAMOTORS: This denotes the symbol of Tata Motors Limited as listed on the NSE.
• JUL: This denotes the month of expiry of the futures contract. In this case, the futures contract expires in the month of July. We’ll discuss contract expiries once again in the next segment of this chapter.
• FUT: The tag ‘FUT’ denotes that this is a futures contract.

Notice how there’s no strike price here? Unlike options, you cannot buy a futures contract with a specific strike price in mind. 

So, now that you’re familiar with the basic structure of futures contracts, let’s get to the main crux of the chapter. Here are some of the key terms that you should know with respect to futures trading.

1. Lot size

The lot size is an important term to know when we’re discussing futures trading basics. It is the minimum number of shares or derivatives (in the case of an index) in a contract. It is a standardised quantity that is specified by the exchange and cannot be changed by the user. The lot size is not constant and varies from one security to the other. 

For instance, the lot size of HDFC Bank is 250, while that of Tata Motors is set at 5,700.   This effectively means that when you buy a futures contract of HDFC Bank, you agree to buy 250 shares of the company upon expiry of the contract.   

2. Contract value

The contract value is the current price of the futures contract multiplied by the lot size of the contract. Since the current price of the futures contract keeps changing, the contract value also changes accordingly. Let’s take up the following example to better understand contract value. 

Assume that the July futures contract of Maruti Suzuki India (MARUTI JUL FUT) is currently trading at Rs. 6,000. The lot size of the contract is set at 100. Therefore, the contract value would then be Rs. 6,00,000 (Rs. 6,000 x 100 shares).      

From the future contract buyer’s perspective, the contract value is the total amount that he has to part with when taking delivery on the contract expiry date. Conversely, from the future contract seller’s perspective, the contract value is the total amount that he will receive upon selling the shares on the contract expiry date.

3. Contract expiry

Contract expiry is also another fundamental concept that you need to be aware of as a part of futures trading basics. Similar to options, every future contract expires on the last Thursday of every month. In the event of the last Thursday being a holiday, the contract would expire on the previous trading day. 

Also, at any point in time, futures contracts would always have three different expiries. For example, if you were to search for the futures contracts of Axis Bank on the 2nd of July, 2020, you would find the following. 

• AXISBANK JUL FUT (also known as near month) 
• AXISBANK AUG FUT (also known as next month)
• AXISBANK SEP FUT (also known as far month)

Once the July futures contract expires, the August futures contract then gets categorized as near month, the September contract becomes next month, and the October futures contract becomes the far month. This goes on month after month.

4. Open contract

A futures contract that you’ve bought (or sold) is termed as an open contract if it has not been squared off or if it has not yet expired. For instance, let’s say that you’ve bought a TVSMOTOR JUL FUT contract on the exchange. This contract will continue to be termed as an open contract till the date of expiry or till the time you decide to square it off by selling the contract.

5. Open interest

The open interest is the total number of open contracts of a particular financial asset in the market. This asset can be a stock, an index, a commodity, or a currency, among others. For instance, if the open interest for the BAJAJ-AUTO JUL FUT contract is 7,400, it essentially means that there are 7,400 contracts currently open and unsettled in the market.

6. Margin

To trade in futures, you are not required to pay the entire contract value upfront. Instead, you’re only required to deposit a percentage of the contract value with the exchange. This amount that you deposit is known as the ‘margin.’ Consider the margin as a sort of a security deposit that’s collected by the stock exchange to ensure that you, as the trader, fulfil all the obligations related to the futures contract. Let’s take up an example to better understand the concept of margins. 

Assume that you wish to buy 1 CANBK JUL FUT contract. The contract is currently trading at Rs. 105. The lot size of the contract is 5,000. The total contract value then comes up to around Rs. 5,25,000. You’re not required to pay the entire contract value to purchase 1 CANBK JUL FUT contract. You can do so by just paying a percentage (SAY 34%) of this total contract value as ‘margin,’ which in this case will come out to be Rs. 1,80,000.  

So, to purchase 1 CANBK JUL FUT contract, you’re only required to part with Rs. 1,80,000. The margin amount varies from one contract to the other and is determined on the basis of the volatility and price movements of the security. The margin money charged by the exchange can be divided into two parts - SPAN margin and exposure margin, which we will learn about next. 

7. SPAN margin

SPAN stands for Standardised Portfolio ANalysis of risk. Employed by stock exchanges, it is a sophisticated system that’s powered by algorithms and is used to assess margin requirements for a particular contract. The SPAN margin is the bare minimum margin required to trade in a futures contract. 

8. Exposure margin

The exposure margin is essentially an additional margin charged by an exchange over and above the SPAN margin. This amount is used to account for any mark to market (MTM) losses. We’ll learn more about MTM in the next segment.  

Therefore, to enter into a futures contract, you’re required to deposit both SPAN margin and exposure margin.

9. Mark to market (MTM)

Mark to market (MTM) is a methodology wherein the stock exchange recalculates the margin requirements for your open positions at the end of every trading day. It also calculates the profit or loss that you incurred on your open positions at the end of a trading day. For the purposes of recalculation, the stock exchange makes use of the closing price of the stock on every trading day. MTM is primarily done by the stock exchange to ensure that you have adequate margin funds in your account and to reduce the risk of default. 

Does the concept seem confusing or intimidating? Let’s take up an example to help clear things out.     

Details of the futures contract 

• Assume that you buy a CANBK JUL FUT contract. The futures price of the contract is currently at Rs. 100 per share. 
• The lot size of the contract is 5,000 shares.
• The contract value: Rs. 5,00,000 (5000 shares x Rs. 100)
• Margin to be deposited: Rs. 1,75,000 (assuming the margin is at 35%)   

Now, take a look at the table below. It clearly outlines the MTM profit or loss that you made on every trading day, the total profit or loss, and whether the available margin is sufficient to compensate for the MTM losses that you suffer.  

Let’s understand this table now.

• At the time of purchase of the future contract at Rs. 100 per share, you end up depositing Rs. 1,75,000 as margin. 
• At the end of the trade day (T0), the price drops down to Rs. 80 per share. As per the MTM methodology, the stock exchange calculates the profit or loss as at the end of the trading day. Since the stock price dropped by Rs. 20, the MTM loss as on T0 would then be Rs. 1,00,000 (Rs. 20 x 5,000 shares). 
• As at the end of the next trade day (T1), the price drops even further down to Rs. 70 per share. Here, again, you suffer an MTM loss of Rs. 10 per share, which comes to Rs. 50,000 (Rs. 10 x 5,000 shares). 
• The total loss at the end of T1 widens to Rs. 1,50,000 [(Rs. 100 - Rs. 70) x 5,000 shares]. 
• Now, as at the end of T2, the price drops once again down to Rs. 60 per share. The MTM loss as on this day is again Rs. 50,000 (Rs. 10 x 5,000 shares). 
• This brings the total loss at the end of T2 to Rs. 2,00,000 [(Rs. 100 - Rs. 60) x 5,000 shares]. 
• This loss at the end of T2 is higher than the initial margin that you deposited (Rs. 1,75,000). So, you’ll be required to pay the difference. This is what we’ll see in the next segment.

10. Margin call

Take a good look at the table above. At the end of T2, you’ve incurred a total MTM loss of Rs. 2,00,000, right? The total MTM loss is now greater than the margin (Rs. 1,75,000) you deposited when entering into the contract. 

This increases the risk of default as the initial margin deposit is no longer enough to cover the obligations of your future contract. In such a case, the stock exchange demands that you deposit additional margin money (Rs. 25,000, according to the table) to nullify the risk of default. This demand for additional margin is termed as ‘margin call.’

Generally, if the margin call is not met within the stipulated time, your open positions are automatically squared off by the exchange. Therefore, to keep your open positions afloat, you’re required to meet the margin call on time.  

Wrapping up

Now that you know the key terms related to a futures contract, you’re probably eager to know more about futures trading. Right? Well, that’s just what our next chapter deals with. Keep reading to discover how to perform a trade using futures.

A quick recap

• The lot size is the minimum number of shares or derivatives (in the case of an index) in a contract.
• The contract value is the current price of the futures contract multiplied by the lot size of the contract.
• Similar to options, every future contract expires on the last Thursday of every month. In the event of the last Thursday being a holiday, the contract would expire on the previous trading day. 
• A futures contract that you’ve bought (or sold) is termed as an open contract if it has not been squared off or if it has not yet expired.
• The open interest is the total number of open contracts of a particular financial asset in the market. This asset can be a stock, an index, a commodity, or a currency, among others.
• To trade in futures, you are not required to pay the entire contract value upfront. Instead, you’re only required to deposit a percentage of the contract value with the exchange. This amount that you deposit is known as the ‘margin.’
• SPAN stands for Standardised Portfolio ANalysis of risk. It is the bare minimum margin required to trade in a futures contract. 
• The exposure margin is essentially an additional margin charged by an exchange over and above the SPAN margin.
• Mark to market (MTM) is a methodology wherein the stock exchange recalculates the margin requirements for your open positions at the end of every trading day. It also calculates the profit or loss that you incurred on your open positions at the end of a trading day.
• MTM is primarily done by the stock exchange to ensure that you have adequate margin funds in your account and to reduce the risk of default. 
• The demand for additional margin is termed as ‘margin call.’