We have discussed a lot about derivatives in our different posts. This time we bring for you a yet another enticing topic revolving around the derivative section. You’ll basically learn about the Types of Futures: Stock, Index, Currency & Commodity and much more.
So, welcome back to our derivative segment. One of the most lucrative derivatives, are future contracts, mainly because the sheer flexibility of them. Future contracts sound very modern, sort of like a financial instruments for the new, but they have been around more than 200 years, which means there was trading in future contracts even before there was McDonald’s. Crazy, right? Now, let’s get into it!
What are Future Contracts?
First of all, let’s revise what a derivative is. A derivative is a contract involving a promise to buy or sell an underlying asset which it ‘derives’ value from, at some particular point in future (which in India is the last Thursday of every month.)
Futures contracts are contracts made for an underlying asset; which can be a commodity, stock, currency, metals, bonds, and any other security you can find on an exchange. This contract has a fixed price at which the buyer of the contract intends to buy the asset, and the seller of the contract sells the asset. Which means the buyer is in long position, and the seller of the contract is in short position with regards to the underlying asset.
Futures are traded both on exchanges and in the over-the-counter market. But a majority Futures are essentially what trade on the exchange, because the entire purpose of having Futures as a system is to have the same core basic nature of a forward contract but at the same time have a third party monitoring the transactions, so everyone plays nice. No foul play, no monkey business, we could go on, but you got it, right?
In this one, let’s get into the types of future contracts. You see because of the universal nature of the instruments, its applications are well, universal. So, whatever kind of asset you can think of, there is a futures market for it.
And, we can classify the future contracts into two main categories:
1. Financial Futures:
This comprises of stock, index, currency and interest rate futures.
2. Physical Futures:
This includes agricultural products, metals like gold, silver, energy commodities, etc.
Types of Future Contracts: Financial & Physical Futures
Now, let’s further discuss the types of future contracts ranging from Stock, index, currency, interest rate, and commodities futures one by one.
What are Stock Futures?
Stock futures are something known as financial future contracts. Because stocks are financial instruments. Get it?
There are several advantages to trading stock futures, but the primary one comes in the margin difference. You see, because future trading requires a margin trading from 5-20 % depending on your stock broker, which basically means if you have say Rs.10 Lakh in your account, you use it to trade futures up to Rs.1 Cr. This, when compared to margin requirement of stock trading; which can be around 50%-65% in some cases, is, let’s just say, less.
Also financial derivatives like futures can be traded from 9:30 AM to 11:55 PM, which is more, when compared to equities window of 9:15 AM to 3:30 PM.
But, it should be noted that not all stocks have a futures market.
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What are Index Futures?
Index futures work similar to how index funds work, but instead have the contractual boundaries of a future contract. Basically, when you buy into an index fund, like Nifty, which is top 50 companies on NSE, your money is allocated proportionately to all the 50 companies in the index. This can have several advantages, even beating the market, which investors like Warren Buffet have pointed time and again.
Index futures work similarly. Futures, a speculative instrument, can be used to make money out of a directional view of the index as a whole.
Suppose you put Rs.50,000 in an index future, by paying a margin of Rs.5000. If the index rises by 10%, you will make Rs.5000. But for you to actually lose money, in the sense that you would have to pay additional money over and above margin (which, assume is wiped out in this case due to loss, zero) the index percentage would have to fall below your margin. This means in this case the index has to fall below Rs.45000 for you to get a call from your stock broker it’s time to wrap up or pay up.
What are Currency Futures?
Currency futures market are where the hedgers are. The way currency futures work is simple. Imagine a timeline, if you will. You are standing at point 0, where the price of conversion from Dollar to Rupees is, say Rs. X per dollar. The future contract expires at, say point 1, which can be a month from Point 0 or even a day, doesn’t matter. The way the future contract works is when you get to Point 1, the price of the conversion for you based on the contract will have to be Rs. X. If the current conversion price has increased, you stand to make a notional profit. If it decreases, you stand to make a notional loss.
The idea is to get the currency at the specified date without worry much about the enormous fluctuations of the market, the currency then can be used to buy financial instruments in the other country, or even trading.
What are Interest Rate Futures?
This is an interesting one! Interest rate futures are used for interest paying debt instruments like bonds, or home loans, doesn’t matter. But here’s how they work in a nutshell.
You see, when interest rates on bonds rise, the prices of bonds fall, because opportunity cost. So what you can do in this scenario is sell a future dated to your estimation of interest rate rising, so in case the interest rates rise, you still get a fixed return on your debt instrument. There are several auxiliaries to this, obviously.
What are Commodity Futures?
These type of futures are called Physical Future Contracts. Because commodities are actual, physical things.
Commodity futures include metals like gold, silver, platinum, etc; energy commodities like crude oil, gasoline, etc and agricultural products like grains and even livestock. The basic idea remains the same throughout.
You see, all of the aforementioned commodities have one thing in common, apart from being in the same paragraph, which is they are subject to huge level of fluctuations due to seasonal demand fluctuations. For example, gold prices increase heavily during Diwali, and so do gold futures. For commodities like grains, seasonal price fluctuations literally depend on seasonal environmental fluctuations. Needless to say there is a huge space to make a profit by directional speculation. (Or book a loss!)
In India, these are traded on Multi Commodity Exchange (MCX) and the National Commodity and Derivatives Exchange.
You may also like: Commodity Trading in India
The Bottom Line
Futures can be a great way to make money. But futures can also be a quick way to lose money. Think of it like hiking, there is a lot of strenuous activity, both mentally and physically, but when you get to the top, the view is pretty sweet!
Disclaimer: There is a high degree of risk involved in stock trading and investing in any risky asset classes. The details given on this website are for informational purpose only and cannot be constituted as professional advice in any regard. Please follow due diligence while investing your money.
So that was all about the various Types of Futures, Stock, Index, Currency and Commodity Futures. We hope you got a clear picture of each of these derivative contracts. For any queries, drop in the comments.