In the financial market, you can see there is another segment apart from the cash market where you can trade and make money. The future market is another segment you can use to trade in various underlying securities. Though, there are limited underlying securities allowed to trade in the future market but account for the huge volume in terms of value and number of quantitate traded.
Though, this market is riskier than cash or spot market, but can give better returns and is best for the traders who believe in trading and don’t want to be involved in the cash or delivery-based trading. Future market is available for equity/stocks, commodities and currency or forex trading. In respect of the same here we will discuss about the futures market, how it works and its pros & cons.
What is Futures Trading in the Stock Market?
Futures are type of derivative agreement between two parties to buy or sell underlying security; the security can be a stock, commodity or currency at predefined price and on a pre determined date. When an underlying stock is traded through such contracts, it is called futures trading in the stock market.
What is a Futures Contract in the Futures Market?
A Future contract is a kind of legal agreement between the buyer and seller to buy or sell an underlying security at a predefined agreed price for a specific time in the future. The futures contracts are standardized with specific quantity and quality providing the facility to trade in the market.
While entering into the futures contract, the buyer of the future contract promises / honour the obligation to buy and receive the delivery of underlying assets at the time expiry of the future contract. On the other hand, the seller of the futures contract is taking the obligation to supply or deliver the agreed underlying asset at an agreed number of quantities at an agreed price on the expiration date.
How Future Contracts Works?
First thing to make sure before trading any particular security in futures market is to check whether that asset is actually traded in that particular segment. If the asset trades than it is simply a kind of mutual agreement that is entered through a contract to buy or sell a particular underlying security at a predefined price and date in the future.
Entering the Contract:
In a futures contract, buyer buys a right to purchase the underlying security at a certain specific price at a specific future predefined date. And the seller is selling the future contract with the obligation to sell the underlying security at a certain predefined price and date.
Pricing of Security:
The price of the underlying security is determined by the supply and demand of the asset. Supply and demand is highly correlated with the factors affecting the price of security in market like the economic factors both at macro & micro level, market conditions, investors’ sentiments.
Also Read: What are the Top Factors Affecting the Stock Market in India
Moreover, the price of the underlying security also changes as the expiration date of the security approaches compared to the spot price of security. If at the time of expiration, the price of the underlying security goes up, then the contract holder (buyer) books profit, and if it is price slides, then the contract holder (buyer) has to incur the loss.
Delivery & Margins:
There are two scenarios that can happen at time of expiry. If the position is profitable and buyer of contract didn’t square off the contract, the natural conclusion would be reached through either cash settlement or physical delivery, depending on the contract’s terms. If the position is profitable and buyer square off before expiry, the contract would be cash settled. The price of the contract at the time of buying the security is known as premium and margin money is also paid.
Types of Futures Contract
The future contracts in financial markets are not meant for trading, but for the time being and owing to the increase in the demand for such contracts, the futures market has been divided into two categories. Let’s discuss these two types of future contracts.
Speculators or Traders
Speculators or traders are people who enter into a contract to earn a quick buck by speculating on rise or fall in security. Speculator heavily relies on technical analysis and other indicators to analyse the price action and predict whether a particular underlying security will increase or decrease, accordingly buying or sell the futures contract to make profit. In speculation, there are equal chances of getting profits as well as losses.
Hedgers
The companies, institutional investors, manufacturers and wholesalers who are into business and want to secure the price of underlying security from the volatility in the price change, are the hedgers. Suppose a company who requires a raw material to manufacturing a product for which he has orders of. He won’t be buying and storing full quantity of the raw marital on day one but rather at particular time frame complementing his manufacture capacity and inventory level. So in order to protect against the price change or take advantage of the fluctuation in the change in the price of the underlying security, a trader can use future contracts to hedge from such fluctuations.
Pros and Cons of Futures Trading
Trading in the future market comes with various advantages and disadvantages that you need to understand before you enter into this forward market. As you have to pay certain upfront margins, especially when you are short-selling in the future market and due to high volatility you have to maintain the margin according to the change in the price of the underlying security.
Benefits of Future Trading
The future market provides the best option to hedge your investment by entering into the forward market and gaining profits from any changes in the underlying security. Apart from that there are multiple other benefits you can enjoy trading in the future market.
Low Cost Trading:
In future market trading in futures contracts, you have to pay the lower amount of commission or brokerage fees making your transactions more cost-effective compared to sport or cash market trading. It helps to maximize your rate of returns compared to other markets.
High Liquidity:
Compared to the spot or cash market you will get a higher amount of liquidity in the market. In future trading only limited underlying securities are allowed to trade, hence there is a huge number of buyers and sellers available in the market providing the opportunity to liquidate your investment.