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Sunday, January 15, 2017

How To Make Money By Trading In Futures Contracts?

In an earlier post I had covered in some detail the concept of futures. In this post I will discuss how you can make money by trading in futures. 



Before we proceed a recap, of the distinguishing characteristics of a futures contract would help:
  • Futures are contracts to buy and sell a “standardized quantity” of a particular asset (known as the underlying) on a given ‘future’ date at a predetermined rate (the Futures Price). The standardised quantity is denoted by the lot size. 
  • Futures are always exchange traded. 
  • Futures contracts are net-settled (price difference paid/received in cash; no delivery of assets is involved). 
  • Futures come with an expiry date. 


In India generally the following types of futures contracts are traded: 


Index Futures [ E.g NIFTY Futures]: In case of an Index Future, the underlying is a stock Market Index like the NIFTY.

Stock Futures [E.g Infosys Futures]: In case of a Stock Futures, the underlying is an individual stock or share. In other words, stock futures are contract to buy or sell a specific lot of equity shares on a given 'future' date (contract expiry date) at a predetermined price (the futures price).

Commodity Futures [Eg. Gold Futures]: A Commodity futures is a contract to buy or sell a fixed quantity of a commodity like gold or copper on a a given 'future' date (contract expiry date) at a predetermined price (the futures price).

Currency Futures [E.g USDINR Future Contracts]. A currency futures also known as a Foreign Exchange (FX) Future is an agreement to buy or sell a specific currency (E.g USD) in exchange of another currency (E.g INR) at a future date and at a predetermined future price.

Interest Rate Futures [E.g NSE Bond Futures]: An Interest Rate Future is an agreement to buy or sell a specific interest bearing debt security at a future date and at a predetermined future price.


Duration of Futures Contracts.  

Futures contracts are available in duration of 1, 2 and 3 months. These are called near month, middle month and far month contracts, respectively. All 3 contracts are traded simultaneously. The month in which a contract expires is called the contract month.

In India futures generally expire on the last Thursday of their respective contract months.

Short Selling. 

In the futures market the concept of short selling is applicable. Short selling is selling a security that you don't own now and then buying them back later. Short selling works in situations where the security price falls (subsequent to short-selling) so that the open position can be squared off by buying the security at a lower price thus enabling the trader to register a profit.  

However, unlike in the spot market where short positions cannot be carried overnight, you can carry short positions in derivative contracts till the contract expiry date. 

Making Money By Trading In Futures Contracts. 

The following example will help you understand how you can make money by trading in futures contracts.

Let us assume that you want to trade in futures of Infosys [Stock Futures]. The following data is available:

Current Stock Price (Spot market): Rs 5000

Price in the futures market (near month): Rs 5010. [The difference between spot price and Futures Price is due to the cost of carry i,e Interest.]

Lot size: 125 shares

Margin: 20%

While in the spot market, you can deal in even one Infosys share, in the futures market you will have to trade the minimum lot size. In the present case, the lot size is 125 shares. 

Today is January 1. You are bullish on Infosys and expect the price to rise in a month's time. You buy one Infosys futures contract (January Expiry) at the futures price of Rs. 5010. 

Note that the lot size is of 125 shares so your traded value is: 5010 x 125 = Rs. 626250. 

You, however, need not pay the entire traded value of Rs. 626,250 to buy the contract. The margin requirement being 20%, you only need to have Rs. 125,250 in your account to buy the future contract. 

On the contract expiry date, the price of Infosys in the futures market is 5310. You close out your open position (buy) by taking an opposite position (sell) on the expiry date. You had effectively bought the contract at a value of 5010 per share. Now you sell them at a value of 5310, thus making a gain of Rs.300 per share (5310 - 5010). 

Since the futures contract is comprised of a lot of 125 shares, you make a profit of

300 x 125 = Rs. 37,500. 

On an investment of Rs. 125250 this is a profit of 30% in just one month! 


Conslusion

Futures can thus help you leverage your capital to make some extra-ordinary profits. However, there is always a risk of huge losses as well. So one must trade in futures with caution.

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