If you are a regular stock market trader, you might be aware of the futures trading and options trading concepts. Futures trading allows you to invest in various stocks and indexes, albeit in a different way. For example, you can make money through hedging and speculating by buying or selling a specific number of stocks of a certain company at a pre-agreed price on a future date.
Published on 04 April 2022
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Continue reading this article to know more about the futures trading concept, how futures pricing is determined, and how you can trade in futures to generate profits.
What is Futures Trading?
Futures trading involves buying and selling of futures contracts on the stock markets. A futures contract is a legal agreement that gives the right to its buyer to buy or sell a specific number of stocks of a company at a predetermined price and on a specific expiry date.
The trading of futures contracts takes place on the stock exchanges, so they are strictly regulated as per the Securities and Exchange Board of India (SEBI) guidelines.
You can buy a futures contract at the current price prevailing in the market, known as the spot price. Then, you need to select a strike price – the price at which you want to buy or sell your contract at the expiry date – and pay the premium for that strike price.
What is Futures Pricing, and How is it Determined?
As mentioned, you need to pay a premium to buy a futures contract. This premium is known as the futures price. A futures price is calculated as per the value of the underlying asset and moves in accordance with it. It means that if the value of the underlying asset increases, the price of the futures contract also increases, and if the value of the underlying asset decreases, the price of the futures contract falls.
However, it needs to be noted that the price of a futures contract does not have to be equal to the cost of its underlying asset at all times. Therefore, you can trade them at several different prices in the market. The difference between the spot price or current market price of a futures contract and its price in the future is called the “Spot-Future Parity”.
Several factors are responsible for different futures prices at different points. These include dividends, interest rates, and time remaining for expiry. Below is the futures pricing formula used to determine futures price using the three variables mentioned above:
Futures Price = Spot Price x (1 + rf – d)
In this formula, rf stands for the risk-free rate, and d denotes the dividend.
A risk-free rate denotes the interest or returns that you can gain during a year when the environment is ideal. To calculate the futures pricing, you need to adjust this risk-free rate proportionately for one or two months, depending upon the expiry of the futures contract. So, after the adjustment, the futures pricing formula may look like this:
Futures Price = Spot Price x [1 + rf x (x/365) – d]
In this formula, rf represents the risk-free rate, X denotes the number of days left to the expiry date, and d stands for the dividend.
Let’s understand this with the help of an example. Suppose the spot price of a share named “XYZ” is ₹498.50, and the rf (risk-free rate) is 12.35 percent per annum. Now, assuming that ten days are left till the futures contract of the XYZ stock expires, let's calculate its futures pricing:
Futures price of XYZ when 10 days are left for expiry = 498.50 x [1 + 12.35 x (10 / 365)] – 0
Here, we have taken the dividend as zero because the assumption is that the company is not paying any dividend. In case a company pays any dividend, it will be included in this formula as well. Also Read: What do you mean by Dividend Yeild Stocks?
Understanding Futures Pricing Quote
Now that you know how futures pricing is calculated, you can do your mathematics and start your futures trading to make profits. When you buy or sell a futures contract, you are not taking any physical delivery of the underlying stocks but betting or speculating on the market trends to make a profit in the future.
You can base your speculations on futures pricing quotes, which is a technical tool to predict the price movements of stocks. These quotes contain all information related to futures contracts along with the price movement predictions. The name of the underlying stock and the expiry date of its futures contract is mentioned at the top.
Apart from these, you can get the current market price and the index of price movements of the underlying stocks at the corners of the futures pricing quote. The open and settlement prices are mentioned at the bottom.
To Conclude
Trading in futures and options can provide you with an opportunity to make substantial gains through hedging and speculation. However, before you start your futures trading journey, it’s crucial to have a thorough understanding of the concept. You should also know how futures pricing is determined and the factors that can influence it.
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All You Need to Know about Shorting in Futures & Options
Shorting is just a simple market view. Just like people purchase stock when they expect it to go up, they sell it when they expect it to go down. It's normally a directional outlook and nothing else.
Futures and Options are two important standardised derivative contracts. It is standardised based on the quantity, price, and expiration date. Therefore, quantity based on the lot size is a vital aspect that helps you engage and settle a futures or options contract.
A futures contract is nothing but an improvised forwards contract. It is designed to retain the fundamental transactional structure of a Forwards market. Futures Contracts also eliminate the risks that are generally associated with a Forwards Contract.
All You Need to Know about Shorting in Futures & Options
Shorting is just a simple market view. Just like people purchase stock when they expect it to go up, they sell it when they expect it to go down. It's normally a directional outlook and nothing else.
Futures and Options are two important standardised derivative contracts. It is standardised based on the quantity, price, and expiration date. Therefore, quantity based on the lot size is a vital aspect that helps you engage and settle a futures or options contract.
A futures contract is nothing but an improvised forwards contract. It is designed to retain the fundamental transactional structure of a Forwards market. Futures Contracts also eliminate the risks that are generally associated with a Forwards Contract.
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