Understanding Futures Contracts: 5 Key Concepts to Know

Futures contracts are derivative agreements to buy or sell an underlying asset at a future date for a predetermined price. They are widely used for both hedging against price changes and profiting from future price movements.

To trade in this derivative instrument, you need a good grasp of some basic concepts. In this article, we will break down the five main components of the futures contract, making it easier for you to understand how they function.

5 Key Concepts to Know about Futures Contracts

A futures contract is a standardized agreement between two parties to purchase or sell an underlying asset in the future at a predetermined price.

Futures trading helps with risk management via hedging existing positions and helps trades benefit from price movement. Futures are traded on exchanges like BSE and NSE, which provides transparency.

Here are five key concepts that you need to understand with regard to future contracts.

1. Margin Requirements

When a trader enters into a futures contract, they need to pay the initial margin, which is some part of the total value of the contract. This money is kept as collateral to guarantee the fulfillment of obligations by both sides.

Further, there is also a maintenance margin requirement. Traders need to add funds to their accounts if they go below the maintenance margin, otherwise, their positions can be liquidated.

These margin rules are useful in risk control but can also expose traders to considerable financial risks.

2. Leverage

For futures, traders have to deposit a margin. This is a requirement and also allows leverage. Leverage in futures contracts allows traders to control large positions with a relatively small capital, known as the margin. This means you can potentially amplify your profits with a smaller upfront cost.

However, leverage also increases risk, as losses can be magnified if the market moves against your position. It’s crucial to manage leverage carefully to avoid substantial financial losses, especially given its impact on both potential gains and risks.

3. Contract Specifications

Understanding the specific details of futures contracts is crucial for effective trading. Here are the key specifications:

Underlying Asset: Each futures contract is based on an underlying asset, which can be a stock, commodity, or other financial instrument. Knowing what underlies a contract helps traders gauge market trends and asset volatility.

Contract Size: This refers to the lot size of each contract, which dictates how many units of the underlying asset are covered. This is critical for understanding the leverage and capital requirements involved.

Expiration Date: The date when the contract ends and must be settled. This date is essential for planning trade strategy and timing your exit or rollover.

Tick Size: This is the smallest permissible price movement in the contract. Understanding tick size helps in setting precise stop-loss and take-profit levels.

4. Expiry Day

In the Indian financial markets, futures contracts have specific expiry days that vary depending on the contract type and the exchange. Here’s a detailed look at how expiry days are structured for different contracts:

If the regular expiry day (Thursday or Friday) is a holiday, the expiry is moved to the previous trading day.

5. Mark to Market

Mark to Market (MTM) is a critical concept in futures trading that adjusts the value of open futures contracts to reflect current market prices at the end of each trading day. This ensures that the profit or loss on these contracts is realized daily rather than at the contract’s expiration.

At the close of each trading day, the futures contracts you hold are reassessed based on the closing market prices. If the market price of the asset has increased compared to the price at which you entered the contract, your account is credited with the difference, enhancing your margin balance. Conversely, if the market price has decreased, your account is debited.

Suppose you use a futures trading app to buy a futures contract for wheat at ₹20 per kilogram, expecting the price to rise. Let’s say the contract size is 1,000 kilograms. The total value of your contract at entry is ₹20,000.

Day 1 Closing Price: ₹21/kg. The contract value is now ₹21,000. Your account gets a credit of ₹1,000.

Day 2 Closing Price: ₹19/kg. The contract value falls to ₹19,000. Your account is debited by ₹2,000.

Conclusion

Understanding the fundamentals of futures contracts—such as contract specifications, leverage, and settlement methods—can significantly enhance your trading strategy. By understanding these key concepts, you’ll be better equipped to navigate the complexities of futures trading.