How to Trade in Futures

What are futures?

Future trading is trading in Futures contracts. Trading in futures is derivative trading. In the stock market the underlying or the basis on which these futures contracts are written are the equity shares and indexes traded on the online stock exchanges.

In futures trading, you take buy/sell positions in index or stock(s) contracts expiring in different months. At any time you will find contract available for three months. One will be expiring on the last thursday of current month, another on the last thursday of next month and the third on the last thursday of the month after next month. If, during the course of the contract life, the price moves in your favor (rises in case you have a buy position or falls in case you have a sell position), you make a profit. In case the price movement is adverse, you incur a loss.

To take the buy/sell position on index/stock futures, you have to place certain % of order value as margin. With futures trading, you can leverage on your trading limit by taking buy/sell positions much more than what you could have taken in cash segment. However, the risk profile of your transactions goes up.

You have done an analysis and decide to buy ONGC futures. That is you are willing to buy ONGC shares at a specified current price and undertake to close the contract on the expiry date. The first step is find out the trading lot of ONGC futures. The trading lots are decided by the stock exchanges. If the trading lot is 50, then you can do trades for a minimum of 50 and in multiples there after; The expiry date is the date on which the contract will be due for settlement and will expire. It is usually the last thursday of every month. On the last thursday the contract of that month will expire. It is not necessary to wait till the expiry date. You can square the trade on or before the expiry date. If you are holding a long position ie., you have purchased ONGC futures, then you can sell an equal quantity and square the trade. The following example will make the process more clear.

Equity Shares of ONGC
Trading lot 225
Buy Price 1200 per share
Margin prescibed 25%
Expiry Date 27th August 2009
You expect the price of ONGC to go up. You buy one lot of ONGC shares at 1200 per share.

Total value of the trade = 225 x 1200 = 270000 Margin required for trading = (270000*25) / 100 = 67500 With an investment of Rs.67500 you can buy shares worth 270000. This is called as leveraging.

As expected by you the prices go up to 1400. You can square up by selling the future contract for 1400. You will make a profit of Rs. 225 * 200 = 45000. You can also wait till the expiry on 27/Aug/2009. On that day it will be squared up automatically at the price prevailing on that day. If the prices fall from 1200 which is your purchase price to say 1000 then you will incur a loss of 225 * 200 = 45000.

Initially, margin is blocked at the applicable margin percentage of the order value. For market orders, margin is blocked considering the order price as the last traded price of the contract. On execution of the order, the same is suitably adjusted as per the actual execution price of the market order.

Squaring off a position means closing out a futures position. For example, if you have futures buy position of 225 ONGC expiring on 27th August, 2009 squaring off this position would mean taking sell position in 225 ONGC expiring on 27th August 2009 on or prior to 27th August, 2009. The order placed for squaring off an open position is called a cover order.

Futures Trading – A Temptation to Leverage on Trading Limits

Normally to buy shares, you need to have sufficient limit to provide for 100% of the order value, while to sell shares, you need to have shares in your demat account. However, in F&O Trading, funds are blocked only to the extent of some % of the order value allowing you to leverage on your trading limits. Investors generally use F&O to increase their purchasing power so that they can own more stock without fully paying for it. But F&O exposes you to the potential for higher losses. Here's what you need to know about F&O.

How Does Leveraging Works

Let's say you buy a stock for Rs. 60 and the price of the stock rises to Rs. 75. If you bought the stock in ‘Cash" Segment and paid for it in full, you'll earn a 25 percent return on your investment. But if you bought the stock on futures (say 33.33%) paying only Rs. 20 in cash – you'll earn a 75 percent return on the money you invested. The downside of using F&O is that if the stock price moves unfavorably, losses can mount quickly. For example, let's say the stock you bought for Rs. 60 falls to Rs. 39. If you fully paid for the stock, you'll lose 35 percent of your money. But if you bought on futures, you'll lose more than 100 percent.