Futures

The older of the two instruments, and the simpler. Both sides are bound.

The definition

SEBI:

A futures contract is a standardized exchange traded contract to buy or sell an underlying product at a predetermined price on a future date.

Four words doing work there.

Standardised. You do not negotiate the terms. The exchange fixes the quantity, the expiry and the settlement method, and you choose only the price and whether you are buying or selling. Chapter 4 is the specification.

Exchange traded. The clearing corporation of chapter 3 of the markets subject stands between the two sides, so you are not relying on the stranger who took the other side.

Predetermined price. Agreed now, settled later.

Future date. The expiry, after which the contract does not exist.

Obligation on both sides

This is the distinguishing feature, and the whole difference from an option.

If you buy a future you must buy at expiry. If you sell one you must sell. Neither side chooses later; both are committed from the moment the trade happens.

So a future is symmetric. If the underlying rises ₹10, the buyer gains ₹10 a unit and the seller loses ₹10 a unit. If it falls ₹10, the reverse. There is no premium, nothing is paid for the privilege, and both sides face unlimited movement in their own direction.

Draw it and it is a straight line through the agreed price at 45 degrees, up for the buyer and down for the seller. Chapter 6 draws it next to an option's, where the difference becomes obvious.

What you actually pay

Almost nothing for the contract itself, which is the part that surprises people.

Buying ₹18 lakh of an index future does not require ₹18 lakh. It requires margin — a deposit, a fraction of the position, held by the broker and the clearing corporation as security against your losses.

You have not bought anything. You have entered an agreement and posted collateral against your side of it.

That is the mechanism behind every leverage story in this subject, and chapter 5 is about what it does.

Mark to market

Futures are settled daily, not at expiry, and this is the detail that catches people out.

Each day the exchange compares the closing price with the previous day's. If the market moved against you, that loss is debited from your margin that evening. If it moved in your favour, it is credited.

Two consequences.

Losses arrive as cash calls, immediately. You do not wait for expiry to find out. If your margin falls below the required level you receive a margin call, and you must add money the same day or the next morning.

Being right eventually is not sufficient. A position that would have been profitable at expiry can be closed out in the middle, because you could not meet a margin call during a move against you. The contract was right; you were not there at the end.

This is chapter 3 of the fixed income subject's lesson in a harsher form. There, a price fall you could sit through cost nothing. Here you may not be allowed to sit through it.

Why the future's price differs from the spot

An index future usually trades a little away from the index itself, and the reason is money rather than opinion.

Holding the actual shares means paying for them today and tying up the money until the date in question. Buying the future gives the same exposure without that outlay. The future therefore prices in roughly the cost of money over the remaining period, adjusted for dividends the shares would have paid and the future does not.

As expiry approaches that difference shrinks, and at expiry the future settles at the underlying's value. A future converging on spot is arithmetic, not a signal.

Closing a position

You rarely take delivery. Most positions are closed by taking the opposite trade before expiry — sell what you bought, or buy what you sold — and your profit or loss is the difference.

Positions left open to expiry are settled per the contract's specification, which chapter 4 covers.

What a future is good for

Hedging. A fund holding ₹50 crore of shares and expecting a rough month can sell index futures against it. If the market falls, the shares lose and the futures gain. That is the function chapter 1 said derivatives exist for, and chapter 8 works it through.

Taking a view cheaply. The honest description of the other use. A view on direction, expressed with a fraction of the capital, which magnifies both outcomes.

The point

A futures contract obliges both sides to trade at a fixed price on a fixed date. You pay no price for the contract, only margin, so a small deposit controls a large position. Losses are debited daily through mark to market, which means being right at expiry does not help if you were closed out on the way.