Welcome to our Futures Basics FAQ section! Whether you’re just starting out or looking to enhance your knowledge of futures trading, this guide is designed to answer the most common questions and provide you with the essential information you need.
Futures trading can seem complex at first, but with the right insights and strategies, it can become a powerful tool for hedging, speculation, and portfolio diversification. In this section, we’ve compiled answers to frequently asked questions on everything from basic concepts to advanced trading techniques.
If you’re curious about how futures contracts work, what it takes to get started, or how to manage risk, you’ll find clear and concise answers right here. Let’s dive in and get you on the path to understanding the fundamentals of futures trading!
Still have questions? Feel free to reach out to our support team for further assistance.
What is Futures Trading?
Futures trading is when you agree to buy or sell something (like a commodity, stock, or index) at a set price, but you make the transaction at a later date. It’s like locking in a price now for something that will happen in the future.
Example:
Suppose you are a trader in India and you agree to buy 10 kg of gold at ₹50,000 per kg, but the actual purchase will happen 3 months from now.
If, in the next 3 months, the price of gold increases to ₹55,000 per kg, you can still buy it at ₹50,000 and make a profit by selling it at the current price.
However, if the price drops to ₹45,000 per kg, you will still have to buy it for ₹50,000, causing a loss.
Futures trading helps you protect yourself against price changes (called hedging) or to make a profit by predicting price movements.
How Do Futures Contracts Work?
A futures contract is an agreement to buy or sell something at a fixed price on a specific future date. The buyer agrees to purchase, and the seller agrees to sell the item at the agreed price, no matter what the actual market price is on that date.
Example:
Imagine you’re a farmer in India growing wheat. Right now, the price of wheat is ₹2,000 per quintal. You’re worried that the price might drop by the time you harvest and sell it in 3 months. So, you make a futures contract with a buyer to sell your wheat at ₹2,000 per quintal in 3 months.
- If the price of wheat goes down to ₹1,800 per quintal, you still get ₹2,000 as agreed in the contract, which protects you from the price drop.
- If the price of wheat rises to ₹2,200 per quintal, you still have to sell it at ₹2,000, which means you miss out on the higher price but you were protected from the price drop.
In this way, futures contracts help both buyers and sellers manage risk by locking in prices ahead of time.
What is the Difference Between Futures and Stocks?
Futures and stocks are both ways to invest, but they work very differently.
Here’s a simple breakdown:
- Stocks represent ownership in a company. When you buy stocks, you become a partial owner of that company. The value of your stock goes up or down depending on how well the company performs and other market factors.
- Futures are agreements to buy or sell something at a future date, at a price agreed upon today. You’re not owning anything directly (like you would with stocks). Instead, you’re speculating (guessing) whether the price of an asset, like gold, oil, or wheat, will go up or down.
Key Differences:
- Ownership: When you buy stocks, you own a share of the company. In futures trading, you don’t own the asset; you’re just agreeing to buy or sell it later.
- Purpose: Stocks are usually bought for long-term investment (holding onto them for years). Futures are often used for short-term trading, either to speculate or to hedge (protect against price changes).
- Risk and Leverage: Futures involve more risk and can require a smaller initial investment compared to stocks. However, this also means you can make (or lose) money more quickly because of leverage (borrowing money to make bigger trades).
Example:
- Stocks: If you buy 100 shares of Reliance Industries at ₹1,300 per share, you own a small part of the company. If the stock price goes up to ₹1,500, you can sell your shares for a profit.
- Futures: If you believe the price of crude oil will rise in the next 3 months, you can enter into a futures contract to buy oil at today’s price (say ₹5,000 per barrel) in 3 months. If the price of oil goes up, you make a profit. If the price goes down, you make a loss.
In summary, stocks give you ownership in a company, while futures are agreements about buying or selling at future prices, often used for short-term speculation.
What is a Futures Market?
A futures market is a place where people buy and sell futures contracts. It’s like a marketplace where traders agree to buy or sell commodities (like oil, gold, or wheat) or financial instruments (like stock indices) at a specific price, but the actual transaction will happen at a later date.
In a futures market, buyers and sellers can make deals about the price of something, even though they don’t own it yet. This helps them manage risks or try to profit from price changes in the future.
Example:
Imagine you are a trader in India and you think the price of soybean will rise in the next few months. You can buy a futures contract on a commodity exchange, to buy soybean at today’s price, but the contract says you’ll take delivery 3 months later.
- If the price of soybean rises by the time the contract expires, you can sell it at the new higher price and make a profit.
- If the price falls, you’ll still have to buy it at the agreed-upon price, leading to a loss.
The futures market allows farmers, traders, and investors to protect themselves from future price changes (hedging), or they can try to profit by predicting whether prices will go up or down.
So, the futures market helps with managing risk and offers opportunities for profit, all while trading contracts for something that will be delivered or settled in the future.
Who Participates in the Futures Market?
Different types of people and organizations take part in the futures market. They usually fall into two broad categories: Hedgers and Speculators.
Hedgers
These are people or companies who use the futures market to protect themselves from future price changes. They are usually involved in businesses that deal with commodities (like oil, wheat, or gold) or other products.
They want to lock in a price now to avoid losing money if prices change in the future. They’re not looking to make quick profits; they’re trying to reduce risk.
Example
- A farmer growing wheat might use the futures market to agree on a price to sell their wheat in the future, protecting themselves if wheat prices fall by the time they harvest.
- A fuel company may buy oil futures to secure a lower price for oil in the future, preventing higher costs if oil prices increase.
Speculators
Speculators are individuals or firms who don’t intend to actually buy or sell the commodity. Instead, they aim to profit by predicting price movements. They buy futures contracts when they think prices will go up and sell them when they think prices will go down.
They are looking to make a profit based on market trends or price movements, and they often trade in the futures market for short-term gains.
Example
A trader might buy a futures contract for gold at ₹55,000 per 10 grams, thinking that the price will rise to ₹60,000. If the price does rise, the trader can sell the contract at the higher price and make a profit.
Investment funds may buy or sell futures contracts for stock indices (like the Nifty 50) to profit from market movements without owning the stocks directly.
Arbitrageurs
These are traders who look for price differences in the futures market and other markets. They buy in one market where the price is lower and sell in another market where the price is higher, making a profit from the price difference.
They make money by exploiting small price differences between the futures market and other markets (like spot markets or other exchanges).
Example
An arbitrageur might notice that the price of soybean futures is lower on one exchange than on another. They could buy it at the lower price and sell it at the higher price to make a profit.
All these participants help keep the futures market active and provide liquidity, which makes it easier for others to buy and sell futures contracts.
Why is Margin Important?
Margin allows you to control a larger position with a smaller amount of capital, meaning you can profit more (but also lose more) with less investment.
It ensures you have enough funds to cover potential losses, protecting both you and the broker.
What Are Commodity Futures?
Commodity futures are contracts that allow you to buy or sell a specific quantity of a commodity (such as oil, gold, wheat, etc.) at a future date and at a price agreed upon today.
A wheat farmer might sell wheat futures to lock in a price for their crop, protecting themselves from price drops in the future.
What Are Financial Futures?
These futures are contracts based on financial instruments like stock indices, bonds, or interest rates. They allow traders to speculate on the future value of these instruments.
A trader might buy a futures contract on the Nifty 50 index, speculating that the index will rise in the future.
What Are Stock Index Futures?
Stock index futures are contracts that track the performance of a group of stocks, like the Nifty 50 or Sensex. These futures allow traders to bet on the overall movement of the stock market, rather than individual stocks.
If you believe the Nifty 50 index will rise, you can buy Nifty futures contracts.
