Futures contracts are versatile financial instruments that allow traders and investors to speculate on, hedge against, or gain exposure to various asset classes and commodities. Stock markets comprise different types of futures and options, each tailored to underlying assets and market conditions.
In this blog, let us delve deeper into understanding the different types of futures contracts available to market participants.
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What is the meaning of a future contract?
Futures are derivative instruments that derive their value from an underlying asset. These contracts facilitate the trading of commodities at a predetermined price today, with delivery set for a future date as outlined in the contract. This arrangement offers investors the opportunity to reap profits if the market price of the traded commodity rises by the agreed-upon delivery date.
It is important to note that futures contracts come with expiration dates. However, there is no obligation to hold them until maturity. Traders enjoy the flexibility to cancel these contracts at any time during their duration.
Futures contracts involve two distinct positions: the short (sell) position, which entails delivering the asset on the specified date, and the long (buy) position, which obligates the acceptance of delivery on the maturity date. Investors may opt to initiate a short position while holding a long position in the same contract, nullifying the original long position.
Difference between a forward contract and a future derivative contract
A forward contract is an over-the-counter (OTC) contract and concludes only once, typically at the contract’s end. The parties engaged in this agreement negotiate and determine the specific terms privately. Forward contracts carry a certain level of default risk as it is the counterparty’s responsibility to make the payment on time as agreed upon.
In contrast, futures contracts are standardised agreements traded on stock exchanges. They involve daily settlements, fixed maturity dates, and uniform terms. Futures contracts are low-risk since they provide a guarantee of payment on the specified date, reducing the risk associated with default.
Functions of future markets
They provide a platform for businesses and producers to mitigate price risk by locking in prices for future transactions, ensuring cost stability and income protection.
Speculators enhance market liquidity, aid in price discovery, and seek profit opportunities by actively participating in trading. Their activities create price volatility and depth, allowing for more complex trading strategies and risk management.
Different types of future contracts
Futures markets offer a range of contract types, with the most common being forex, indices and commodities, particularly oil.
Forex futures are also known as currency futures. They establish a future date’s price for purchasing one currency using another. These contracts are exchange-traded, which differentiates them from the over-the-counter nature of regular foreign exchange (FX) trading. While the forex futures market is relatively smaller and less flexible, it provides a gateway for individuals accustomed to trading more regulated products like stocks.
When trading forex futures, it is crucial to consider the liquidity of the currency pair, with major pairs typically offering higher daily trading volumes. Currencies like the USD, GBP, EUR, and JPY are among the most liquid currencies. Forex futures are used for hedging and speculative purposes rather than physical settlement.
VIX futures contracts are associated with the NIFTY Volatility Index (VIX), a gauge reflecting market expectations regarding future volatility. NSE VIX futures are traded on the NSE under the symbol NVIX.
NVIX is viewed as an indicator of market uncertainty. Traders utilise NVIX futures to speculate on potential shifts in market volatility. If a trader anticipates an uptick in market volatility, they may opt to purchase NVIX futures as a safeguard against potential market declines.
Oil futures allow market participants to fix a future oil price. While no one can predict the exact future market price, traders can choose a level they believe the market will reach. Unlike some other commodity futures, oil contracts have monthly settlements due to the high volatility of oil markets. This frequent expiration schedule makes it easier for traders to speculate on oil prices.
Equity futures represent standardised agreements that require the trader to purchase or sell a specific quantity of shares from a specific company’s stock at a predetermined price for a future date. These contracts are actively traded on exchanges, offering traders a means to participate in the price fluctuations of individual stocks without actual ownership of the shares.
Equity futures are popular among market participants like speculators, hedgers, and arbitrageurs. These contracts enable traders to capitalise on upward and downward movements in stock prices, offering a versatile tool for managing risk and seeking profits.
Index futures contracts are based on specific stock market indices, which are representations of a collection of stocks chosen to mirror a particular market or sector. Examples include Nifty 50 and BANKNIFTY. When engaging in index futures trading, traders are essentially making predictions about the direction of the overall market, as opposed to focusing on individual stocks. These contracts are widely used for managing portfolio risk and capitalising on broader market trends.
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To engage in futures trading successfully, it is essential to possess a comprehensive grasp of the functions of the futures market and the behaviour of the underlying asset. This knowledge is crucial for making informed decisions regarding trading positions and timing entry and exit points. Although futures trading has witnessed significant growth in trading volumes on stock exchanges, traders must be mindful of the potential pitfalls and exercise caution in their trading endeavours.