Introduction to Derivatives Market-What are Futures and How do they work? | Beginner’s Guide to The Stock Market | Module 22

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Introduction to Derivatives Market-What are Futures and How do they work? | Beginner’s Guide to The Stock Market | Module 22

The derivative market is probably the most interesting topic in this Beginner’s Guide series. The derivatives market is also called the FnO market. As the name suggests, the value of derivatives is derived from other assets. Through this article, I am going to explain to you how the FnO market works and how the beginner should trade in the FnO market.

Introduction to Derivatives Market

How do Future Contracts work?

Technically speaking, the futures contract is a legal contract through which one can buy or sell a particular asset or commodity at a predetermined price at the specified time in the future generally, referred to as the expiry date. Also, after the expiration date, the buyer may opt to receive a cash settlement instead of the physical delivery of shares.

This was the technical definition of futures. Now I will explain it to you in simple words. Let’s say, for example, the Reliance stock is trading around  ₹ 1,900 and you think that at the end of this month it will go to ₹2,000. Now, there can be 3 ways to trade this opportunity.

1st is you can buy reliance stocks and then once it goes to 2,000 you can sell it, 2nd option is you can buy futures of reliance stock of this month ( In Indian Markets, the expiry date for futures is last Wednesday of the month) or you can buy the Call option (This we will see next).

In futures, there is a specific lot size for every contract. For example, the reliance lot size is 250, which means you can buy reliance futures in multiples of 250 and the margin required for this is nearly around 1.4L. Now one may get the question “Why would I buy the futures instead of buying stocks directly?” There are mainly two benefits of buying futures instead of stocks.

1st is for buying one lot of reliance i.e 250 quantities in cash you need 4.75L (Considering the price of one stock = ₹1,900.) Here you can buy 1 lot of reliance just at ₹ 1.4L. So, one major advantage is margin benefit.

The second advantage is, that you can’t take short positions in stocks in the equity market whereas, in futures, you can take short positions.

Now, At the expiry date if reliance goes to ₹2,000, then, in that case, you make a profit, and if your analysis goes wrong and reliance closes below ₹1,900 at the expiry date then, in that case, you will make a loss. (Please note that there is a slight difference between futures price and spot price but on the expiry future price and spot price will be equal)

 This is how futures work.

 Some Disadvantages of Trading Futures

  As there are a lot of benefits to trading futures, on the other hand, there also are some disadvantages to futures trading.

 1) Liquidity Problem

 In some stocks or in commodities you can face a liquidity issue and because of it, you may end up paying huge slippage. Also, if you want to exit your position in that case due to illiquidity you may face some problems in exiting your position. However, you may not face liquidity problems in Index futures such as Nifty or Banknifty.

2) You have to trade in lots

 As a futures trader, you can’t trade in 1 or 2 quantities. You have to trade in lots which require quite large capital.

 3) Future Price Vs Spot Price

 There is always a slight difference between futures price and spot price. Normally the future is costlier than a spot price by some difference, so there is always a time value associated with the future contract.

These are the few disadvantages of future trading.

Beginners Approach For Futures Trading

Futures and Options are high-risk high-reward trading instruments. If you are new to the market, then it is important that you practice in the equity market first and then you can trade in futures that too with a single lot in the initial days. Before entering the futures market, you should know exactly what your trading edge is and how your edge will make you profitable over a long period of time.

Also, Before entering into any trade, you should keep your risk in check so that you can always trade without fear. I think with strict risk management and money management principles, future trading can maximize your returns and with the help of future trading, you can grow your equity curve like never before!

I am sure that this article has helped in understanding futures and how they work. Also, don’t forget to share us across your social media platforms & tag us.

Have a good day.


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