Futures Contracts

Trading in Futures Contract

• Types of Trade– Proprietary (PRO) means that the orders are

entered on the trading member’s own account.

– Client (CLI) means that the trading member enters the orders on behalf of a client.

Types of Orders

– Market Order- Specifies that the transaction be executed at the current market price

– Limit Order- Specifies a certain price and requests that the transaction be executed only if that price or a better one is obtained

– Stop Loss Order- Specifies to release an order into the system, after the market price of the security reaches or crosses a threshold price.

• Example : If for stop loss buy order, the trigger is 1027, the limit price is 1030 and the market (last traded) price is 1023, then this order is released into the system once the market price reaches or exceeds 1027. For the stop loss sell order, the trigger price has to be greater than the limit price.

Open and Close out Positions

• Open a position involves entering into a trade as a original one.

• Close out a position involves entering into a trade opposite to the original one.

Specification of futures contract

• Asset specifications

• Contract Size

• Delivery Arrangement

• Price Quote

• Daily Price Movement Limits

• Position Limits

• Expiry Date

Asset SpecificationsQuality

Grades • When the asset is a commodity, there may be

variation in the quality of what is available in the market place. Hence Exchange stipulates the grade or grades of the commodity that are acceptable.

• The financial assets in futures contracts are generally well defined and unambiguous.

Contract Size

• The contract size specifies the amount of the asset that has to be delivered under one contract.

• Example :– 200 shares of Infosys– 50 units of Nifty– 100 gms of gold– 5 Kg of Silver

Delivery Arrangement

Delivery arrangement include the place of delivery and the precise period in the month during which the delivery has to be made.

Exchange specifies when the trading in a particular month’s contract will begin as well as the last day on which the trading can take place for a given contract.

Price Quote

• The futures price is quoted in a way that is convenient and easy to understand.

• Example:– Crude oil future prices on the New York

Mercantile Exchange (NYMEX) are quoted in dollars per barrel to two decimal places.(i.e. to the nearest cent)

Daily Price Movement Limits

• Daily Price limits are specified by the exchange to prevent large price movements occurring because of speculative excesses.

• If the price moves down by an amount equal to the daily price limit the contract is said to be limit down

• If the price moves up by an amount equal to the dail price limit the contract is said to be limit up.

Position Limits

• Position limits are the maximum number of contracts that a speculator may hold.

• The purpose of the limits is to prevent speculators from exercising undue influence on the market.

Contract Specification – S&P CNX Nifty Futures

MARGIN REQUIREMENTS

• Initial Margin

• Maintenance Margin

• Marking to Market

Initial Margin

• The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin

Maintenance Margin

• Maintenance margin is set to ensure that the balance in the margin account never becomes negative. This is somewhat lower than the initial margin

• If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

Marking to market

• At the end of the day margin account is adjusted to reflect the investor’s gain or loss depending upon the futures closing price. This is called marking to market.

Zero sum game

• The total number of long in any contract always equals the total number of short in that contract

• The total number of outstanding contracts (long/short) at any point in time is called Open interest.

• Open interest is a good indicator of the liquidity in every contract.

Convergence of future price to spot price

• As the delivery month of the futures contract approached the futures price converges to the spot price of the underlying asset.

• When the delivery period is reached the futures price equals or is very close to the spot price.

Hedging using FuturesShort hedge

• A company that knows that it is due to sell an asset at a particular time in the future can hedge by taking short position

• This is called short hedge• If the price of the asset goes down, the company

may not fare well on the sale of the asset but makes gain on the short futures position

• If the price goes up company gains from the sale of the asset, but takes the loss on the futures position.

Hedging using FuturesLong hedge

• A company that knows that it is due to buy an asset at a particular time in the future can hedge by taking long position

• This is called long hedge• If the price of the asset goes up, the company

may not fare well on the sale of the asset but makes gain on the long futures position

• If the price goes down company gains from the buying of the asset, but takes the loss on the futures position.

Basis Risk

• The basis in a hedging situation is defined as• Basis = spot price of asset to hedged – futures

of the contract used.• When the spot price increases by more than

futures price the basis is increases. This is referred to as a strengthening of the basis.

• When the futures price increases than the spot price the basis declines. This is referred to as a weakening of the basis.

Types of Futures Contracts

• Stock Index Futures• Stock index tracks the changes in the value of a

hypothetical portfolio of stocks • The weight of a stock in the portfolio equals the

proportion of the portfolio invested in the stock• The percentage increase in the value of the

stock index over a small interval of time is usually defined so that it is equal to the percentage increase in the total value of stocks comprising the portfolio at that time

Securities

Currencies

Commodities

Delivery Options

Relationship between Futures, Forward and Futures Spot

The cost of carry

• The relationship between futures prices and spot prices is termed as the cost of carry