Illustration of an index futures contract
If the index stands at 3550 points in the cash market today and you decide to purchase one Nifty 50 July future, you would have to purchase it at the price prevailing in the futures market. This price of one July futures contract could be anywhere above, below or at Rs 3.55 lakh (i.e., 3550* 100), depending on the prevailing market conditions.
Pricing of Futures Contracts on Stocks and Indices
There are various models that try to explain how futures are priced. Naturally, since futures are a derivative product, they derive their value largely from the price of the underlying stock or index. However, what these models try to explain is what constitutes the difference between the spot price (i.e., the current price of the stock in the cash market or the value of an index on that day) and the futures price. There are two popular theories that explain how futures contracts are priced the cost of carry model and the expectancy model. While these models merely give you a scaffolding on which to base your understanding of futures prices, being aware of these theories gives you a feel of what you can expect from the futures price of a stock or an index.
The Cost of Carry model
This model assumes that arbitrage between the cash market and the futures market eliminates all imperfections in pricing, i.e., unaccounted for differences between the cash price and futures price. The difference that remains is due to a factor called ‘The Cost of Carry’. The model also assumes, for simplicity sake, that the contract is held till maturity, so that a fair price can be arrived at.
To put it briefly, once all distortions in the futures price have been erased by arbitrage, a fair futures price = the spot price + the net cost of carry of the asset from today to the date on which the contract expires.
The net cost of carry involves all costs that you may have had to incur in order to hold a similar position open in the cash market, less the returns that you would have received from this position. The costs typically include financing charges, at the prevailing rate of interest. This is because you may have borrowed to finance a similar position in the cash market, and if not, you may have lost interest on the capital that you invested to keep your position open. In contrast in the futures market, you merely have to deposit a fraction of the value of your position in the form of a margin. The returns that you receive could consist of dividends or bonuses that you may have received in case you had held stocks in the cash market. In the case of an index future, your returns may be gauged by the average return that an index delivers.
As this theory is modified to become more realistic, by discarding assumptions or including variables, it becomes more complex. However, what you must absorb from this theory is the fact that there are costs and benefits involved in keeping a position open in a cash market and the price of a futures contract charges you or compensates you to reflect these.
Expectancy model of futures pricing
This model argues that the futures price is nothing but the expected spot price of an asset in the future. If there are more traders who expect the future price of an asset to rise in the future than those who expect it to fall, the current futures price of that asset will be positive. In fact, the theory suggests that it is not the relation between the cash market price and the futures price that is relevant, but the relationship between the expected spot price on the date of expiry of the contract and the futures price that is.
Basis While both these models do explain some part of the movement in futures prices, at a practical level, what you will observe is that there is usually a difference between the future price and the spot price. This difference is called the basis. The basis normally remains positive when the markets are not volatile or are in a secular run (not affected by short term, speculation driven volatility). However, when the markets are in a bear grip and cash market prices are expected to fall in the near term, the basis could turn negative.
Since a futures contract is settled at the cash market price on the date of the expiry of the contract, as it reaches expiration, the futures price and spot price converge. This is illustrated below:
How to Buy Futures:
In general, buying stock futures contracts is similar to buying a number of shares of the same underlying stock but without taking delivery of the same. In the case of index futures too, the number of index points move up or down, replicating the movement of a stock price. So, you can actually trade in index and stock contracts in just the same way as you would trade in shares.
Before you actually begin trading, you must tie up with a broker who is a member of the stock exchange on which you plan to trade. Alternatively, you could trade through a sub-broker, who routes your trades through a broker to the stock exchange. As per SEBI rules, all clients have to enter into a Client Broker Agreement with the broker with whom they wish to trade. In addition, you will have to furnish personal and financial information in a form called the Know Your Client or KYC form. Once these legal formalities are complete, the broker sets up an account for you and allots you a client code, which is a unique alphanumeric code that will be used to represent all your trades through the broker. Once you have been allotted a client code and you deposit a margin (some amount of money) as per the business rules of the broker, you can commence placing orders with your broker. There are different categories of orders and depending on your requirements, you can specify which category your broker should choose on your behalf. The main order types are:
When you place a market order, it is executed at the prevailing market price.
When you place a limit order to buy or sell, it gets executed at a specific price as stated by you. Such types of orders are shown as ‘pending orders’ in the system till such time the market price of the share in question reaches the ‘limit’ price.
Stop loss orders:
As a security measure, when you have a long or short position open in the market, you can direct your broker to square up your position at a predetermined price, in order to limit your losses.
Unlike purchasing stocks from the cash market, when you purchase futures contracts you are required to deposit only a percentage of the value of your outstanding position with the stock exchange, irrespective of whether you buy or sell futures. This mandatory deposit, which is called margin money, covers an initial margin and an exposure margin. These margins act as a risk containment measure for the exchanges and serve to preserve the integrity of the market.
You are expected to deposit the initial margin upfront and the exchange/clearing house prescribes the magnitude (percentage of your open position) of this margin for different positions, taking into account the average volatility of a stock over a specified time period and the interest cost. This initial margin is adjusted daily depending upon the market value of your open positions.
The exposure margin is used to control volatility and excessive speculation in the futures markets. This margin is also stipulated by the exchange and levied on the value of the contract that you buy or sell.
Besides the initial and exposure margins, you also have to maintain Mark-to-Market (MTM) margins, which cover the daily difference between the cost of the contract and the closing price on the day the contract is purchased. Thereafter, the MTM margin covers the differences in closing price from day to day.
Settling stock futures contracts
In the Indian markets, buying a stock futures contract does not result in delivery of the underlying shares. The futures contract has to be settled (sold off if purchased or bought back if sold, as the case maybe) on the expiry day at the closing price of the underlying stock in the cash market.
So, let’s get back to our example, wherein you have purchased a single future of ABC Ltd. (consisting of 200 shares; contract month July). If on the last Thursday of July, ABC Ltd. closes at a price of Rs 1,050 in the cash market, your futures position will be settled at that price. You will receive a profit of Rs 50 per share (the settlement price of Rs 1,050 less your cost price of Rs 1,000), which adds up to a neat little sum of Rs 10,000, since you have purchase one lot of 200 shares. For simplicity, we have not mentioned the process of maintaining margins, but once your contract expires, you receive profits, the margins that you have deposited to keep this position open will be added to these and if you made a loss, you are required to payoff the loss, net of the margins that you have deposited
Index closed at MTM margin Explanation Illustration of Mark-to-Market margins for 100 Nifty bought at 3550
Difference between Debit of Rs 10000 the closing price on (100*100) date of purchase day 2 closing price, i.e., (3500-3600)*100 Difference between Credit of Rs5,000 purchase price and closing price, i.e. (3600-3550)* 100 Difference between day 2 Debit of Rs 1000 and day 3 closing prices, i.e., (3490-3500)*100 3490 3500 Day 3 Day 2 Day of purchase 3600
Although futures expire on a particular date, most traders do not hold on to their positions until the expiry date of the contract. They usually exit much before the expiry date by offsetting or cancelling their position, i.e. selling their long positions or buying back their short positions. Here again, your profits or losses will be returned to or collected from you, after adjusting them for the margins that you have deposited till the day on which you square off your position.
Index futures contracts are settled in cashand the closing index value on the date of the expiry of the contract is considered as the settlement price for index futures.
To explain, let’s consider a case where you purchase one contract of Nifty future at 3560, say on July 7. This particular contract expires on July 27, being the last Thursday of the contract series. If you have left India for a holiday and are not in a position to sell the future till the day of expiry, the exchange will settle your contract at the closing price of the Nifty prevailing on the expiry day. So, if on July 27, the Nifty stands at 3550, you will have made a 1055 of Rs 1,000 (i.e., difference in index levels 10* contract size 100). Your broker will deduct the amount from your margins deposited with him and forward it to the stock exchange, which in turn will forward it to the seller who has made that profit.
10 times 10 times • 576000 Amount required for purchase of similar qty in cash market • •…. Buy Futures 57600 960 Sell futures 57600 960 Bullish Bearish Perception Using Futures …..
However, as you know by now, you do not have to wait till the expiry date of the contract in order to exit a position in the futures market. In the above case, you could have sold your long position on the day of purchase itself or on any day till the expiry date of the contract, if the price in the futures market looked attractive. You would also base the timing of your sale on your perception of which way the market may move and your investment horizon.
As explained earlier, speculators, hedgers and arbitrageurs all stand to benefit from trading in derivative products. Let’s take a look at what types of positions they would take in futures and what payoffs they could receive.
Speculators take long or short positions in index and stock futures, depending on their perceptions of the market.
Let’s take the case of stock futures of RIL;
Contract size: 600 shares; Price of Future: 960; Spot Price: 955; Margin Required: 10 per cent of the contract value.
In the above case, any movement in the stock prices to say Rs 980 would make the futures buyer richer by Rs 12,000 (600 x 20) for each contract. Similarly in the case of a fall in prices to say Rs 950, the investor would lose Rs 6,000 (600×10) for each contract. The seller, on the other hand, would losewhen the buyer gains and gain when the buyer loses, to the same extent.