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Future Contracts: Definition, Purpose, Types, Uses, Example, Limitations          

Future Contracts: Definition, Purpose, Types, Uses, Example, Limitations

Future Contracts: Definition, Purpose, Types, Uses, Example, Limitations
By Arjun Arjun Remesh | Reviewed by Shivam Shivam Gaba | Updated on May 14, 2024

A futures contract is a legally binding agreement to buy or sell a commodity or asset at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange. 

Futures originated centuries ago when merchants needed stability amid rice price swings. Today, they empower stakeholders across sectors seeking certainty. For farmers, they secure income regardless of crop value fluctuations. Airlines lock fuel costs to streamline budgeting. Manufacturers hedge commodity input prices. 

Futures also benefit speculators. By betting on prices through regulated exchanges, they provide liquidity while accepting risks others offload. Their participation boosts discovery as market sentiment emerges. 

A plethora of contracts span reference assets. Index futures give portfolio-level exposure. Equity futures leverage single stocks. Commodity futures cover metals, energy and agriculture. Even weather is tradable through typhoon futures.  Standardization achieves scale. Contract sizes, tick sizes and expirations match buyer and seller needs across borders. Cash settlement eases delivery hurdles. Margin requirements balance leverage and stability.

As risks intensify globally, futures importance grows. Whether hedging through corn contracts or speculating on index direction, they empower users to face uncertainty with confidence. By future-proofing investment decisions against unpredictability, these tools unlock resilience for businesses and progress for economies.

What exactly is a future contract?

A futures contract is a standardised agreement to buy or sell a specified asset at a predetermined price on a set future date. Futures contracts allow producers, consumers, and investors to lock in a price today for delivery of the asset at a future date, which helps them manage price risk.

Both parties to the futures contract are obligated to fulfil the terms regardless of how the asset’s market price changes in the interim before delivery or settlement. The contract size specifies the quantity and quality of the underlying asset being traded. For example, one crude oil futures contract on the NYMEX is for 1,000 barrels of crude oil. 

What is the origin of future contracts?

The origin of futures contracts are traced back to the 17th century in Japan. At that time, Japan was ruled by the Tokugawa Shogunate and had a feudal economic system. The main commodity traded was rice, which was used to pay samurai warriors as well as taxes. After a series of poor harvests in the late 1600s, samurai found it difficult to get stable value for their rice payments, as rice prices fluctuated wildly. To address this problem, the Dōjima Rice Exchange was established in 1697 in Osaka as the first organised futures market.

On the Dōjima Rice Exchange, contracts were made for future delivery of rice at a specified price. This allowed samurai and merchants to lock in a future value for their rice, removing price uncertainty. The Dōjima Exchange is considered by historians to be the world’s first futures exchange. It introduced important innovations like futures contracts, trading pits, inspectors to ensure contract performance and settlement procedures. Over the next century, the Exchange grew substantially in trading volume and organised structure.

Futures trading evolved considerably from its origins in Japan. In the 1800s, the rise of industrialization led to increased trading of commodities in Europe and the United States. However, producers and purchasers still faced substantial price uncertainty, as commodity prices fluctuate depending on harvests, weather and transportation costs. 

To address these price fluctuations, exchanges began offering standardised futures contracts on various commodities. One of the pioneering markets was the Chicago Board of Trade (CBOT), which listed the first modern futures contracts in 1864. These contracts were on grain trading and were called futures when they allowed buyers and sellers to trade in advance of the planned delivery date. The CBOT and other exchanges required contracts to have standardised qualities and delivery procedures. This brought order, transparency and liquidity to futures trading.

Within a few decades of their introduction, commodity futures expanded beyond grains to contracts on cotton, sugar, tobacco, rice, coffee and other agricultural goods in trading hubs like London, New York and Bombay. In India, cotton futures were traded in Bombay starting in 1875, followed by futures on edible oils, raw jute and bullion. The market matured quickly, with about two-thirds of all futures trading focused on wheat by the 1930s.

A major development came in 1972 with the creation of financial futures. The Chicago Mercantile Exchange (CME) introduced currency futures, allowing speculators to bet on fluctuations in global currencies. In the decades since then, exchanges have introduced futures contracts on interest rates, stock market indexes and other financial instruments. Financial futures now account for over half of all futures trading activity.

In recent decades, futures trading has exploded in volume and introduced new products at a rapid pace. In the 1980s, stock index futures were introduced, allowing speculation on entire stock markets. In the 1990s and 2000s, derivatives based on interest rates, energy prices and other underlying assets were created. The 21st century also saw crypto currency futures introduced by CME and other exchanges.

In India, futures trading took off after reforms in the 1990s allowed re-opening and growth of commodity derivatives markets. Important commodity futures introduced in India included pepper, cotton, castor seed and potato futures. However, trading volumes remained thin until 2000, when futures on the Nifty 50 index were introduced by the National Stock Exchange (NSE). Index futures saw immediate success, with the Nifty 50 now the most actively traded index futures contract in the world.

The NSE subsequently introduced futures on stocks, interest rates, currencies and other financial instruments. On the commodity side, the Multi-Commodity Exchange (MCX) and National Commodity Derivatives Exchange (NCDEX) launched futures on metals, energy and agricultural commodities. In the 21st century, Indian exchanges have consistently been ranked among the top futures exchanges globally in terms of number of contracts traded.

Regulation of the Indian futures market occurs through the Securities and Exchange Board of India (SEBI), which took over regulation from the Forward Markets Commission in 2015. SEBI enforces rules and regulations for participant eligibility, market monitoring, settlement procedures, contract quality standards and more. Its oversight aims to keep the market transparent and prevent manipulation.

What are the purposes of future contracts?

Futures serve vital purposes like price discovery, leverage, risk mitigation, speculation, arbitrage and diversification, as explored through the lens of their economic and financial utility. 

  • Price Discovery

One of the primary functions of futures markets is price discovery – the process of determining the price level for an asset through supply and demand. Futures trading generates price transparency and provides valuable information about the expected future spot price of the underlying commodity, currency, bonds etc. The futures price represents the market consensus on the value of the asset at the specified future delivery date. This “forward pricing” helps producers, consumers, and other market participants make informed plans and budgeting decisions.

  • Leverage 

Futures contracts are highly leveraged instruments that enable traders to outsize market exposure with less capital outlay. Leverage allows taking a large position using little initial margin. For example, in commodities futures, the initial margin is 5-15% of the full contract value. This frees up capital for other investments. Leverage provides opportunity for greater profits but also increases risk of magnified losses if the trade moves against you. Appropriate risk management is vital when using leverage.

  • Risk Mitigation

Hedging price risk is the fundamental economic purpose of futures markets. Futures contracts allow producers, consumers, and investors to lock in prices today for delivery or settlement at a future date. This protects against adverse price movements and provides stability. For example, a farmer sells crop futures to guarantee a selling price and revenue at harvest. An airline hedges jet fuel costs by buying oil futures to cap fuel expenses. Risk mitigation with futures is vital for business planning and stability. 

  • Speculation

Futures contracts enable speculators to bet on the future direction of the underlying asset for profit. Speculators provide liquidity to futures markets and accept price risk that hedgers are looking to offload. Their participation is critical for healthy markets. Speculation with futures produces sizable profits but also exposes speculators to potentially unlimited losses. Therefore prudent risk management, capital allocation and trading discipline are essential for successful speculation.

  • Arbitrage 

Futures are used to profit from arbitrage – exploiting price discrepancies between markets. For example, arbitrageurs simultaneously buy and sell identical futures contracts on two exchanges if there’s a temporary price deviation. This helps enforce the law of one price between markets. Arbitrage opportunities in futures typically exist briefly and require fast execution. Utilising futures for arbitrage promotes efficient price discovery.

  • Portfolio Diversification

Futures provide an avenue for diversification as their prices generally have low correlation with traditional assets like stocks and bonds. Adding even a small futures allocation enhances returns and reduces overall portfolio volatility and drawdowns. Commodity futures in particular tend to perform well when financial assets decline, providing a hedge. Diversification with futures allows creating a more balanced, higher performing portfolio.

Futures markets have evolved to meet these economic and financial functions which underpin their utility. The foundational purpose of futures contracts remains unchanged – to manage risk and discover fair value through voluntary exchange. 

How pricing is determined in future contracts?

Pricing is determined in futures contracts through the interaction of buyers and sellers in an exchange’s centralised marketplace. Like other tradable assets, futures prices are driven by supply and demand dynamics. There are nine key factors that influence the value of futures contracts.

The spot or cash price of the underlying commodity, currency, bonds etc. serves as the baseline for futures pricing. Since the futures contract derives its value from the underlying asset, its price needs to properly reflect the underlying spot market value. An arbitrage opportunity arises, if the futures price deviates too much from the spot.

Carrying costs are important in pricing futures. Owning the physical underlying asset entails storage, insurance, financing, and opportunity costs. The futures price needs to account for these carrying costs relative to the spot price for the delivery period. For example, commodities that are expensive to store will have higher carrying charges baked into the futures pricing.

Interest rates play a role in futures valuation, as money is earned on the underlying asset’s value over the life of the contract. Higher interest rates increase carry costs and push futures prices higher. This interest rate component is most relevant in financial futures like bonds and currencies.

Time to expiration is a key variable. Futures prices tend to converge toward the spot price as expiry approaches. Far dated futures will generally trade at a higher premium to spot versus near dated contracts. The former carries more time value.

Expected supply and demand is crucial. Suppose the market expects tightening supply for an underlying commodity like oil, its futures will rise in anticipation of higher spot prices at expiration. Changing demand expectations also impact pricing. 

Volatility of the underlying influences futures pricing, as greater volatility raises uncertainty around the spot price at expiry. Higher volatility commands more compensation and boosts futures values.

Futures exchanges play an important role in price discovery. Their centralised marketplaces and transparency allow valuable price information to emerge through bidding and asking activity. The futures price signals market expectations of the asset’s future spot value. This forward pricing helps producers, consumers and other stakeholders make informed business decisions.

Speculators are critical to futures price discovery, as they accept the risk that hedgers aim to offload. Their capital and trading activity greatly enhances market liquidity and robust price formation. Speculators aim to capture profits by anticipating moves in the futures before they occur.

Arbitrage also influences futures pricing. Arbitrageurs will trade to capture risk-free profit until the futures price returns to equilibrium, if a contract’s price deviates from fair value relative to the underlying spot price. Arbitrage trading promotes efficient futures valuation.

How settlements happen in future contracts?

Settlement is the process by which the obligations of the futures contract are fulfilled when it expires. There are two main ways that settlements occur in futures contracts – physical delivery or cash settlement.

With physical delivery settlement, the actual underlying asset specified in the futures contract is delivered by the seller to the buyer when the contract expires. For example, with a futures contract for wheat, the farmer who is short the contract would be obligated to deliver the specified amount of wheat to the buyer who is long the contract on the expiration date. 

The delivery process begins a few days prior to the expiration date when the short position holder provides intent to deliver the commodity to the buyer. On the expiration date, the long position holder is required to pay the price stated in the futures contract in exchange for delivery of the asset. With commodities, the short position holder typically delivers a warehouse receipt that gives the long position holder title to the commodity stored at a licensed warehouse. 

Physical delivery settlement occurs predominantly with commodities futures like agriculture (wheat, corn, soybeans), metals (gold, silver), and energy (crude oil). It gives commercial users of the commodities a way to secure supply for their business needs. However, physical delivery is less common for financial futures like stock indexes and interest rates.

With cash settlement, the buyer and seller settle the futures contract in cash based on the market price of the underlying asset at expiration, rather than through physical delivery of the asset. The difference between the expiration price and the original contract price is exchanged between the long and short positions.

For example, the long position holder would receive Rs.100 from the short position holder to settle the contract, if an S&P 500 futures contract is trading at Rs.3,000 when it expires and the original contract price was Rs.2,900. This reflects the Rs.100 gain in value of the underlying S&P 500 index. The short would receive money from the long to settle, if the contract expired below the original Rs.2,900 price.

Cash settlement provides an efficient way to realise gains and losses without requiring physical delivery. It is more convenient for financial assets like stocks, bonds, currencies and financial indexes that are impractical to physically deliver. Cash settlement also removes the complications involved with storage, shipping, and legal transfer of ownership of a physical asset.

Most major futures exchanges now utilise cash settlement for their major contracts, including the CME Group and ICE exchanges. The NYMEX division of CME still relies primarily on physical delivery for its energy contracts however.

The prices used for final settlement of futures contracts are determined systematically by the exchange on which they are traded. On expiration day, futures contracts are settled based on prices of the underlying asset to prevent manipulation. Financial futures settle to opening prices or special auctions on the expiration day. Commodity futures settle to industry surveys of cash market prices or exchange-set indexes tracking spot prices. Exchanges monitor settlement days and intervene to adjust settlement prices if necessary to reflect true market value. Robust settlement procedures like these ensure futures prices remain aligned with fundamentals.

Where future contracts are traded?

In India, future contracts are primarily traded on two derivative exchanges – the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). 

The National Stock Exchange launched the first derivative exchange in India in June 2000 called the NSE Derivative Exchange or NDEX. It started by launching futures on the Nifty 50 index and later introduced options as well. Over the years, it has expanded to offer futures and options on stock indices, individual stocks, interest rates and currencies. NDEX allows trading in futures contracts on equity indices like Nifty 50, Bank Nifty, Fin Nifty etc. It also provides futures on individual stocks of around 100 large cap companies. For commodities, it offers futures trading in bullion (gold and silver) and energy contracts (crude oil and natural gas). In the currency derivatives segment, futures contracts on USD-INR, EUR-INR, GBP-INR and JPY-INR are available. NDEX is the largest derivative exchange in India with more than 99% of the total turnover coming from its platform.

The Bombay Stock Exchange established the BSE Derivative Market or BDEX in June 2000. It was the first stock exchange to launch derivatives in the equity market before NSE. BDEX offers trading in index and stock futures as well as index & stock options. The main index futures available are on Sensex, mini Sensex, BSE 100, BSE Midcap, BSE Smallcap. Individual stock futures are offered on around 100 stocks similar to NDEX. Options contracts are provided on Sensex, BSE 100 as well as 50 individual stocks. Apart from equities, BDEX also provides interest rate futures on 10-year government bonds. However, the turnover on BDEX is miniscule compared to NDEX with less than 1% of total derivative volume in India. 

Apart from NSE and BSE, there are few other Indian exchanges that offer trading in derivatives. India International Exchange or India INX is the leading bourse for currency derivatives based in GIFT City, Gujarat. It offers futures and options on currency pairs including EUR-USD, GBP-USD, USD-JPY etc. Metropolitan Stock Exchange introduced equity derivatives in 2018 but has failed to gain traction. NSE remains the undisputed leader controlling the lion’s share of the Indian derivative market.

What are the types of future contracts?

The major types of futures contracts traded on exchanges include index futures that track market benchmarks, currency futures to hedge foreign exchange risk, equity futures to speculate on shares of individual companies, interest rate futures used by debt issuers and investors to lock in rates, commodity futures for agricultural products, metals, energy sources like crude oil and natural gas, livestock, as well as more specialised contracts like weather futures. 

1. Index futures

Index futures are hugely popular for trading in the Indian stock markets. Key index futures include Nifty 50, Sensex, Bank Nifty and Nifty IT futures tracking the benchmark indexes. They provide exposure to the broader market without needing to buy individual stocks. Prices of index futures depend on the expected value of the underlying index on expiration. In India, index futures are widely used to hedge against market risk and rebalance portfolios ahead of major events. Intraday traders exploit their liquidity and leverage for speculative trading on index volatility.

The availability of index futures on sectoral indexes allows precise hedging and speculation. Index futures are a critical tool for investors in Indian markets to manage risk, enhance returns, and capitalize on index movements. The liquidity of these futures and their span across key stock market indexes make them pivotal for equity trading strategies. By focusing on stock market index futures, investors can effectively implement sophisticated strategies to navigate market volatility.

2. Currency futures

Currency futures are crucial trading instruments in the Indian stock markets. Key currency futures traded include USD/INR, EUR/INR and GBP/INR tracking the rupee’s exchange rate with major global currencies. Currency futures enable investors to hedge foreign exchange risk and speculate on rupee movements. Their prices depend on expectations of the rupee’s future value against currencies on contract expiration. In India, importers/exporters use currency futures to mitigate exchange rate risk. Portfolio investors use them to hedge foreign asset holdings. Intraday traders exploit their volatility for speculative gains. The availability of currency futures across major currency pairs allows diversified trading and hedging against currency fluctuations. Currency futures are thus an indispensable tool for Indian stock market participants to manage foreign exchange exposure and leverage currency volatility.

3. Equity futures

Equity futures are contracts that derive value from the future price of individual stocks. In India, equity futures are available on stocks of major companies like Reliance, Infosys, HDFC Bank etc. They allow traders to speculate on or hedge against future stock price movements. Equity futures prices depend on the expected spot price of the underlying stock on expiration. In the Indian market, traders use equity futures to benefit from short-term price movements in stocks without owning them. Investors use them to hedge positions in single stocks without selling. The availability of equity futures across major Indian stocks makes them important tools for gaining exposure to individual stocks, managing risk, and exploiting their price volatility. Equity futures are thus integral for equity trading strategies focused on Indian stocks requiring effective leverage and hedging capabilities.

4. Interest rate futures

Interest rate futures are contracts that derive value from the future price of interest-bearing securities. In India, key interest rate futures are based on 10-year G-Sec yields and the 91-day T-bill rate. They allow investors to hedge interest rate risk or speculate on rate moves. Prices depend on expectations of the future direction of interest rates. In the Indian markets, banks use bond futures to hedge rate risk in fixed income portfolios. Investors use them to protect against rate moves impacting bond prices. Intraday traders exploit their volatility for speculative gains. The availability of rate futures linked to benchmark government securities makes them indispensable for fixed income strategies in India requiring effective leverage and hedging capabilities against interest rate fluctuations.

5. Commodity futures

Commodity futures are contracts that derive value from the future price of commodities. In India, key commodity futures cover agriculture, energy, metals and more. Agricultural futures like chana, soybean and cotton allow hedging price risk. Energy futures like crude oil and natural gas allow managing exposure. Metal futures like gold, silver and copper provide leverage. Commodity futures prices depend on expected spot prices at expiration. In India, commodity futures aid producers/consumers in hedging volatile commodity prices. Investors use them to diversify portfolios. Speculators exploit their volatility for gains. The wide range of commodity futures available in Indian markets makes them essential for commodity trading strategies requiring effective leverage and price risk management.

6. Agriculture futures

Agricultural commodity futures are vital trading instruments in Indian markets. Key agricultural futures cover chana, soybean, mustard seed, guar seed, cotton, cardamom and more. They allow farmers, producers and consumers to hedge price volatility in agricultural commodities. Their prices depend on factors like crop yields, weather, export demand and inventory levels. In India, agri futures aid farmers in securing stable income despite commodity price fluctuations. Agribusinesses use them to manage input costs. Investors exploit their volatility for gains. The availability of agricultural futures across diverse crops, aligned with India’s agrarian economy, makes them indispensable for price risk management in this sector. Agricultural futures thus empower Indian agriculture sector stakeholders to effectively hedge commodity price risk.

7. Energy futures

Energy commodity futures are critical trading instruments in Indian markets. Key energy futures cover crude oil, natural gas, electricity and carbon credits. They allow market participants to hedge volatility in energy prices. Prices depend on global demand-supply dynamics, geopolitical events, costs of production/transportation and inventory levels. In India, energy companies use futures to hedge input price risk. Businesses use them to manage energy cost exposure. Investors exploit their volatility to diversify portfolios. The availability of energy futures aligned with India’s rising energy demand makes them essential for managing price risk and leveraging energy price movements. Energy futures empower Indian market participants to effectively manage exposure to volatile global energy prices.

8. Metal futures

Metal commodity futures are important trading tools in Indian markets. Key metal futures cover gold, silver, copper, zinc, lead, nickel and aluminium. They allow miners, metal producers/consumers to hedge volatile metal prices. Prices depend on global demand-supply dynamics, production costs, economic growth outlooks and geopolitical events. In India, jewellery makers use gold futures to lock input prices. Industrial consumers of base metals use futures to manage exposure to metal costs. Investors use metal futures to diversify portfolios. The availability of futures across precious and base metals makes them vital for leveraging metal price movements and managing price risk. Metal futures thus empower Indian market participants to effectively hedge exposure to fluctuating global metal prices.

9. Finance futures

Financial futures are contracts deriving value from future prices of financial instruments. Key financial futures in India include stock futures, index futures, interest rate futures and currency futures. They allow investors to speculate on or hedge against financial market movements. Prices depend on factors like economic trends, corporate earnings, interest rate policy, currency dynamics etc. In India, financial futures aid investors in leveraging upside potential in markets while managing risks. Banks use interest rate futures to manage rate exposure. Importers/exporters use currency futures to hedge foreign exchange risk. The wide range of financial futures makes them indispensable trading instruments for investors pursuing diverse trading strategies requiring effective risk management and leveraged exposure.

10. Livestock futures

Livestock futures are important agricultural contracts in Indian markets. Key livestock futures cover chana, soybean, guar seeds and mentha oil. They allow farmers, producers and consumers to hedge price risks in livestock feed ingredients. Prices depend on factors like acreage, yields, demand and exports. In India, soybean futures help poultry farmers secure stable input costs. Chana futures aid cattle farmers in managing feed expenses. Guar seed futures allow manufacturers to lock input prices. The availability of livestock futures aligned with India’s large livestock sector makes them vital for managing input price risks. Livestock futures empower Indian market participants across poultry, cattle and related sectors to effectively hedge volatile feed ingredient costs.

11. Weather futures

Weather futures are unconventional yet important instruments in Indian markets. Key weather futures are based on metrics like rainfall, temperature and monsoon winds. They allow stakeholders in weather-sensitive sectors like agriculture, energy and infrastructure to hedge financial risks from adverse weather events. Prices depend on weather projections and historical patterns. In India, rainfall futures help farmers offset drought-related crop losses. Temperature futures allow power companies to hedge demand fluctuations due to extreme heat/cold. The availability of diversified weather futures aligned with India’s large weather-dependent economy makes them vital for managing financial risks arising from variable weather conditions. Weather futures thus empower Indian stakeholders to effectively stabilise incomes against weather vagaries.

The wide range of futures contracts available in the Indian market, spanning indexes, currencies, equities, interest rates, commodities, agriculture, metals, energy, finance, livestock and weather, serve as indispensable risk management and trading instruments for diverse participants across sectors.

Who uses future contracts?

There are two main types of market participants who utilise futures contracts in stock markets – hedgers and speculators. 

Hedgers use futures to reduce risk by locking in prices for assets they already own or plan to own in the future. For example, a wheat farmer is concerned that prices will fall by harvest time in a few months. To hedge this risk, the farmer could sell a wheat futures contract now to lock in a sale price months before the crop is ready.

This guarantees the farmer will get a certain price, even if spot market prices decline later. Another hedger might be a jewellery manufacturer who relies on gold as a raw material. To hedge against the risk of gold prices rising, the manufacturer could buy gold futures to lock in prices today for gold they will need to buy for production in the coming months. Hedging with futures helps reduce price risk for both producers and consumers of commodities.

The most common hedgers in the Indian stock futures market are institutional investors like mutual funds, foreign portfolio investors (FPIs), and insurance companies. These large investors often have substantial holdings in individual stocks. To protect against downside risk, they sell index futures or futures on their underlying stock holdings. For example, they short sell index futures as a hedge, if a mutual fund expects the broader market to decline. This provides downside protection while still allowing them to maintain their cash equity positions. Hedging with stock futures is an essential risk management tool for major institutional investors in Indian markets.

Speculators aim to profit from futures price movements rather than use them to hedge risk. They attempt to anticipate future price direction and buy/sell accordingly, realising profits if the market moves in their favour. Speculators typically close out futures positions before expiration and never take delivery of the underlying asset. 

Certain types of traders act as speculators in Indian futures markets. Active retail traders frequently speculate on stock futures trying to profit from short-term swings. Large trading firms and hedge funds will speculate on index and stock futures to capitalise on expected volatility. Even some hedgers will take on speculative positions in futures markets outside their core business as a way to potentially generate extra income.

Speculation provides vital liquidity to futures markets and enhances price discovery. However, excessive speculation potentially destabilises markets during periods of high volatility. To prevent this, regulators like Securities and Exchange Board of India (SEBI) impose position limits on how many futures contracts a speculator holds at one time. This helps curb excessive speculation while still allowing traders with a higher risk tolerance to participate.

Who regulates future contracts?

The regulation of futures contracts in India’s stock market is overseen by the Securities and Exchange Board of India (SEBI). SEBI is the statutory regulatory body established by the Government of India under the Securities and Exchange Board of India Act, 1992. 

SEBI is responsible for protecting the interests of investors, promoting the development of the securities market, and regulating the securities market. This includes regulating trading in derivatives like futures contracts. SEBI formulates policies, regulations, and guidelines related to derivatives trading in India. It also has the power to inspect, investigate, and audit derivatives brokers, exchanges, and other market intermediaries.

Key regulations imposed by SEBI on futures trading include mandating registration of all market intermediaries, specifying eligibility criteria and disclosure requirements, setting exposure limits and position limits, establishing margin requirements, and overseeing the operations and risk management practices of exchanges and clearing corporations. SEBI requires all futures contracts to be traded on recognized stock exchanges with established clearing corporations to guarantee settlement.

The main futures exchange in India is the National Stock Exchange (NSE), which launched futures trading in 2000. All futures contracts on the NSE must be approved by SEBI. Clearing and settlement is handled by the Indian Clearing Corporation Limited (ICCL). Both NSE and ICCL come under SEBI’s regulatory purview. 

SEBI also regulates participatory notes and foreign institutional investors (FIIs) involved in derivatives trading. It works to detect cases of insider trading and prohibit other unfair trade practices in the futures market. By regulating futures contracts, SEBI aims to protect investors, maintain orderly markets, and prevent excessive speculation. Its oversight is essential for building confidence in the fairness and integrity of India’s stock futures market.

What happens to future contracts after expiry?

Futures contracts have a fixed expiration date, after which the contract ceases to exist. The process for settling and closing out futures positions depends on whether the trader holds a long or short position, and whether they want to settle in cash or take physical delivery of the underlying asset.

For stock index futures, settlement is exclusively in cash with no physical delivery of stocks. On the expiration date, the exchange marks all open futures positions to the market, meaning they are valued at the current market price of the underlying index. Traders with open long positions gain if the market price settles above their original purchase price, while short sellers gain if settlement occurs below the price they initially sold at. The profits or losses are reflected in the trader’s account balance. The futures contracts themselves expire with no further action required.

Settling stock futures is more complex due to physical share delivery being possible. A trader holds a stock futures contract until expiration, they have two choices – settle in cash at market price like index futures, or exercise the contract to receive/deliver actual shares. 

Traders holding long stock futures decide if they want to take delivery of the shares by providing notice to their broker. The long receives shares and pays the agreed contract price. Investors might opt for delivery if they want to acquire the stock as a long-term holding. 

On the short side, the trader is obligated to deliver shares if the long exercises. This is arranged through the short’s broker. To obtain the shares, the short already owns the stock in their portfolio. Otherwise, they will have to borrow or purchase the stock on the open market at current prices. While the short sells at the fixed contract price, they must buy at market rates. Hence, stock futures carry price risk into expiration that index futures do not.

Most traders, whether long or short, close out stock futures before expiry rather than settle delivery. Longs take profits by selling back the contract. Shorts close positions by buying back the same contract. This offsets the original trade, with gains or losses paid in cash to the trader’s account. No shares change hands. 

Closing out early allows traders to capture profits without tying up capital taking delivery. It also avoids the risks and administrative costs of physical settlement. Almost all speculators will exit futures positions before contract expiration. But hedgers sometimes hold contracts into expiry if the goal is acquiring/delivering stock rather than just hedging risk.

In rare cases, physical settlement is not possible on the expiry date. Exchanges declare a futures contract “cash settled” if underlying shares are unavailable due to corporate actions like mergers or splits. Instead of delivery, open positions are marked to market like index futures. This avoids disruption from technical issues preventing share delivery on expiry.

What is an example of a future contract trading?

This is an example of how a futures contract on the NIFTY 50 index could be traded on the National Stock Exchange (NSE) in India.

The NIFTY 50 is a key Indian stock market benchmark tracking the top 50 stocks by market capitalization across major sectors. It is one of the most actively traded index futures contracts. NIFTY futures allow traders to speculate on the overall market direction or hedge their equity portfolios against downturns. 

Futures contracts on the NIFTY 50 index are available for expiry in the current month, as well as the next two calendar months. For example, traders in March could trade March, April and May expiry NIFTY futures. On any given day, the most liquid contract month is typically the nearest expiry one as it attracts the highest trading volumes. 

Now suppose on March 10, a trader expects the NIFTY 50 to decline over the next month due to global growth concerns and rising oil prices putting pressure on the Indian economy. To capitalise on this view, they decide to short sell the March expiry NIFTY futures contract currently trading at 11,500.

The NIFTY futures contract value is fixed at 50 times the index level. So at 11,500, the contract value is 11,500 x 50 = 5,75,000. The minimum tick size or price change is 0.05 index points equal to ₹25 (0.05 x 50). 

The trader sells 1 March expiry futures at 11,500, receiving ₹5,75,000 in their margin account as credit. This creates a short futures position, allowing them to profit if the NIFTY declines. The margin requirement is around 15% i.e. ₹86,250 which gets blocked from the account, with the rest available to the trader. 

Over the next few weeks, mixed global cues kept the NIFTY directionless around 11,500 initially. But by early April, growth concerns escalated, triggering a risk-off sentiment. Strong selling pressure pushes the NIFTY sharply lower by mid-April to 11,000.

With the March futures expiration approaching, the trader decides to close their profitable short position. They buy back the 1 March contract at current market price of 11,000, spending ₹5,50,000 from their margin account. 

Their initial short sale at 11,500, coupled with the cover buyback at 11,000, completes a profitable trade. The trader captures a profit of ₹25,000 on this futures trade (11,500 – 11,000) * 50 = ₹25,000. The blocked margin money gets released back to their account.

Instead of closing early, the trader also had the option to hold the short position into expiry. In that case, on expiry day the March contract would have settled automatically to the spot NIFTY 50 closing level. For example, the March future would also settle at 10,800, if the NIFTY ended at 10,800 on expiry. 

The settlement price gets compared to the trader’s entry price of 11,500 to determine final profit or loss. By settling ₹700 lower at 10,800, the trade profit would have been ₹700 * 50 = ₹35,000 excluding trading costs. But most traders close before expiry to realise gains and avoid additional risks.

This demonstrates how a trader anticipated index declines using NIFTY 50 futures to open a short position, maintaining it for a month as the view played out. Eventually buying back the contract captured profits before expiry. The same process works in reverse for traders expecting the market to rise. 

What are the limitations of future contracts?

Limitations of future contracts include liquidity risk, leverage risks, expirations effects, and vulnerability to gaps and correlation breakdowns.

One of the main drawbacks of futures contracts is liquidity risk. The futures market is much less liquid than the underlying stocks or cash markets, meaning there are fewer traders actively buying and selling contracts. This is especially true further out on the expiration cycle. The front month contracts close to expiration tend to be the most liquid and have the tightest bid-ask spreads. However, the longer-dated contracts have very wide spreads and low trading volume, making it difficult to enter and exit positions without incurring large transaction costs. Illiquid futures markets increase the chances of slippage on order execution. Traders must be aware of the liquidity conditions and adjust position sizing accordingly.

The leverage provided by futures contracts is a double-edged sword. While leverage allows traders to control large dollar amounts with little upfront capital, it also magnifies losses. Futures contracts only require a small percentage of the total contract value to be deposited as initial margin. But losses quickly eat into the margin, triggering margin calls from brokers to restore account equity. Traders get trapped in a negative spiral of meeting margin calls through liquidating deteriorating positions at inopportune times. The leverage and margin requirements make proper risk management essential.

The definitive expiration dates of futures contracts impose additional risks and considerations. As expiration nears, the futures price will converge toward the price of the underlying asset in a process called “basis convergence.” This causes the futures to rise or fall rapidly to match the spot price, creating unexpected volatility. Some traders will close out futures positions prior to expiration to avoid this volatility. Also, expiring contracts must either be closed out or settled in cash or through physical delivery of the underlying asset. Stock index futures are cash settled, but managing physical delivery of commodities adds complexity. Rolling over expiring contracts into newer ones also incurs transaction costs.

There is no upside limit to how high a stock price potentially climbs. But with futures, the maximum gain is limited to the agreed contract price. The buyer of the future only gains up to the agreed-upon amount even if the spot price of the underlying skyrockets above the futures price at expiration. This limited upside makes futures less attractive than stocks for some traders seeking unlimited upside in a rally.

While stock index futures generally closely track the underlying index, there are periods where the correlation breaks down. Unexpected market events or volatility causes the futures to diverge from the underlying benchmark’s moves. This correlation risk undermines some hedging and speculative strategies. For example, a trader might buy S&P 500 futures to hedge a portfolio of large cap U.S. stocks, expecting mirror-image moves. However, the portfolio remains vulnerable to market risk if the correlation decreases.

Gapping refers to futures opening significantly above or below the prior day’s close. This typically happens when new market-moving information emerges overnight after the close. The release of economic data, earnings reports, news events, or changes in monetary policy all cause futures to gap. The problem is the gaps invalidate technical indicators and strategies that rely on continuity from closing to opening prices. Gapping stops positions placed close to the previous day’s settlement or causes slippage on opening orders. While gapping also occurs in stocks, the around-the-clock trading of futures makes them more susceptible.

The standardised contract specifications of futures limit their usefulness for some traders. The contract size, minimum price fluctuation, expiration cycle, and delivery arrangements are fixed by the exchange for each type of contract. This standardisation provides liquidity by encouraging participation. However, the predetermined contract sizes and values mean traders only fine-tune their exposure to a certain extent. Also, the limited number of available expiration months does not align perfectly with a trader’s strategy timeframe or hedging needs.

Are future contracts good for investing?

No, future contracts are generally not the best investment for most individual investors. While futures provide leverage and allow speculating on the direction of stock prices, they come with significant risks. The high leverage of futures means small price moves in the underlying asset leads to huge gains or losses for the investor.

Additionally, futures contracts have an expiration date that most retail investors are not equipped to properly manage. The complexity and risks involved mean futures are better suited for professional traders and institutions hedging portfolios. For most individual stock investors, it is better to invest directly in stocks and equities over the long run rather than speculate with futures contracts unless they thoroughly understand the risks and leverage involved.

How options are related to future contracts?

Options and futures are both derivative contracts that derive their value from an underlying asset, often a stock, commodity, or index. While futures obligate the holder to buy or sell the underlying asset at expiration, options simply give the holder the right, but not the obligation, to buy or sell. Both options and futures are used by investors for speculation or hedging purposes.

Futures are commonly used by producers and consumers looking to lock in prices for commodities they will need to buy or sell in the future. Options allow investors to speculate on the future price movements of stocks with limited downside risk. Options and futures are valued using comparable models that take time value, volatility, and other factors into consideration, but having differing reward structures. Both types of derivatives are frequently used by large institutions and hedge funds to express views on markets or manage risk. Options provide leverage like futures, but with defined and capped risk. 

What is the difference between future contracts vs forward contracts?

The main distinction between futures and forwards is that futures are standardised contracts traded on exchanges with daily mark-to-market cash settlement, while forwards are customised private agreements between two parties that settle at maturity. Futures have lower counterparty risk due to the clearinghouse guarantee and margin requirements, while forwards have higher counterparty risk.

Futures also benefit from higher liquidity than forwards, as the standardised terms facilitate active trading on exchanges. Forwards are relatively illiquid due to the tailored terms involving only the two counterparties directly involved. Futures offer transparency, liquidity, and lower risk through exchange-trading, while forwards provide flexibility and customization as private over-the-counter instruments.

Arjun
Arjun Remesh

Head of Content

Arjun is a seasoned stock market content expert with over 7 years of experience in stock market, technical & fundamental analysis. Since 2020, he has been a key contributor to Strike platform. Arjun is an active stock market investor with his in-depth stock market analysis knowledge. Arjun is also an certified stock market researcher from Indiacharts, mentored by Rohit Srivastava.

Shivam
Shivam Gaba

Reviewer of Content

Shivam is a stock market content expert with CFTe certification. He is been trading from last 8 years in indian stock market. He has a vast knowledge in technical analysis, financial market education, product management, risk assessment, derivatives trading & market Research. He won Zerodha 60-Day Challenge thrice in a row. He is being mentored by Rohit Srivastava, Indiacharts.

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