All you need to know about futures derivative

Live in the present! This is the very common and overrated advice that always comes from motivational speakers nowadays. The truth is that we can only live in the present, there is no way we can live our life in  the future or past. Our body lives in the present but our mind plays with past memory to create illusion of past and future.

A human body is equipped with a mind which has invented a lot of astonishing things till date and, the stock market is one of them. In the stock market, we trade in shares and debenture of listed companies and invest our hard earned money with the hope of earning a good return in future. Unlike accounting, where we concentrate what happened in past, in stock trading we emphasize on probable future outcomes based on the past events.

What is futures derivative?

Our mind is always hovering around the future and the past. In this blog post, I will let you know all the basic ideas of the future derivative. A derivative is an instrument which derives its value from an underlying asset. It is obvious that underlying asset, in this case, it will be a listed company’s stock.

To simplify the things, let’s look at your mind. Suppose, John, your best friend and, suddenly stopped his car on his way to a zero percent interest on EMI store, and told you that he may not go to his office tomorrow, and then he leaves without uttering a single word. Now, your mind will start thinking about the probable reasons for John’s statement. You see your mind already started to hover around the uncertainties attached to the statement, and you will also think about the probability of John’s absence on tomorrow.

Here, the underlying asset is John’s statement, and all the thoughts that popped up in your head due to this statement are derivative. Some of them are futures and some of them are options.

Now, you understood the future derivative. Certainly, it is the thoughts of tomorrow in your mind caused by John’s statement. Stories are over. now, I am going to tell you all the technical terms which you need to know to understand the future market better. In this post, I will cover concepts like taking the short-long position, initial margin, maintenance margin, market-to-market settlement, arbitrage possibilities and computation of fair future price.

Long-Short Position:

There are two positions that you can take in derivative market namely short position and long position. Let’s understand what I mean by taking a position. In the share market, you either buy a share or sell a share. In the same way, when you choose to buy a  future in the derivative market by entering into a future contract with your broker, it is termed as long position. Again, if you decide to sell a future, then it will be called that you took a short position. You should note that when you enter into a position in the derivative market, you do not actually buy or sell shares or derivatives. Instead, you just take a position in respect of the derivative.

Initial Margin:

The fun part of playing in the future is that you do not need to pay a dime to take a position. You just need to call your dealer to tell him your position in a future contract of a listed share. The broker will ask you to deposit a certain sum of money which is not your cost but just a deposit with the broker. This deposit is known as initial margin. Suppose you choose to take a position in a futures derivative. Your broker will ask you to deposit a sum, for example, INR 10,000, which is your initial margin.

Marked-to-market settlement:

This concept can easily be understood with the help of the above example. Suppose, you entered into a future when the price of the contract is INR 1200. Now, at the end of the day, the future price stood at INR 1190. Your broker will deduct INR 10  from your initial margin kept with him. In the next day, suppose market closes at INR 1310, your broker will add INR 120 to your balance which will be INR 10,120.

Maintainance Margin:

Suppose, You entered into a futures derivative contract worth INR 1,00,000. within two days you booked loss amounting INR 16,000. Do you think you broker will pay the extra INR 6,000 out of his own pocket? You know that is never going to happen. Actually, such situation will never come when your loss falls below your initial margin because your broker will call you to refill your initial margin as soon as your loss touches a pre-determined level of your initial margin amount.

Computation of fair futures price:

If you open Moneycontrol, you will find futures price of listed securities, but these prices are the actual future price. You need to know the fair future price to determine your position. The fair future price is calculated by multiplying the current market price of the security with the risk-free interest rate for the duration of the future.

If the fair future price is higher than the actual future price, then you will take a long position because the future derivative is undervalued. On the contrary, when the fair future price is lower than actual future price, you should take a short position because the future is overvalued.

Expiry of a futures derivative contract:

On the expiration date, the future contract expires because on that date there is no future exists. It becomes present. as per the convergence theory, future price and spot price becomes same on the expiration date. You can square off your position before expiry for booking profit or to avoid further loss. On expiry date, all future contract position get squared off.

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About KOUSHIK DAS

I am Koushik Das, and I live in Kolkata, India. I am a passionate personal finance blogger at iplancash.com
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