How to Trade in Futures
How Futures work?
Buy a contract: When you buy shares, you can buy any number you please, even if it is just one share. In Futures, you buy a contract which will have a specific lot size depending on the stock.
Let's say you want to buy an XYZ Futures contract. This will comprise 100 shares. Or, you want to buy a LML Futures contract. This will be a lot of 650 shares.
In Futures, you buy a lot. The lot size is set for each futures contract and it differs from stock to stock.
Margin payment: When you buy a Futures contract, you don't pay the entire value of the contract but just the margin. This margin amount too is prescribed by the exchange.
Let's say you buy a LML Futures contract. And the price of each LML share is Rs 311. This will amount to Rs 2,02,150 (Rs 311 x 650 shares). You don't pay the entire amount of Rs 2,02,150. You only pay 15% to 20% of that amount and this is called the margin amount.
The margin depends on what the exchange sets for the day. Based on certain parameters, it declares the margin for each stock. So the margin for Infosys will vary from, say, LML. Let's say the margin for the LML Futures is 15%. So you end up just paying just Rs 30,322 (not Rs 2,02,150).
How you make or lose money
You purchased a LML Futures contract and the underlying price is Rs 311 per share.
Let's say, the next day it moves to Rs 312. The difference is Rs 1 per share (312 • 311)
You get a credit Rs 650 (Rs 1 per share x 650 shares). The following day, it dips to Rs 310.
The difference is Rs 2 per share (312 • 310). Since the price has dipped, Rs 1,300 (Rs 2 per share x 650 shares) is debited from your account. This will go on till you sell the Futures contract or it expires (last Thursday of the month). So, on a daily basis you make and lose money.
Why Futures are popular?
No Delivery: There is no delivery. When you buy in the cash segment (where investors buy and sell any number of shares and hold them in demat accounts), the shares are delivered to you and sent to your demat account. Over here, there is no delivery so you do not need a demat account.
Lower Brokerage: The brokerage in Futures is much lower. It will be around 0.03% to 0.05% of the transaction. These are the rates given to regular investors. An occasional investor may end up paying up to 0.1% as brokerage. In the cash segment, the brokerage will be around 0.25% to 0.75%.
Margin Payment: When you buy shares in the cash segment, you have to make the entire payment to your broker. Let's say you buy 650 HPCL shares for Rs 311 per share. You end up paying Rs 2,02,150.
Within two days, you will have to make the full payment to your broker. In Futures, you just pay the margin, not the entire amount.
Can effectively short sell: When you sell shares without owning them, it is known as short selling. You would do so if you believe that the price of the stock is going to drop. This way, you sell it at a higher rate and buy it at a lower rate later.
With Futures, you do not have to square your transaction at the end of the day. You can square the transaction whenever you want or wait till it expires on the last Thursday of the month. But, in the cash segment, you have to square your transaction by the end of the day, so you can short sell just for a day.
Where the cash segment scores?
Price differential: It is worth noting that the price of the shares in the cash segment is mostly lower than the Futures price. So, if it is available for Rs 311 in the Futures segment, you should get it for Rs 308 in the cash segment. Though, on occasions it may even be slightly higher.
Tax: In Futures, you pay a tax of 33% on your profit. In equity, it is a flat rate of 10% (short term capital gains) if you sell within a year and no tax if you sell after a year (long term capital gains).
Flexibility in purchases: In the cash segment, you can pick up however many shares you want starting from just one share. In Futures, you cannot buy less than the lot size prescribed. If you want to buy more you can, but they must be in multiples of the lot. So, you can buy one or two contracts.
Risk in Futures is higher: If you are an investor who wants to buy shares and hold on to it, you should invest in the cash segment. Since Futures is a trading tool, the risk is also much higher. Let's say the shares of Infosys are going at Rs 2,700 per share. And, you buy 100 shares in the cash segment. You end up paying Rs 2,70,000.
The price dips to Rs 2,200. If you sell the shares at this rate, you make a loss of 18.5%. Now let's say you purchase an Infosys Futures at the underlying share price being the same. You pay the 20% margin of Rs 54,000. Let's say the price dips to Rs 2,200. You have to pay out Rs 50,000. Since you invested only Rs 54,000, you have incurred a loss of 92.5%.
Hence, your losses can be much higher in Futures.
Where can you trade?
All stocks are not permitted for trading in derivatives. To check the list of stocks available for trading, go onto the National Stock Exchange website. You can also check the Bombay Stock Exchange website to read more about derivatives trading. But do note, to trade in futures, you will have to approach a broker who is authorized to trade in derivatives.
How Commodity Trading Works
The commodity markets have changed a lot from the poky, little hole-in-the-wall trading offices in narrow streets next to crowded markets where traditional dhoti-clad merchants used to trade.
Brand new commodities exchanges---the main ones are NCDEX and MCX---have been set up and these are fully computerized.
More and more stock brokers are setting up commodity brokerages as well, and trading volumes in commodity futures is widely predicted to rival the volume of derivative transactions (futures and options) on the stock exchanges. What's more, you can also trade online.
Why commodities trading?
Well, let's suppose you want to buy gold because you believe that the price of gold will rise. You could then buy gold ingots, store them, wait for them to go up in price, and then sell them at a profit. But, you have to be sure that the gold you buy is pure, you have to find a place to store it, you have to provide the security, transport it to vault and other such hassles. A far better way to invest in gold would be to buy gold futures from the commodities exchange.
How do you do that?
When you buy a Gold Futures contract, you undertake to do three things.
1. Buy the amount of gold specified in the contract.
2. Buy it at the price specified in the contract.
3. Buy it on the expiry of the contract. This could be after one month, two months, three months and so on. Of course, if you sell the Gold Futures contract before it expires, then you don't have to worry about actually buying the gold.
Let's say you buy the Gold Future contract at say Rs 7,200 per 10 gm. Your hunch comes true and the gold prices rally to Rs 8,000 per 10 gm. You can sell the Gold Futures any time before expiry of the contract.
Gold and other commodity futures prices are quoted on the commodity exchanges in exactly the same way in which stock prices or stock futures prices are quoted on a daily basis in the stock markets.
How it Works: Just like stock futures when you buy a Futures, you don't have to pay the entire amount, just a fixed percentage of the cost. This is known as the margin.
Let's say you are buying a Gold Futures contract. The minimum contract size for a gold future is 100 gms. 100 gms of gold may be worth Rs 72,000. The margin for gold set by MCX is 3.5%. So you only end up paying Rs 2,520. The low margin means that you can buy futures representing a large amount of gold by paying only a fraction of the price. So you bought the Gold Futures contract when it was Rs 72,000 per 100 gms.
The next day, the price of gold rose to Rs 73,000 per 100 gms. Rs 1,000 (Rs 73,000 • Rs 72,000) will be credited to your account. The following day, the price dips to Rs 72,500. Rs 500 will get debited from your account (Rs 73,000 - Rs 72,500).
What you need to know: Compared to stocks, trading in commodities is much cheaper, because margins are much lower than in stock futures. Brokerage is low for commodity futures. It ranges from 0.05% to 0.12%. Because of this, commodity futures are a speculator's paradise.
If you are a hard-core trader who follows the technical charts and do not really care what you trade, and if you are nimble and savvy, then commodity futures could be another asset class that you would be interested in.
The advantages in this line is that there are no balance sheets, no complicated financial statements----all you have to do is follow the supply and demand position of the commodities you trade in very closely. Go onto the commodities trading exchange - NCDEX and MCX - to see which commodities are offered for trading, their contract size and other criteria. You will have to get hold of a commodities broker but that should not be a problem. There are lots of brokers that offer commodity trading these days.
But, it would be wise to avoid commodity trading if you are a rookie. A better move would be to initially trade in stock futures before opting for commodity futures.