How Futures Contract is different from stock Investing?

Like we buy stocks in share market, futures contract is another investment vehicle.

Stock performance is based on the performance of its underlying business.

Similarly performance of Futures contract is based on its underlying stock. Means, if stock price of Britannia Industries is moving up, it futures contract will also show a similar trend.

If it is so, then why to invest in Futures Contract instead of direct-stocks?

The reason why people invest in stocks through futures contract is because it helps them to manage investment risk. How?


That is what we will see in this blog post that how futures contract is different from direct stock investing.

But before that, lets understand one very important basic thing about Futures.

We do not buy shares using Futures Contract…

One day, one of my friend asked me; if she should buy shares directly or through Futures Contract.

If you are not prepared for this kind of query, you may end up believing that my friend is a stock market geek.

But reality is, this question itself says how little she knew about the Futures Contract.

Stock investing is very different from Futures investing.

When we buy stocks, we actually get physical delivery of shares. These shares in turn are stored in our Demat Account.

But in case of Futures Contract – nothing is delivered to us.

There is only exchange of money while dealing with Futures. In case of loss, we pay money. In case of profit, we get money.

So to answer the question of my friend, one cannot buy shares using Futures.

Futures Contract

It is better to trade in direct stocks or Futures Contract?

The correct answer is “it depends”.

Shares and Futures are two different way of investing in stock market.

Person investing in direct shares can trade any number of shares. Starting from 1 number to any numbers can be bought from stock market.

But Futures contracts are traded in Lots. One lot of Futures Contract of a company is a collection of many units. For example, 1 Lot of RIL’s Futures Contract consists of 1,000 units of Futures Contract.

Means, if RIL’s Future Contract is trading at Rs.945 per share, 1 Lot of Futures Contract is valued as 1000 x 945 = Rs.945,000. This total value is called Contract Value.

To buy one stock of RIL, only approx Rs.945 will be sufficient.

But to buy 1 Lot of RIL’s Futures, Rs.945 is not sufficient.

It is also true that one does not pay upfront the full value in dealing with Futures Contract. One has to pay only the margin.

The stock exchange decides the ‘Margin for the day’ for each stock which has Futures (not all stocks has Futures Contract).

Suppose, for RIL’s Futures the Margin is say 15% of Contract value. In this case the person has to pay only Rs.141,750 (15% of 1000 x 945 = Rs.945,000 ).

The Lot size and margin percentage is different for different stocks.

How one Makes Money by Futures Contract?

One makes money in Futures Contract on daily basis. How?

We have see how Margin needs to be deposited to buy 1 lot of RIL’s Future Contract..

[Note: For simplicity of understanding lets assume that the validity of Futures Contract is only 6 days. In reality, the validity term can be as long as one quarter or more]

This margin value was Rs.141,750 (example).

Suppose on day 1, the stock price rose by Rs.1. It means your deposit account gets credited by additional Rs.1000 (1000 x 1 = Rs. 1,000).

A/c Balance is (day 1): 141,750 + 1000 = Rs. 142,750

Suppose on day 2, the stock price fell by Rs.3. It means your deposit account gets debited by Rs.3000 (1000 x 3 = Rs. 3,000)

A/c Balance is (day 2): 142,750 – 3000  = Rs.139,750

Suppose on day 3, the stock price fell by Rs.14. It means your deposit account gets debited by Rs.14,000 (1000 x 14 = Rs.14,000)

A/c Balance is (day 3): 139,750 – 14000  = 125,750

Suppose on day 4, the stock price fell by Rs.110. It means your deposit account gets debited by Rs.110,000 (1000 x110 = Rs.110,000)

A/c Balance is (day 4): 125,750 – 110,000 = Rs.15,750)

Suppose on day 5, the stock price fell by another Rs.18. It means your deposit account gets debited by Rs.18,000 (1000 x18 = Rs.18,000)

A/c Balance is (day 5): 15,750 – 18,000 = Rs.-2,250)

As the deposit account goes in negative by Rs.2,250, your broker (HDFC Security, Axis Direct, ICICI Securities etc) will ask you to deposit Rs.2,250 as additional margin amount for the Futures Contract you are holding.

After this, the balance of your deposit account will be zero.

Suppose on day 6, the stock price rose by Rs.210. It means your deposit account gets credited by Rs.210,000 (1000 x 210 = Rs.210,000)

A/c Balance is (day 6): 0 + 210,000 = Rs.210,000

This amount (after deducting for brokerage and taxes etc) will be credited back to your bank account.

Investment (your cost): Rs.141,750

Appreciated Amount: Rs.210,000 – Adjustments = Rs.200,000 (say).

Your gain in 6 days of trading is Rs.58,250 (200,000 – 141,750 = Rs.58,250).

Important: What “1 Lot of a Futures Contract” mean?

Futures Contract - Quote View

Suppose, Today (27-Oct’2017) you have placed a BUY order of Futures Contract of a Company ABC shown in above screenshot.

The details are like this:

  • Instrument Type: Stock Futures (Future Contract of ABC)
  • Expiry Date: 28-Dec-2017 (This contract remains valid for next 2 months approx.)
  • Contract Price: Rs.2,585.85
  • Quantity: 1 Lot (250 nos of stocks of ABC)
  • Current Stock Price: 2,557.57

Other Details

  • Contract Value :Rs.6,46,462.5 (250 x 2,585.85 = 6,46,462.5)
  • Margin: 15% (example)
  • Margin Amount: Rs.96,970 (15% x 6,46,462.5 = 96,970 – this value you have to deposit to your broker)
What does all these numbers tell us…?

By placing a BUY order – for 1 Lot of ABC’s Futures Contract – you have actually agreed to buy 250 units (1Lot) of ABC’s Future Contract on 28’Dec’17.

But what you have placed a BUY order (and not SELL order)?

It is because you are expecting that on 28-DEc’17, the price of Future Contract will be above Rs.2,585.85.

Who told you so?

You have done the STOCK ANALYSIS of ABC stocks’ and you have derived this conclusion from there. You know that the stock price will rise by close to Rs.2,650.

But how this will make you profit?

On 28th-Dec’17, you will buy units of Future Contract @ Rs.2,585.85, and would sell it @ Rs.2,650

Thereby you will make a profit of Rs.16,037 [250 x (2,650 – 2,585.85)]

But who will buy this Future Contract from me?

Like you have placed a BUY order, there will be another trader who has placed a SELL order.

Like you, he has also done his own stock analysis and have come to this conclusion that, instead of ABC stocks going up, it is likely to fall.

The buyers (your) position is always opposite to the sellers (yours counterpart) position.

Who is correct?

Only time will tell (28-Dec’17) 🙂

Futures Contract follows its underlying stock movements

Future Contracts Manages Risk for its investors.

Future contract price moves in tandem with the individual stock price.

If stock price moves up, futures contract price will also move up. If stock price will move down, the futures contract price will also move down.

Imagine it like this, in the world of stock market there are ‘two’ separate mini markets, one is ‘asset market’ and the other is ‘futures market’.

[Asset market: is our normal market from where we generally buy and sell stocks]

As both these markets almost moves in tandem, investors can take advantage of this tandem movement by taking opposite position.

We have seen above what means by opposite position.

Now lets see some examples of Futures Contract.

#1. FIRST EXAMPLE (ABC Stock goes up as expected)

You have 1 Lot of ABC’s Futures Contract (as shown above) on 27-Oct’17.

It means, on 28th-Dec’17, you will buy units of Future Contract @ Rs.2585.85 and would sell it @ Rs.2,650 to a counterparty.

The seller has placed a SELL order to sell 1 Lot of Futures Contract @ Rs.2,585.85 on 28-Dec’17

The buyer (you) has placed a BUY order to buy 1 Lot of Futures Contract @ Rs.2,585.85 on 28-Dec’17

On 28-Dec’17, stock price rose by 3.72%. Hence the Futures Contract price also rose by 3.72%. Now, the Futures Contract is trading at Rs.2,682.04.

Sellers Position:

The seller has to virtually buy the 250 units at market rate of Rs.2,682.04. But he is obliged to sell it at a lower price of Rs.2,585.9 to you (as per Futures Contract). Thereby the seller makes a loss of Rs.24,048.4 (see the below infographic).

Buyers Position:

The buyer (you) buy the 250 units at agreed rate of Rs.2,589.9 and then sells it at a higher market price of Rs.2,682.04. Thereby you as a buyer makes a profit of Rs.24,08.4 (see the below infographic).

Here the sellers loss, is buyers profit.

The brokerage firm in between also makes money in form of brokerage from the buyer and seller.

Futures Contract Example 1.

#2. SECOND EXAMPLE (ABC Stock falls against the expectation)

You have 1 Lot of ABC’s Futures Contract (as shown above) on 27-Oct’17.

Means, on 28th-Dec’17, you will buy units of Future Contract @ Rs.2,585.85 and would sell it @ Rs.2,650 to a counterparty.

The seller has placed a SELL order to sell 1 Lot of Futures Contract @ Rs.2,585.85 on 28-Dec’17

The buyer (you) has placed a BUY order to buy 1 Lot of Futures Contract @ Rs.2,585.85 on 28-Dec’17

On 28-Dec’17, stock price falls by 2.6%. Hence the Futures Contract price also fell by 2.6%. Now, the Futures Contract is trading at Rs.2,518.62.

Sellers Position:

The seller has to virtually buy the 250 units at market rate of Rs.2,518.62. Then, he sell it at an agreed price of Rs.2,585.9 to you (as per Futures Contract). Thereby the seller makes a profit of Rs.16,808 (see the below infographic).

Buyers Position:

The buyer (you) is obliged to buy the 250 units at agreed rate of Rs.2,589.9 and then sells it at a lower market price of Rs.2,518.62. Thereby you as a buyer makes a loss of Rs.16,808 (see the below infographic).

Here again the sellers profit, is buyers loss.

The brokerage firm in between again makes money in form of brokerage from the buyer and seller.

Futures Contract Example 2





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About the Author

Mani

I am a Blogger with a passion for Investment Education. I started blogging in 2007-08. Those where the early years when I went on the family way.

Blogging didn’t happened to me as a coincidence. It was a very conscious decision. I started blogging as a process to build a new hobby and also learn a new skill of personal finance management.

Eventually this hobby transformed into a passion. I love blogging on the topic of money management…know more…

1 Comment on "How Futures Contract is different from stock Investing?"

  1. corporate legacies | October 27, 2017 at 1:08 pm | Reply

    Hi Mani, Really great article for the purpose of future investment.Thanks for the articles.

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