Benefits of Futures Trading You Can’t Ignore
Among all the trading strategies used in the stock market, purchasing futures contracts is an effective way to reap potential gains. Moreover, once understood, it is a simple method allowing even new investors to use it easily. Read on to learn the benefits of futures trading.
What Is Futures Trading?
A future contract is an agreement or understanding between two parties to manage an exchange at a predetermined price at some point in the future. It is basically a wagered on the possibilities of a stock. Two parties take opposite positions, with one consenting to purchase shares and the other consenting to sell them at a specific price in future, regardless of the current market price.
Futures trading is a method in which traders buy and sell assets using futures contracts. They are financial agreements between two individuals, the buyer and the seller, who decide to trade the asset at a specific price on a fixed date in future.
You can purchase futures contracts of various financial instruments, like stocks, commodities, currencies or market indices. These agreements are derivative, and thus their value is determined by the underlying asset’s price.
Individuals who use this trading method generally aim to profit from the fluctuating values of the underlying asset. They usually follow the policy of “buy low and sell high” and use futures contracts to sell off the asset when they spot an opportunity for profit.
Generally, there are two types of investors who engage in futures trading. They are as follows:
- Speculators: Speculators are private investors or traders who use futures trading to generate profits.
- Hedgers: Entities like banks, commodity producers, organisations, financial institutes etc., use futures contracts to protect their businesses or current investments from the effects of price fluctuation and are known as hedgers.
What Are the Benefits of Futures Trading?
The benefits of trading using futures contracts are as follows:
Diversifying Your Portfolio
One of the most significant benefits of using futures contracts is adding a wide array of assets to your portfolio. Several asset classes, like stocks, commodities, etc., are dealt with in the futures market, enabling you to diversify your portfolio and manage risks.
The futures market is highly liquid because there is a high number of future trades taking place every day, allowing you to sell off your investments easily.
You don’t have to pay the full price of stock futures to buy or sell futures. Only a fraction of the amount needs to be paid, which is called margin. This differentiates futures from purely cash market trading.
Low Trading Costs
Another significant benefit of trading in futures is their low trading costs. The Securities Transaction Tax (STT) and commission rates are much lower than other trading activities. Thus, you can reap more profits by using this method.
Hedge Against Risks
Using future contracts is a great way to hedge against risks. Hedging is buying or selling futures contracts as protection against the risk of loss due to market fluctuations. For example, if you believe that the price of a specific security will rise in value in the future, you can take a long position in your futures contract.
On the other hand, if you plan to go short on a specific stock because you expect an imminent fall in price, you may take a short position on your contract.
No Risk of Defaulting
When you use futures contracts, there is absolutely no risk of liquidity because when you agree with another individual on the Futures & Options (F&O) exchange, the clearing corporation provides a counter-guarantee. It ensures that even if one of the parties involved couldn’t make the payment, the exchange would take care of the loss.
Opting for futures contracts is a great way to enter the world of leveraged trading. You only need the necessary capital, a computer, an internet connection and a reliable broker.
How Is Futures Trading Different from Options Trading?
Let’s take an example for a clearer understanding.
Suppose the shares of Company ABC are currently trading at ₹2,000. Now, you predict a price rise in the future and decide to take advantage of the opportunity to gain profits. So, you buy a futures contract with a strike price of ₹2,000 for all 10,000 shares. (Remember future contracts can be bought in terms of lots.)
Now, if the share prices appreciate to ₹2,600, you can execute your contract, buy the shares at ₹2000 each and then sell them at the new price to gain a profit of (₹2,600 – ₹2,000) * 10,000, amounting to ₹60,00,000.
However, if there is a loss of value and the price falls to ₹1,500, you will have to incur the losses as you are obligated to execute the contract and buy shares at ₹2000. Moreover, it is to be noted that in futures, profits and losses are market to market.
Things to Keep in Mind Before Investing in Futures Contracts
Here are a few things you should consider before taking part in futures trading:
- Assess your risk appetite
- Consider practising this strategy in a simulated trading account
- Open a trading account with your preferred brokerage firm
- Deposit the margin funds. However, if the margin money goes up during the period that you hold your contract, you will have to pay additional margin funds.
Many new investors prefer using futures just because of their ease of execution. However, as with any investment method, it also has its share of risks that you must assess. In addition, you must conduct a thorough market analysis before taking any decision.
Frequently Asked Questions (FAQs)
Can I trade using futures throughout the day?
In India, you can trade using equity futures during the regular exchange hours, i.e., from 9:15 a.m. to 3:30 p.m. However, it would help if you kept in mind that there is a separate opening and closing time for each commodity segment, in case of commodity futures. Even trading forex futures have different hours.
Can I exit a futures contract before the expiry date?
Yes, you can exit your futures contracts before the date of expiry. The profits or losses are adjusted against your deposited margins until you decide to exit.
What happens when a futures contract expires?
As the futures contract expires, the position gets automatically squared off. You are obligated to exercise your contract; hence, the profits or losses that you have incurred get adjusted with your trading account.