Futures Trading Basics Every Trader Must Know

CA Manish Singh: Hello everyone, and welcome to the 14^th chapter. 
Since we have already learnt so much about trading, technical analysis, indicators and market patterns, the next step is to understand the instruments we actually trade with. In India, the two most popular trading instruments are Futures and Options. 

Before we begin discussing Futures in detail, let us first understand what a futures contract is. 

What This Chapter Covers: 

• What a futures contract means
• How futures evolved from forward contracts
• Why futures are used
• The difference between forwards and futures
• Key components of a futures contract 

Understanding Forward Contracts 

CA Manish Singh: The word “futures” itself suggests something that will happen at a later date. 
So let me start with a simple example. 

Imagine there is a wedding in your family six months from now. You expect that you will need 100 grams of gold for jewellery. Now you know gold prices are uncertain. They may rise or come down. They usually rise, of course. Since you are worried that gold prices may increase before the wedding, you go to a jeweller and tell him: 

“Let me lock the price for 100 grams of gold today. We will collect the jewellery in a few months.” 

Here, you are entering into a contract today for delivery at a future date. This agreement, between just you and the jeweller, is called a forward contract. 

Forward contracts were commonly used historically because they were simple agreements between two parties for a future transaction. 

But the problem was this: 
There was no certainty and a high chance of counterparty default. 

For example, suppose three months later the jeweller says: 
“When you booked it, gold was ₹1 lakh per 100 grams. Now it is ₹10,000 per 10 grams. I cannot sell it to you at the old rate because I will lose ₹10,000.” 

This means the jeweller has defaulted. 
Because forwards are private agreements, default risk was very high. There was no standardisation either. 

This is why the need for a more structured contract arose, and futures contracts began to evolve. 

How Futures Contracts Evolved 

As demand grew and markets matured, futures contracts were introduced to bring structure and certainty. 
Today, futures contracts are traded on exchanges. 

Examples: 

• If you want gold in November, you can lock its price today through a futures contract.
• If you want to buy a stock one month later but do not want to pay the full amount today, you can pay 15 to 20 percent as margin and take a futures position.
• Closer to expiry, you can arrange the remaining money and take delivery if the contract allows it. 

Before the expiry date, you must square off your position, which we will learn in upcoming chapters. 

Futures contracts were introduced because people needed: 

• Standardisation
• Certainty
• A system where counterparty default is prevented 

Long and Short Futures 

In futures, we use two terms often: Long and Short. 

Long Futures: You go long when you expect the price to rise. 
Example: You think gold prices will increase. So you buy a gold futures contract. 
If the price rises, you benefit. 

Short Futures: You short when you expect the price to fall. 
Example: If gold becomes expensive, you expect the stock market to fall. So you short Nifty Futures. If Nifty falls, you benefit. The advantage of futures is that you can also sell something you do not currently own, because the obligation of delivery comes only on the expiry date. Some futures contracts settle through physical delivery (like gold). Others, like Nifty, settle through cash settlement, meaning profit or loss is adjusted in your trading account without physical transfer. 

Forward Contracts vs Futures Contracts 

Key differences: 

1. Trading Venue 

• Forwards: Over-the-counter (OTC), private negotiations
• Futures: Exchange-traded 

2. Customisation 

• Forwards: Fully customisable
• Futures: Fully standardised 
  Example: 
  Gold contracts are standardised at 1 kg. You cannot trade 950 grams. 

3. Default Risk 

• Forwards: Very high
• Futures: Significantly low because exchanges guarantee settlement 

4. Expiry 

• Forwards: Flexible, mutually decided
• Futures: Fixed expiry dates 

5. Settlement 

• Forwards: Physical delivery of the commodity
• Futures: Physical delivery or cash settlement depending on the contract 

Components of a Futures Contract 

The two key components are: 

1. Expiry Date 

The date on which the contract matures. 

2. Lot Size 

The minimum tradable quantity for that contract. 
Examples: 

• Gold: 1 kg
• Nifty Futures: Lot size of 75 

Summary and Takeaways 

• Futures evolved from forward contracts due to high default risk and lack of standardisation.
• Futures are exchange-traded, standardised, and provide much higher certainty.
• Going long means buying a futures contract, going short means selling it.
• Many futures settle in cash, while some settle through physical delivery.
• Futures have defined expiry dates and fixed lot sizes.
• These concepts form the foundation for how we trade futures positions. 

In the next chapter, we will learn how futures margins work, how leverage is calculated, and how futures amplify both profits and losses. 

Disclaimer: Investments in securities markets are subject to market risks. Read all related documents carefully before investing.