Introduction to Futures Trading

Futures trading is basically an agreement to buy or sell an asset at a future date for a price decided today. It is a type of derivative, meaning its value comes from an underlying asset like stocks, commodities, or even currencies. For instance, if an investor thinks that the price of a commodity will increase in 3 months, then he/she can enter into a futures contract to buy the commodity, three months from at a price fixed today.

Futures Contract

A futures contract specifies the quantity of the asset, the price at which it will be bought or sold, and the delivery date. Let us say, an oil futures contract might specify the delivery of 1,000 barrels of oil at ₹5,000 per barrel, three months from now. The unique thing is, both parties have to stick to the terms of the contract at the specified date, unlike options, where the buyer has the right but no obligation to execute the contract.

Market Conditions and Future Prices

Market conditions are crucial factors in the determination of the future prices. If the market is bullish, futures prices for assets like stocks or commodities might be higher than their current spot prices. Conversely, in a bearish market, futures prices might be lower. For example, during the 2008 financial crisis, crude oil futures prices dropped from around $145 per barrel to just over $30, showing fears of a global recession.

Let us further discuss the interdependence of market conditions and future price with a more basic and easier to understand example.

Imagine a farmer growing wheat in India. He can use futures contracts to lock in a price for his crop, protecting against the risk of falling prices at harvest time. Let us say, if wheat is currently priced at ₹2,000 per quintal and the farmer expects the price to drop, he can enter a futures contract to sell wheat at ₹2,000 per quintal in three months. This way, he ensures he receives the agreed price regardless of market fluctuations.

Things to Keep in Mind While Entering Future Contracts

• Derivatives such as Futures & Options are mainly for the purpose of hedging.
• Derivatives can be risky if they are used for the purpose of speculation.
• Studies show that around 90% of retail traders in India lose money in futures and options trading. For example, in FY22, the average loss per trader was close to ₹50,000.
• The high leverage in futures trading amplifies both gains and losses.
• One small adverse movement in the underlying asset can wipe out a trader’s entire margin.

Let us Understand These Risks with an Example

Let us say you decide to trade Nifty futures. Let us further assume that the current Nifty index is at 15,000. You think it will go up, so you enter a futures contract. The contract size is 75 units of the Nifty index, and the margin requirement is 10%, so you need to put up ₹1,12,500 (15,000 * 75 * 10%).

Now, if the Nifty goes up to 15,500, you make a profit. Your profit would be (15,500 – 15,000) * 75, which is ₹37,500. That’s a 33.3% return on your margin.

But if the Nifty drops to 14,500, you lose the same amount, ₹37,500, which is a 33.3% loss on your margin.

If Nifty goes down by mere 7%, the trader loses their entire margin. That is why leverage is risky, especially for retail traders who might not have the deep pockets or risk management strategies to handle such volatility.

Proposed SEBI Regulations on Options Trading

• SEBI has increased the minimum contract size for equity derivatives to ₹5 lakh to ensure that only serious investors participate.
• The Working Committee of SEBI on Futures and Options has recommended increasing the minimum lot size of derivative contracts to Rs 20 lakh-Rs 30 lakh from Rs 5 lakh presently,
• The Working Committee of SEBI on Futures and Options has further recommended even restricting weekly options to only one expiry per stock exchange per week.
• They’ve implemented peak margin rules with the intent to limit excessive speculation.
• SEBI has also mandated brokers to disclose the percentage of profitable clients in derivatives trading, promoting transparency and helping retail investors make informed decisions.

Securities Transaction Tax (STT) on Futures

The Union Budget for 2024-25 increased the STT on futures from 0.0125% to 0.02% of the contract value. For example, if a trader sells Nifty futures at ₹24,500, the STT rises from ₹77 to ₹123 per contract.

Way Forward

Given the challenges that are discussed above, in order to address them, both regulators and exchanges have launched educational initiatives. NSE and BSE have programs to educate retail investors about the risks and complexities of futures trading. Regulatory efforts will likely focus on enhancing financial literacy and possibly introducing stricter eligibility criteria for retail traders. Futures trading is a powerful tool, but it is essential to approach it with knowledge, understanding and caution.