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Future and Options Basics Explained : A Beginners Guide

Below Information about Futures will clarify your all doubts about trading in this instrument and do take time to read the same as an informed investor is able to take better and Judicious decisions.

What are "derivatives"?
A derivative is a financial instrument, which derives its value from some other financial price. This "other financial price" is called the underlying. In the case of Nifty futures, Nifty index is the underlying.

What is a futures contract?
A futures contract is a contract to buy/sell, on an organised exchange, a standard quantity of a specific financial instrument at a future date at a price agreed between two parties. At present futures on S&P CNX Nifty and 31 stocks are available for trading on the National Stock Exchange and Bombay Stock Exchange.

What is the difference between a futures and a forward contract?
Forwards are contracts to buy or sell an asset at a certain future time for a certain price. Usually there is no standardized quantity; no standardized time period; not normally traded on an exchange and is between two institutions or an institution and a corporate client. On the other hand, Futures contracts have standardized quantity, a standardized expiry period, exchange traded and anonymity of the counter party and usually fully covered from the counter party risk.

How do futures trade?
In the cash market, the issuers issue securities, and investors trade in those securities. However, with futures, there is no issuer company, and hence, there is no fixed issue size. Buyers and sellers determine the quantity of future contracts available in the market. A contract (trade) takes place when a buy order and sell order matches on the screen.

Why should I trade in Futures?
Futures trading will be of interest to those who wish to:
1) Invest/Speculate - take a view on the stock (or market) and buy or sell its (or Nifty) futures accordingly. One can go short with the same ease as taking a long position. In case of index futures the advantage is that instead of investing in a particular stock and thereby taking on the risks associated with the price movements in that stock, one can trade the entire market by buying or selling the index.

2) Leverage - paying only a small percentage of the contracted value as margins one can take a leveraged position whereby his profits are significantly enhanced if his view turns out to be right.

3) Hedge - reduce risks associated with market exposure by taking a counter position in the futures market, i.e. buy stock, sell Nifty futures.

4) Arbitrage - take advantage of the price difference between the futures market and the cash market.

How do I start trading in futures?
Futures can be bought and sold through the trading members of National Stock Exchange and Bombay Stock Exchange on their online trading systems. To open an account with the trading member you will be required to complete the formalities, which includes signing of member - constituent agreement, constituent registration form and a risk disclosure document. The trading member will allot you a unique client identification number.
To begin trading, you must deposit cash or collateral with your trading member as may be stipulated by him.

What happens on the expiry of a contract?
Currently future contracts are cash settled. The final mark-to-market cash flow is calculated from the closing price of the underlying asset in the cash market and the client's a/c is credited or debited. No Exchange of shares and money is involved.

Do I need to have the stock if I sell its futures or in case of Nifty do I need to have the securities that comprise Nifty, if I sell futures?
No, in order to buy or sell futures whether Nifty or Individual stocks you need not own any of those securities.

How long should I hold on to a position?
The period up to which you should hold on to a position in Nifty futures would depend on your personal preference and perspective. You may take a short term trading view (a day or hour or even a few minutes), or a medium term trading view (several days to several weeks) or long term trading approach. Once you have taken an open position, you may

1) Exit from the position before contract expiration by taking an equal but opposite futures position (selling if you have bought, buying, if you have sold);
2) Make cash settlement at expiration:

What about the margining in case of futures contracts?
In case of Futures as well as Options contracts a portfolio based margining model (SPAN) is adopted which takes an integrated view of the risk involved in the portfolio of each individual client comprising of his positions in all the derivatives contract traded in the F&O segment. This SPAN (Standard Portfolio Analysis of Risk) developed by Chicago Mercantile Exchange is used in margin computations and risk management in almost all the leading derivatives exchanges. Theoretically speaking the Initial Margin is based on worst-case loss of the portfolio of a client to cover 99% VaR over two days horizon.

What if the position taken by me turns adverse?
The Portfolio will be marked to market on a daily basis. All mark-to-mark losses are collected on a daily basis and similarly all mark-to-mark profits are released for allowing additional exposure on a daily basis.

How can I profit from trading Nifty futures?
If you own a stock portfolio you can protect your portfolio by using futures contract. For example, if you own a portfolio of securities you may sell equivalent value of Nifty futures. Assume the market falls because of which your portfolio suffers a loss. On expiration date of the futures contract, you can close both your positions (cash and futures) and the loss you have made in the cash market will get off-set by the profits made in the futures market.
If you have a view on the market you can take a position in the futures. For example, if you think the market will be going up you may establish a 'long' (buy) position in Nifty futures. Similarly, if you think the market will go down, you may initiate a 'short' (sell) position. This way, the buying / selling of individual securities and the company specific price risks associated with it can be avoided. Futures have a non linear returns, however one must not forget financial and risk management.

What determines the fair price of a futures product?
The pricing of a futures contract depends upon the underlying's price, the cost of carry, and expected dividends. For simplicity, suppose no dividends are expected, Nifty is at 5000 and the one-month interest rate is 1%. Then the fair price of an index futures contract that expires in a month is 5050. The difference between the spot and the futures price is called the basis. When Nifty futures trades at 5050 and the spot Nifty is at 5000, "the basis" is said to be -50 points or -1%.

Hope above questions and answers about F&O will be able to clear your all the doubts about trading in this segment and all those who can trade in this segment, than none on earth can stop them from becoming a multi millionaire. Happy Future ans Options Trading.

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