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Futures Market

An auction market in which participants buy and sell commodity/future contracts for delivery on a specified future date. Trading is carried on through open yelling and hand signals in a trading pit. In finance, a futures contract (more colloquially, futures) is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed upon today (the futures price or strike price) with delivery and payment occurring at a specified future date, the delivery date. The contracts are negotiated at a futures exchange, which acts as an intermediary between the two parties. The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be "short". The terminology reflects the expectations of the partiesthe buyer hopes or expects that the asset price is going to increase, while the seller hopes or expects that it will decrease in near future. In many cases, the underlying asset to a futures contract may not be traditional commodities at all that is, for financial futures the underlying item can be any financial instrument (also including currency, bonds, and stocks); they can be also based on intangible assets or referenced items, such as stock indexes and interest rates. While the futures contract specifies a trade taking place in the future, the purpose of the futures exchange institution is to act as intermediary and minimize the risk of default by either party. Thus the exchange requires both parties to put up an initial amount of cash, the margin. Additionally, since the futures price will generally change daily, the difference in the prior agreed-upon price and the daily futures price is settled daily also (variation margin). The exchange will draw money out of one party's margin account and put it into the other's so that each party has the appropriate daily loss or profit. If the margin account goes below a certain value, then a margin call is made and the account owner must replenish the margin account. This process is known as marking to market. Thus on the delivery date, the amount exchanged is not the specified price on the contract but the spot value (i.e. the original value agreed upon, since any gain or loss has already been previously settled by marking to market). Speculating with FuturesA futures contract represents a zero-sum game between a buyer and a seller. Any gain realized by the buyer is exactly equal to the loss realized by the seller, and vice versa. Futures contracts can be used for speculation or for hedging. Hedgers transfer price risk to speculators, while speculators absorb price risk. Hedging and speculating are complementary activities. Buying futures is often referred to as going long, or establishing a long position . A long position profits from a futures price increase.

Selling futures is often called going short, or establishing a short position . A short position profits from a futures price decrease. A speculator accepts price risk by going long or short to bet on the future direction of prices.

Hedging with FuturesA hedger is a trader who seeks to transfer price risk by taking a futures position opposite to an existing position in the underlying commodity or financial instrument. Suppose a large operating inventory is needed. The sale of futures to offset potential losses from falling prices is called a short hedge . When some commodity is needed in the future, the purchase of futures to offset potential losses from rising prices is called a long hedge . Futures Trading Accounts A futures exchange, like a stock exchange, allows only exchange members to trade on the exchange. Exchange members may be firms or individuals trading for their own accounts, or they may be brokerage firms handling trades for customers. Cash-Futures Arbitrage Earning risk-free profits from an unusual difference between cash and futures prices is called cashfutures arbitrage . In a competitive market, cash-futures arbitrage has very slim profit margins. Cash prices and futures prices are seldom equal. The difference between the cash price and the futures price for a commodity is known as basis . basis = cash price futures price For commodities with storage costsThe cash price is usually less than the futures price, i.e. basis < 0. This is referred to as a carrying-charge market . Sometimes, the cash price is greater than the futures price, i.e. basis > 0. This is referred to as an inverted market . Basis is kept at an economically appropriate level by arbitrage.

IMPORTANCE OF FUTURE MARKET


The 6 reasons why we should consider futures trading as a tool of investment. 1. Leverage Unlike stocks, trading futures does not require us to enter into a contract with a full value. We will only need to deposit a margin, usually between 5% - 10% of the total contract value. In this manner, we are able to trade larger amounts of commodities than compared to purchasing commodities outright. 2. Higher Returns Since we are entering a position of a contract with only a margin, when the market movement is towards our favour, the profit can be of ten-fold of the margin. Due to this unique and great leverage, futures trading offers excellent return in comparison to other investment instruments, though the loss may also be substantial. 3. Being a Paper Investment Futures trading is basically a paper investment. Even though futures trading involves commodities, we will not need to worry about the actual commodities itself, or changing hands of the commodities. This makes it convenient without the concern about the physical commodities and storage. 4. Highly Liquid Trading futures are considered to be very liquid. There are large amounts of contracts traded in the market daily. We can place an order and they can be bought or sold very quickly. There will always be a significant available number of buyers and sellers for futures contracts. 5. Making Returns When Market Moves Both Ways When we're trading futures, we will have the option to go long or short. We will be able to profit whether the market is going on an upward trend or a downward trend. We may enter a long position in a bullish market and go short on a bearish market. 6. Timeframe Apart from the high return of investments, futures trading may also bring we fast returns as opposed to the stock markets where significant returns can be seen after years of investing. This is due to the volatility of the futures market, especially in commodity markets like Crude Palm Oil.

STOCK FUTURES Vs OPTIONS In the case of equity futures we are obliged to honour our exchange-traded contract for buying or selling a specified quantity of a stock at a future date. We can, however, close the deal before maturity by entering into an equal and opposite transaction called 'squaring off'. In contrast, an options contract is more flexible as it grants the holder the right to buy or sell shares on or before a specific date but does not make it mandatory. The buyer enters into a contract with the options writer or the seller, a deal is done at a strike price or the price at which the two parties agree to buy or sell the asset in the future. The contract-holder can choose to exercise the 'call' option for buying or the 'put' option for selling the shares. But the options writer is obliged to sell or buy the stock if the option is exercised. Futures and options contracts are traded through clearing corporations such as National Securities Clearing Corporation (NSCCL), which provide a guarantee in case there is a breach of contract.

ADVANTAGES OF THE FUTURES MARKET One big advantage of the futures markets is that they are traded in one central marketplace, the CME. This is advantageous for two reasons. First, it allows you to trade at a fixed, one-tick spread between the bid and ask. Second, because it is one centralized market, you are viewing the absolute price at which the market is trading. On the other hand, the cash markets have no centralized marketplace, which means that, when you look at a chart, you see a price that your broker may not be seeing. The forex market is a very large market with many different features, advantages and pitfalls. Forex investors may engage in currency futures as well as trade in the spot forex market. The difference between these two investment options is very subtle, but worth noting. A currency futures contract is a legally binding contract that obligates the two parties involved to trade a particular amount of a currency pair at a predetermined price (the stated exchange rate) at some point in the future. Assuming that the seller does not prematurely close out the position, he or she can either own the currency at the time the future is written, or may "gamble" that the currency will be cheaper in the spot market some time before the settlement date. With the spot FX, the underlying currencies are physically exchanged following the settlement date. In general, any spot market involves the actual exchange of theunderlying asset; this is most common in commodities markets. For example, whenever someone goes to a bank to

exchange currencies, that person is participating in the forex spot market. The main difference between currency futures and spot FX is when the trading price is determined and when the physical exchange of the currency pair takes place. With currency futures, the price is determined when the contract is signed and the currency pair is exchanged on the delivery date, which is usually some time in the distant future. In the spot FX, the price is also determined at the point of trade, but the physical exchange of the currency pair takes place right at the point of trade or within a short period of time thereafter. However, it is important to note that most participants in the futures markets are speculators who usually close out their positions before the date of settlement and, therefore, most contracts do not tend to last until the date of delivery.

EXAMPLE
Let's assume that you are gung-ho on a stock and expect it to rise from Rs 90 per share to Rs 125 in about three months. In the futures market, it is trading at Rs 100. If the contract size is 1,000 and margin requirement is 20%, you have to keep Rs 20,000 as security (which is later returned) for buying the contract. If your prediction comes true, you make a profit of Rs 25 on each share or Rs 25,000. If you had operated in the spot market, you may have been able to buy just 222 shares of the scrip for Rs 20,000 and earned just Rs 7,750 (See Profit Potential). An alternative would be to buy a call option for the stock and exercise it when the share crosses your target. Let's now assume that you expect a particular share trading at Rs 120 per share and expect it to decline to Rs 80. You place a put option or buy the right to sell 100 shares of this stock after a month. At a strike rate of Rs 100 for a premium of Rs 5 per share, your investment comes to Rs 500. If the share price actually declines to Rs 80, you buy the share from the cash market and sell it to the option writer for Rs 100. As you have paid a premium of Rs 5 per share, your profit per share will be Rs 15. For 100 shares, your profit will be Rs 1,500 (Rs 2000 less Rs 500). You lose just Rs 500 if the shares do not decline It is this profit potential that has made the average daily turnover in the derivatives market grow from Rs 11 crore in 2000-01, when it came into existence, to around Rs 1.15 lakh crore at the beginning of March 2011.

Spot Market
A commodities or securities market in which goods are sold for cash and delivered immediately. Contracts bought and sold on these markets are immediately effective. The spot market is also called the "cash market" or "physical market", because prices are settled in cash on the spot at current market prices, as opposed to forward prices. Crude oil is an example of a future that is sold at spot prices but its physical delivery occurs in one month or less. The spot market is a commodity or security market where goods, both perishable and nonperishable are sold for money and delivered immediately or within a short span of time. Contracts traded on a spot market are also in effect instantly. The purchases are settled in cash at the current prices fixed by the market as opposed to the price at the time of distribution. An example of a spot market commodity that is often sold is crude oil. It is sold at the existing prices, and physically supplied later. A commodity is basic goods, which is substitutable with other similar commodities. Some examples of commodities are grains, gold, oil, electricity and natural gas. Technology has entered the market with commodities such as mobile minutes and bandwidth. Commodities are standardized, and are essential to meet the specific standards to be traded on the spot market. The world spot market or foreign currency trading is a vast spot market. It is the simultaneous exchange of one nations currency with another. The way it works is through a stakeholder choosing a currency pair. Types of Spot Market The spot market which is also called the cash market is a financial market, in which the financial commodities and instruments are transacted for instantaneous delivery. It contrasts with a futures market in which distribution or delivery is owed at a later date. A spot market can be: 1. Exchange- It is also called an organized market where the security or commodity is traded on an exchange using and changing the current market price. 2. Over the counter (OTC) - In OTC, the trades are based on contracts which are done openly between two parties, and not subject to the guidelines of an exchange. The contract terms are approved between the parties and might be non-standard.

How It Works/Example: Spot markets differ from futures markets in that delivery takes place immediately. For example, if an investor wishes to purchase Company XYZ shares and own them immediately, he would go to the cash market on which the shares are traded (the New York Stock Exchange, for example). If he wanted to buy gold on the spot market, he could go to a coin dealer and exchange cash for gold.

The foreign exchange (FOREX) market is one of the largest spot markets in the world. People and companies all over the world are constantly exchanging one currency for another as transactions occur all over the globe.

Why It Matters: The difference known as the time spread is important economically because it illuminates the markets expectation about the future price. For the most part, spot markets are influenced solely by supply and demand, whereas futures markets are also influenced by expectations about future prices, storage costs, weather predictions (for perishable commodities in particular), and a host of other factors. Difference between Spot Market and Futures Market The spot market is different from the futures market in that the value in the futures market is affected by the price of storage and future price movements. In the spot market, prices are affected by the existing supply and demand, which inclines to make the prices more volatile. Another aspect that affects spot market prices is whether the commodity is perishable or nonperishable. Currency traders today have a distinct advantage when it comes to choosing and placing their trades because of the opportunities that both the cash spot markets and the futures markets can provide. And, because these two markets are similar, good traders should evaluate both the cash and futures markets so that they are in the best position to be profitable. Foreign Exchange Advantages The spot cash markets' main advantage is the sheer trading volume. Often, when trading lower volume currency pairs, the futures markets can be very lightly traded. This is important because every aspect of the trade ( from entry to exit ) depends on the ability to effortlessly enter and exit the markets with some precision in the orders to maintain the optimum balance of reward and risk. In the spot Forex markets, however, the high volume of even the less common pairs gives an advantage because the investor can use precise orders both to enter and exit the trade. This allows him to maintain a consistent money management plan.

In addition, the increased volume of the spot markets during non-peak hours allows the investor to trade 24 hours a day; whereas, in the futures markets, the volume significantly lessens overnight, again, potentially affecting the order entries and exits. Another great advantage to Forex trading is the ability to trade at various contract sizes. Spot Futures Parity
The relationship between spot prices and futures prices that holds in the absence of arbitrage opportunities is known as the spot-futures parity condition. Let F be the futures price, and S be the spot price. If r is the risk-free rate per period, and the futures contract matures in T periods, then the spotfutures parity condition is:

FT = S(1+r)^T Let D be the dividend (or coupon payment) paid in one period, at or near the end of the futures contracts life. Then, the spot-futures parity condition becomes F = S (1 + r ) D. Alternatively, we can write the dividend-adjusted parity result as F = S (1 + r d ), where dividend yield d = D/S . Then FT = S(1+r-d)^t