How Futures Trading Works

Futures Contract is a derivative contract which derives its value from the underlying asset. For example, S&P CNX Nifty Futures will derive its value based on the Nifty Index Points. Traders and Investors use Futures Contract in three ways.

1. To protect the value of their stock portfolio - they will consider buying/selling Futures with the intention to protect themselves from adverse price movements. This is known as Hedging.
2. If the traders or the investors feel, that the value of the index will go up or down in the near future, then they may act accordingly like either buying or selling the futures. This is known as Speculation.
3. If there exists as a drastic price difference between the spot market price of the index and the futures, then one may consider exploiting the price difference thereby making a risk-free profit. This is known as Hedging.

How Futures trading works?

To enter into a Futures Contract, one has to pay the initial margin which is fixed by the stock exchange. Let's assume that the initial margin required to enter into one S&P CNX Nifty Futures contract is 10% and the contract is traded at Rs.6000 and the contract size is 50.

Therefore, the total value of one futures contract comes around Rs.6000 * 50 = Rs.3,00,000. But, it is enough if we pay only the initial margin of 10% of the Contract size which comes around Rs.30,000.

Now, if the price of S&P CNX Nifty Futures rises to 6100, then one makes a profit of Rs.5,000 on an investment of Rs.30,000. The Rate of Return in this case is 16.67%. Similarly, if the price of S&P CNX Nifty Futures falls to 5900, then one lose Rs.5000 with a negative Rate of Return of 16.67%.

Conclusion

Since, it is enough to pay only the initial margin amount in order to enter into a Futures Trading, it may either result in a huge profit within a short period of time or it may swallow the entire trading capital. One has to evaluate his risk taking appetite before entering into a Futures Contract.