When a new trader is about to open a demat account and wants to get into futures trading, he may feel a bit anxious or apprehensive. Due to their very nature, futures contracts may seem a lot more complex than other instruments, like stocks, mutual funds, bonds, etc.
More importantly, futures are a derivative contract. They derive their value from an underlying asset, which can be a stock, an index, or a commodity. So, if you are new to futures trading, here are the three things that you must know.
Futures Trading Basics: 3 Key Things to Know
1. Understand How Futures Work
If you are new to future trading, you need to thoroughly understand how futures contracts work. In a futures contract, two parties reach an agreement to buy or sell an asset at a predetermined price on a certain date.
The buyer is under a legal obligation to buy the asset and the seller is under an obligation to sell the asset based on the terms of the agreement. Let us take an example to understand it better.
Suppose you agree to buy 10 stocks of a company called “ABC” at ₹100 per share from a person called “XYZ” on December 31. If the price of ABC rises to ₹110, you will gain because you will buy the stock at ₹100 and sell it at ₹110. However, if it falls to ₹90, you will lose because you will still have to buy it at ₹100.
2. Understand How Margin And Leverage Work
You must learn how margin and leverage work in a futures contract. Let us take an example to explain these concepts. Suppose you want to enter into a futures contract to buy 1 contract of Nifty 50. Each contract of Nifty 50 futures represents 75 units of the Nifty 50 index. Let us say that the Nifty 50’s current level is 24,000.
Hence the total value of the futures contract is 75 * 24000 is ₹18 lakhs. Suppose the initial margin requirement for Nifty 50 futures is 10% of the contract value. This means that you have to pay ₹1.8 lakhs to control the futures contract worth ₹18 lakhs.
Suppose the Nifty 50 index moves up from 24,000 to 24,200. The value of your futures contract will increase by ₹15,000 (75 * 200). Hence, ₹15,000 will be added to the margin you had deposited earlier. So, now you have a total margin value of ₹1.95 lakhs.
Now, suppose the Nifty 50 index moves down from 24,000 to 23,800. The value of your futures contract now is ₹17.85 lakhs (75 * 23,800). In this case, you have to bear a loss of ₹15,000. Consequently, your margin will now be reduced by ₹15,000.
If the value of Nifty 50 falls significantly and your margin value is lower than the maintenance margin, your broker will issue a margin call. Hence, you will have to open demat account to deposit additional funds to bring your margin back to the required level.
3. Concentrate On Risk Management
It is true that a futures contract can amplify your gains due to margin or leverage. However, it can also amplify your losses. Hence, you should focus on risk management.
In simple words, before entering into a futures contract, you should ask yourself how much money you are comfortable losing.
Or, how much you can lose without losing your sleep. In addition, you should use stop-loss orders, which will automatically execute your trades if the underlying asset’s price does not move in the desired direction.
Conclusion
With a rock-solid understanding of the basics, you will gain confidence, which will help you successfully trade futures.
However, bear in mind that the three things mentioned above are just the starting point. To be an active futures trader, you need to develop a feel for the market or an ability to predict how an asset’s price is likely to behave in the future.
Hence, if you are about to open a demat account, you should not jump straightaway into futures trading. Instead, you should learn the basics of the futures market first. Then, you must develop a feel for the market and only then you should get into futures trading.
