Stock Market Futures
Futures contract is a standardized contract between two parties to buy or sell a particular product or financial instrument in future at specified date and price agreed upon today.
In finance, a stock market index future is a cash-settled futures contract on the value of a particular stock market index.
Characteristics of Futures Contract
- Futures contract is a standardized contract. Quality and quantity of the underlying asset, settlement date etc., are decided by the exchanges. This uniformity in terms and conditions of the contracts promote liquidity. Therefore, futures contract are more liquid than forwards.
- There is a clearing house that guarantees the settlement of each trade. It acts as buyer to every seller and seller to every buyer.
- In futures contract, there is concept of Margin Account. We will discuss this concept in details later in this article.
- Unlike forwards, futures contract are usually not settled at expiration. Most of the futures contracts are closed out before expiration.
Mechanics of Futures Market
- Investor places the order with the broker.
- Investor also maintains margin account with the broker.
- Broker places the order with the trader and trader executes the order on the exchange.
- Broker also deposits the margin with the clearing house member and clearing house member deposits the margin with the clearing house.
Specifications of Futures Contract
- If the asset is a commodity, exchange will decide all the details of the asset like grade, color, shape, size etc.
- The contract size – amount of asset to delivered.
- Place of delivery will be decided.
- Delivery month will be decided.
Margin Account – Investor deposits certain amount of margin with their brokers.
Initial amount deposited in the margin account at the initiation of the contract is known as initial margin. Futures contract are marked to market (explained in detail later in article) on daily basis. If the price of the underlying asset has gone up, then the party in long position will make some profit. This profit will be deposited in the margin account of the long. Similarly, if the price of the underlying asset has gone up, then the party in short position will make some loss. This loss will be withdrawn from the margin account of the long. If the price of the underlying goes down, then the party in long will make loss and the party in short will make profit.
It is the minimum amount after which margin call is sent to the investor to deposit money in the margin account to make balance equal to the initial margin. The amount of money deposited to make the balance equal to initial margin is known as variation margin.
Termination of Futures Contract
Futures contract can be terminated in following four ways:
- Delivery – Party in short position can terminate the futures contract by delivering the good and party in long position can terminate the contract by accepting the delivery and by paying the short future price.
- Cash Settlement – Instead of delivering the underlying asset, parties exchange the cash based on the difference between the price of the underlying asset and the future price.
- Close out – Most of the futures contracts are not settled. They are closed out by entering into an off-setting contract. Party in long position can close out the position by entering into a short position. Similarly, a party in short position can close out the position by entering into a long position.
- Exchange for physicals – This is an off the exchange transaction where two parties agree to settle the trade. After these two parties agree to settle the trade, they must inform exchange about the transaction.
Stock index futures are used for hedging, trading, and investments.
- Hedging using stock index futures could involve hedging against a portfolio of shares or equity index options.
- Trading using stock index futures could involve, for instance, volatility trading (The greater the volatility, the greater the likelihood of profit taking – usually taking relatively small but regular profits).
- Investing via the use of stock index futures could involve exposure to a market or sector without having to actually purchase shares directly.