UNIT 2

FORWARDS AND FUTURES

A forward contract is a simple customized contract between two parties to buy
or sell an asset at a certain time in the future for a certain price. Unlike future contracts,
they are not traded on an exchange, rather traded in the over-the-counter market,
usually between two financial institutions or between a financial institution and one of
its client. In brief, a forward contract is an agreement between the counter parties to
buy or sell a specified quantity of an asset at a specified price, with delivery at a
specified time (future) and place. These contracts are not standardized, each one is
usually customized to its owner’s specifications.

Features of forward contract

The basic features of a forward contract are given in brief here as under:

Bilateral: Forward contracts are bilateral contracts, and hence, they are exposed to
counter-party risk.

More risky than futures: There is risk of non-performance of obligation by either of

the parties, so these are riskier than futures contracts.

Customised contracts: Each contract is custom designed, and hence, is unique in

terms of contract size, expiration date, the asset type, quality, etc.

Long and short positions: In forward contract, one of the parties takes a long position
by agreeing to buy the asset at a certain specified future date. The other party assumes
a short position by agreeing to sell the same asset at the same date for the same
specified price. A party with no obligation offsetting the forward contract is said to
have an open position. A party with a closed position is, sometimes, called a hedger.

Delivery price: The specified price in a forward contract is referred to as the delivery
price. The forward price for a particular forward contract at a particular time is the
delivery price that would apply if the contract were entered into at that time. It is
important to differentiate between the forward price and the delivery price. Both are
equal at the time the contract is entered into. However, as time passes, the forward
price is likely to change whereas the delivery price remains the same.

Synthetic assets: In the forward contract, derivative assets can often be contracted
from the combination of underlying assets, such assets are oftenly known as synthetic
assets in the forward market. The forward contract has to be settled by delivery of the
asset on expiration date. In case the party wishes to reverse the contract, it has to
compulsorily go to the same counter party, which may dominate and command the
price it wants as being in a monopoly situation.

Pricing of arbitrage based forward prices: In the forward contract, covered parity or
cost-of-carry relations are relation between the prices of forward and underlying
assets. Such relations further assist in determining the arbitrage-based forward asset
prices.

Popular in forex market: Forward contracts are very popular in foreign exchange
market as well as interest rate bearing instruments. Most of the large and international
banks quote the forward rate through their ‘forward desk’ lying within their foreign
exchange trading room. Forward foreign exchange quotes by these banks are displayed
with the spot rates.

Different types of forward: As per the Indian Forward Contract Act-1952, different
kinds of forward contracts can be done like

hedge contracts,

transferable specific delivery (TSD) contracts and

non-transferable specific delivery (NTSD) contracts. Hedge contracts are freely

transferable and do not specify, any particular lot, consignment or variety for delivery.
Transferable specific delivery contracts are though freely transferable from one party
to another, but are concerned with a specific and predetermined consignment. Delivery
is mandatory. Non-transferable specific delivery contracts, as the name indicates, are
not transferable at all, and as such, they are highly specific.

Difference between spot contract and forward contract

The difference between the spot contract and a forward contract is that:
1. the spot contract has a fixed price on the currency, and the forward contract has
a flexible price.
 2. the spot contract is a contract to be settled immediately, and the forward
contract is a contract to be settled at a future agreed-upon date.

3. The forward contract has a fixed price but the contract can be settled at a later
date, and the spot contract is a contract to be settled immediately.

DIFFERENCE BETWEEN FUTURE AND FORWARD CONTRACT

forward
A forward contract is an A futures contract is a standardized
agreement between two parties to contract, traded on a futures
buy or sell an asset (which can be exchange, to buy or sell a certain
Definition
of any kind) at a pre-agreed underlying instrument at a certain
future point in time at a specified date in the future, at a specified
price. price.
Customized to customer needs.
future Standardized. Initial margin
Usually no initial payment
Structure & payment required. Usually used for
Purpose required. Usually used for
speculation.
hedging.
Negotiated directly by the buyer
Transaction Quoted and traded on the Exchange
method and seller
Government regulated market (the
Commodity Futures Trading
Market Not regulated
regulation Commission or CFTC is the
governing body)
Institutional The contracting parties Clearing House
guarantee
Risk High counterparty risk Low counterparty risk
No guarantee of settlement until Both parties must deposit an initial
the date of maturity only the guarantee (margin). The value of the

Guarantees forward price, based on the spot operation is marked to market rates
price of the underlying asset is with daily settlement of profits and
paid losses.
 forward
Forward contracts generally Future contracts may not
Contract mature by delivering the necessarily mature by delivery of
Maturity
commodity. commodity.

Expiry date Depending on the transaction Standardized

Opposite contract with same or
different counterparty.
Method of
pre- Counterparty risk remains while Opposite contract on the exchange.
termination terminating with different
counterparty.
Depending on the transaction and

Contract size the requirements of the Standardized

contracting parties.

Market Primary & Secondary Primary

Limitations of forward contract

The disadvantages of forward contracts are:

1) It requires tying up capital. There are no intermediate cash flows before settlement.

2) It is subject to default risk.

3) Contracts may be difficult to cancel. 4) There may be difficult to find a counter-party.

Payoff on Forward Contracts

Forward contracts are privately executed between two parties. The buyer of the
underlying commodity or asset is referred to as the long side whereas the seller is the
short side. The obligation to buy the asset at the agreed price on the specified future
date is referred to as the long position. A long position profits when prices rise. The
obligation to sell the asset at the agreed price on the specified future date is referred to
as the short position. A short position profits when prices go [Link] is the payoff of
a forward contract on the delivery date? Let T denote the expiration date, K denote the
forward price, and PT denote the spot price (or market price) at the delivery date. Then

 For the long position: the payoff of a forward contract on the delivery date is
PT_ K
 For the short position: the payoff of a forward contract on the delivery date is
K_PT
Figure shows a payoff diagram on a contract forward. Note that both the long and
short forward payoff positions break even when the spot price is equal to the forward
price. Also note that a long forward’s maximum loss is the forward price whereas the
maximum gain is unlimited.

For a short forward, the maximum gain is the forward price and the maximum loss
is unlimited.

FUTURES

A futures contract is a legal agreement to buy or sell a particular commodity

asset, or security at a predetermined price at a specified time in the future. Futures
contracts are standardized for quality and quantity to facilitate trading on a futures
exchange. The buyer of a futures contract is taking on the obligation to buy and receive
the underlying asset when the futures contract expires. The seller of the futures
contract is taking on the obligation to provide and deliver the underlying asset at the
expiration date.

Features of Futures

1. Organised Exchanges:

Unlike forward contracts which are traded in an over-the-counter market, futures

are traded on organised exchanges with a designated physical location where trading
takes place. This provides a ready, liquid market in which futures can be bought and
sold at any time like in a stock market.

2. Standardisation:

In the case of forward currency contracts, the amount of commodity to be delivered

and the maturity date are negotiated between the buyer and seller and can be tailor-
made to buyer’s requirements. In a futures contract, both these are standardised by
the exchange on which the contract is traded.

3. Clearing House:

The exchange acts as a clearing house to all contracts struck on the trading floor.
For instance, a contract is struck between A and B. Upon entering into the records of
the exchange, this is immediately replaced by two contracts, one between A and the
clearing house and another between B and the clearing house.

4. Trade for clearing member:

Like all exchanges, only members are allowed to trade in futures contracts on the
exchange. Others can use the services of the members as brokers to use this
instrument. Thus, an exchange member can trade on his own account as well as on
behalf of a client. A subset of the members is the “clearing members” or members of the
clearing house and non- clearing members must clear all their transactions through a
clearing member.

5. Marking to Market:
 The exchange uses a system called marking to market where, at the end of each
trading session, all outstanding contracts are reprised at the settlement price of that
trading session. This would mean that some participants would make a loss while
others would stand to gain. The exchange adjusts this by debiting the margin accounts
of those members who made a loss and crediting the accounts of those members who
have gained.

6. Actual Delivery is Rare:

In most forward contracts, the commodity is actually delivered by the seller and is
accepted by the buyer. Forward contracts are entered into for acquiring or disposing
off a commodity in the future for a gain at a price known today.

Advantages of futures

1. Opens the Markets to Investors

Futures contracts are useful for risk-tolerant investors. Investors get to participate
in markets they would otherwise not have access to.

2. Stable Margin Requirements

Margin requirements for most of the commodities and currencies are well-
established in the futures market. Thus, a trader knows how much margin he should
put up in a contract.

3. No Time Decay Involved

In options, the value of assets declines over time and severely reduces the
profitability for the trader. This is known as time decay. A futures trader does not have
to worry about time decay.

4. High Liquidity

Most of the futures markets offer high liquidity, especially in case of currencies,
indexes, and commonly traded commodities. This allows traders to enter and exit the
market when they wish to.
 5. Simple Pricing

Unlike the extremely difficult Black-Scholes Model-based options pricing, futures

pricing is quite easy to understand. It's usually based on the cost-of-carry model,
under which the futures price is determined by adding the cost of carrying to the spot
price of the asset.

6. Protection Against Price Fluctuations

Forward contracts are used as a hedging tool in industries with high level of price
fluctuations. For example, farmers use these contracts to protect themselves against
the risk of drop in crop prices.

7. Hedging Against Future Risks

Many people enter into forward contracts for better risk management. Companies
often use these contracts to limit risk that may arise from foreign currency exchange.

The Disadvantages of Futures Contracts

1. No Control Over Future Events

One common drawback of investing in futures trading is that you don't have any
control over future events. Natural disasters, unexpected weather conditions, political
issues, etc. can completely disrupt the estimated demand-supply equilibrium.

2. Leverage Issues

High leverage can result in rapid fluctuations of futures prices. The prices can go up
and down daily or even within minutes.

3. Expiration Dates

Future contracts involve a certain expiration date. The contracted prices for the
given assets can become less attractive as the expiration date comes nearer. Due to
this, sometimes, a futures contract may even expire as a worthless investment.
SPECIFICATIONS/Futures Terminology

1. Commodity Futures Market – a physical or electronic marketplace where traders

buy and sell commodity futures contracts.
2. Commodity Futures Contracts – purchase and sales agreements having
standardized terms, including quantities, grades, delivery periods, price basis,
and delivery methods of a particular commodity.
3. Long Position - a buyer of futures contracts. A long position is the number of
purchase contracts held by the buyer.
4. Short Position - a seller of futures contracts. A short position is the number of
sales contracts held by the seller.
5. Trade Volume – the number of transactions executed for a particular time
period. The purchase by the buyer and sale by the seller of one futures contract
equals a volume of ONE (Purchases and sales are not double counted.)
6. Open interest – the number of futures contracts that exist on the book of the
Clearinghouse. One purchase and sale, involving two transacting parties –
constitutes an open interest of ONE. The number of purchase and sale contracts
is always equal.
7. Closing Price – the fair value price trading near the end of the trading session, as
determined by the exchange.
8. Futures Delivery – the transfer of commodity ownership from the short (the
seller) to the long (the buyer) during the delivery period. Ownership is
transferred by the surrender of warehouse receipts or some other negotiable
instrument specified by the contract.
9. Futures Expiration– the last trading day of futures contract.
10. Volatility – the variability of prices over time (historical) or projected (Implied) as
determined by a formula.
11. Historical and Implied Volatility - Historical Volatility is a measure of price
variability showing the variation or “dispersion” of prices from the mean over a
chosen time period. Is calculated using a standard deviation Quantity:50 MT EU
origin wheatGrade: Sound, Fair, Merchantable Quality Deliverable months: Jan,
March, May, August, November Price basis Euros per tonn minimum price
movement25 euro cents (€12.50 per contract)Delivery method: Warehouse
receipts in store silo Rouen 2 formula. Implied Volatility is based on a option
 pricing model (such as Black Scholes) using premiums paid for at-the-money
options on futures, that is – the option with a strike price closest to the futures
price. For example, if maize is trading at $6.03/bushel, than IV is derived from
the premiums paid for $6.00 strike. Historical Volatility is backward looking
whereas Implied Volatility – often called the fear index – is forward looking.
12. Clearinghouse – the entity of a futures exchange that acts as counterparty to
every transaction. The clearinghouse “clears” every transaction by becoming the
buyer to the seller and the seller to the buyer. The clearinghouse always holds
an equal number of buy and sell contracts. The purpose of the clearinghouse is
to guard against default.
13. Default – the failure of a long or short to deposit sufficient margin with the
clearinghouse. Also – the failure of a seller to make delivery or the failure of a
buyer to take delivery of the commodity during the delivery period.
14. Position Limit – the maximum number of buy or sell contracts that a speculator
can hold at one time in a futures contract. Normally, exchanges require position
limits to be reduced as the delivery period approaches.
15. Hedging – buying or selling futures contracts against opposite cash positions.
Producers that sell futures against anticipated harvest are called short hedgers.
End-users, such as wheat millers that buy futures against anticipated inventory
needs, are called long hedgers.

Types of futures

There are many types of futures contracts available for trading including:

 Commodity futures such as in crude oil, natural gas, corn, and wheat
 Stock index futures such as the S&P 500 Index
 Currency futures including those for the euro and the British pound
 Precious metal futures for gold and silver
 U.S. Treasury futures for bonds and other products

Trading process

The trading process of futures involves the following steps

1. Select brokerage
 2. Opening a trading account
3. Choose a commodity or financial instrument to trade
4. Study different contract, the costs and goods
5. Develop a trading strategy
6. Purchase the futures contract

Future trading mechanism

1. Placing an order
2. Role of the clearing house
3. Daily settlement
4. Settlement

Role of clearing house

A clearing house acts as an intermediary between a buyer and seller and seeks
to ensure that the process from trade inception to settlement is smooth. Its main role is
to make certain that the buyer and seller honor their contract obligations.
Responsibilities include settling trading accounts, clearing trades, collecting and
maintaining margin monies, regulating delivery of the bought/sold instrument, and
reporting trading data. Clearing houses act as third parties to all futures and options
contracts, as buyers to every clearing member seller, and as sellers to every clearing
member buyer.

The clearing house enters the picture after a buyer and seller have executed a
trade. Its role is to consolidate the steps that lead to settlement of the transaction. In
acting as the middleman, a clearing house provides the security and efficiency that is
integral for financial market stability.

Clearing houses take the opposite position of each side of a trade which greatly
reduces the cost and risk of settling multiple transactions among multiple parties.
While their mandate is to reduce risk, the fact that they have to be both buyer and
seller at trade inception means that they are subject to default risk from both parties.
To mitigate this, clearing houses impose margin (initial and maintenance)
requirements.
Functions of clearing house

A clearing house is basically the mediator between two transacting parties.

However, there is also more to what clearing houses do. Let’s take a look at some of
their functions in more detail.

1. The clearing house guarantees that the transactions will occur smoothly and
that both parties will receive what is due to them. This is done by checking the
financial capabilities of both parties to enter into a legal transaction, regardless
of whether they are an individual or an organization.

2. The clearing firm makes sure that the parties involved respect the system and
follow the proper procedures for a successful transaction. The facilitation of
smooth transactions leads to a more liquid market.

3. It is the clearing house firm that provides a level playing field for both parties,
where they can agree on the terms of their negotiation. This includes having the
responsibility for setting the price, quality, quantity, and maturity of the
contract.

4. The clearing house makes sure that the right goods are delivered to the buyer, in
terms of both quantity and quality, so that at the end of the transaction there
are no complaints nor arbitration necessary.

MARGIN SYSTEM

In futures contract, the clearing house undertakes the default risk. To protect
itself from this risk, the clearing house requires the participants to keep margin money.
Thus margins are amounts required to be paid by dealers in respect of their futures
position to ensure that both parties will perform their contract obligations.

Types of margin

1. Initial Margin

Initial Margin is the capital sum which an investor needs to park with his broker as
a down payment in its account to initiate trades. This acts as a collateral. An investor
can offer cash and securities or other collateral like open ended Mutual fund as
collateral to enter into a trade.

In most cases, especially for equity securities, the initial margin requirement is 30
% or exchange defined margin whichever is higher, but this may vary. And yes, both
buyers and sellers must put up a payment to enter into a trade.

2. Maintenance Margin

After purchasing the stocks, a minimum balance called as maintenance margin

needs to be parked with the broker. In case the margin drops below the limit, your
broker will make a margin call and can also liquidate the position if you do not make
up for the requirement amount.

Maintenance Margin varies between 20-30% subject to minimum exchange charged

margin and may change depending on a position an investor wants to hold in a stock
market.

3. Variation Margin

Variation margin is the additional amount of cash you are required to deposit in
your trading account to bring it up to the initial margin after you have incurred
sufficient losses to bring it below the "Maintenance Margin". Variation Margin = Initial
Margin - Margin Balance.

Marking to Market (daily settlement)

Marking to market refers to the daily settling of gains and losses due to changes
in the market value of the security. For financial derivative instruments, such as
futures contracts, use marking to market.

If the value of the security goes up on a given trading day, the trader who bought
the security (the long position) collects money – equal to the security’s change in value
– from the trader who sold the security (the short position). Conversely, if the value of
the security goes down on a given trading day, the trader who sold the security collects
money from the trader who bought the security. The money is equal to the security’s
change in value.
 The value of the security at maturity does not change as a result of these daily
price fluctuations. However, the parties involved in the contract pay losses and collect
gains at the end of each trading day.

Arrange futures contracts using borrowed money via a clearinghouse. At the end
of each trading day, the clearinghouse settles the difference in the value of the contract.
They do this by adjusting the margin posted by the trading counterparties. The margin
is also the collateral.

Types of future contracts:

[Link] Futures

2. Currency futures
3. Interest rate futures

4. Stock index futures

5. Commodity futures

[Link] Futures
Stock Futures are financial contracts where the underlying asset is an individual
stock. Stock Future contract is an agreement to buy or sell a specified quantity of
underlying equity share for a future date at a price agreed upon between the buyer and
seller. The contracts have standardized specifications like market lot, expiry day, unit
of price quotation, tick size and method of settlement.

[Link] futures

Currency futures are a exchange-traded futures contract that specify the price in
one currency at which another currency can be bought or sold at a future date.
Currency futures contracts are legally binding and counterparties that are still holding
the contracts on the expiration date must deliver the currency amount at the specified
price on the specified delivery date. Currency futures can be used to hedge other trades
or currency risks, or to speculate on price movements in currencies.

The Features of currency futures are:

 → High Liquidity

 → Simple and easy to understand

 → Standardized trading platform with Online/Offline modes

 → Less volatile market as compared to other trading product

 Low Margin with High Leverage

 → Currency follows close correlations with Equities, Commodities

 → Currency Options are also available in USD/INR

 → Spread Trading - Inter Currency and Intra Currency Spread

 → Huge trading limits for Retail, corporate and Institutional clients

 → Exchange Traded Currency Derivatives are effective risk management tools

[Link] rate futures

Interest rate futures are a type of futures contract that are based on a financial
instrument which pays interest. It is a contract between a buyer and a seller which
agrees to buy and sell a debt instrument at a future date when the contract expires at a
price that is determined today.

Some of these futures may require the delivery of specific types of bonds, mostly
government bonds on the delivery date.

These futures may also be cash-settled in which case, the one who holds the
long position receives and one who holds the short position pays. These futures are
thus used to hedge against or offset interest rate risks. Which means investors and
financial institutions cover their risks against future interest rate fluctuations with
these.

These futures can be short or long term in nature. Short term futures invest in
underlying securities that mature within a year. Long term futures have a maturity
period of more than one year.

Pricing for these futures is derived by a simple formula: 100 – the implied
interest rate. So a futures price of 96 means that the implied interest rate for the
security is 4 percent.

Since these futures trade in government securities, the default risk is nil. The
prices depend only on the interest rates.
.Applications of interest rate futures

1. Long hedge

T bills futures are used to hedge the short term interest rate risk. A long hedge
involves buying futures contract, in other words, long hedge means assuming a long
position in the futures market.

2. Short hedge

A short hedge involves selling futures contract. If interest rates in the economy go
up, issuer will pay the investors m0re but will be compensated by taking short position
in the futures contract.

3. Converting floating rate loan to a fixed rate loan

A fixed rate loan carries a constant interest rate over the life of the loan. A floating
interest a rate involves the rate being changed at regular pre defined intervals during
the loan period.

4. Converting a fixed rate loan to floating rate loan

We can convert a fixed rate loan to a floating rate loan by using an interest rate
future to protect from risk of unfavorable changes in the interest rate.

5. Extending the maturity of the security

Interest rate futures can e used to extend the maturity of a debt market security.

6. Shortening the maturity of the security

We can use futures for reducing the maturity of a debt market security.

7. Hedging a commercial paper issue

When short term interest rates are expected to increase, the issuer can hedge the
futures commercial paper issue by taking short position in T bill futures contracts.

8. Hedging a bond port folio with T bond futures

 Fixed income portfolio managers often use T bond futures to shield the futures
values of their portfolios against interest rate changes.

[Link] index futures

Stock index futures, also referred to as equity index futures or just index
futures, are futures contracts based on a stock index. Futures contracts are an
agreement to buy or sell the value of the underlying asset at a specific price on a
specific date. In this case, the underlying asset is tied to a stock index. Index futures,
however, are not delivered at the expiration date. They are settled in cash on a daily
basis, which means that investors and traders pay or collect the difference in value
daily. Index futures can be used for a few reasons, often by traders speculating on how
the index or market will move, or by investors looking to hedge their position against
potential future losses.

Uses of Stock index futures

1. Speculation

To make money, speculators use index futures by taking long or short position.
Such positions are taken on the assumption that the index would go up or down, if a
person belives that the market would go up in the futures, he may buy futures.

2. Funds lending by Arbitrageur

For an arbitrageur willing to employ funds, the methodology involves first buying
shares in the cash market and selling index futures. The quantity of shares to be ought
is decided on the basis of their weightage in the index and the order is put through the
system simultaneously using the programe trading methods. At the same time a sell
position is taken in the futures market.

3. Securities lending

An arbitrageur can earn returns by lending securities in the market. The

methodology involoved is first selling shares in cash market and buying index futures
using the cash received in some risk free investment, and finally buying the same
shares and setting the futures position at the expiration.
 4. Strategic arbitrage

An arbitrageur need not hold his position till the date of maturity. The basis does
not remain uniform. It keeps on changing. This is due to the volatility in the market.
The arbitrageur may keep track of the basis and unwind his position as soon as
appropriate opportunity is seen and take advantage of changes in the basis is short
intervals.

5. Hedging

Stock index futures can be effectively used for hedging purposes. They can be used
while taking a long or short position on a stock and for portfolio hedging against
unfavorable price movements.

[Link] futures
A commodity futures contract is an agreement to buy or sell a predetermined
amount of a commodity at a specific price on a specific date in the future. Commodity
futures can be used to hedge or protect an investment position or to bet on the
directional move of the underlying asset. Many investors confuse futures contracts with
options contracts. With futures contracts, the holder has an obligation to act. Unless
the holder unwinds the futures contract before expiration, they must either buy or sell
the underlying asset at the stated price.
Features of commodity futures
1. Organized: Commodity futures contracts always trade on an organized exchange.
NCDEX and MCX are examples of exchanges in India. NYMEX, LME, and COMEX are
some international exchanges.
2. Standardized: Commodity futures contracts are highly standardized. This means
the quality, quantity, and delivery date of commodities is predetermined by the
exchange on which they are traded.
3. Eliminate counter-party risk: Commodity futures exchanges use clearinghouses to
guarantee fulfillment of the terms of the futures contract. This eliminates the risk of
default by the other party.
4. Facilitate margin trading: Commodity futures traders do not have to pay the entire
value of a contract. They need to deposit a margin that is 5–10% of the contract value.
This allows the investor to take larger positions while investing less capital..
5. Fair practices: Government agencies regulate futures markets closely. For example,
there is the Forward Markets Commission (FMC) in India and the Commodity Futures
Trading Commission (CFTC) in the Unites States. The regulation ensures fair practices
in these markets.
6. Physical delivery: The actual delivery of the commodity can take place on expiry of
the contract. For physical delivery, the member needs to provide the exchange with
prior delivery information. He also needs to complete all delivery-related formalities as
specified by the exchange.
Benefits of Commodity Futures

1. Price Discovery:

Based on inputs regarding specific market information, buyers and sellers

conduct trading at futures exchanges. This results into continuous price discovery
mechanism.

2. Hedging:

It is strategy of managing price risk that is inherent in spot market by taking an

equal but opposite position in the futures market to protect their business from
adverse price change.

3. Import- Export competitiveness:

The exporters can hedge their price risk and improve their competitiveness by
making use of futures market. A majority of traders which are involved in physical
trade internationally intend to buy forwards. The existence of futures market allows the
exporters to hedge their proposed purchase by temporarily substituting for actual
purchase till the time is ripe to buy in physical market.

4. Portfolio Diversification

Commodity offers at another investment options which is largely negatively

correlated with equity and currency and thus could offer great portfolio diversification.

Futures pay-offs or profit or loss

Futures contracts have linear payoffs. In simple words, it means that the losses
as well as profits for the buyer and the seller of futures contracts are unlimited. These
liner payoffs are fascinating as they can be combined with options and the underlying
to generate various complex payoffs.

Payoff for Buyer of Futures:

Long Futures the payoff for a person who buys a futures contract is similar to
the payoff for a person who holds an asset .He has a potentially unlimited upside as
well as a potentially unlimited downside. Take the case of a speculator who buys a two
month nifty index futures contract when the nifty stands at 2220. The underlying asset
in this case is the nifty portfolio. When the index moves down it starts making losses.
Fig 5.3shows the payoff diagram for the buyer of a futures contract

The payoff diagram for the buyer of a futures contract

The Fig. shows the profits/losses for a long futures position. The investor bought
futures when the index was at 2220. If the index goes up, his futures position starts
making profit. If the index falls, his futures position starts showing losses.
Payoff for Seller of Futures:
Short Futures The payoff for a person who sells a futures contract is similar to
the payoff for a person who shorts an asset. He/she has a potentially unlimited upside
as well as a potentially unlimited downside. Take the case of a speculator who sells
two-month Nifty index futures when the Nifty stands at 2220. The underlying asset in
this case is the Nifty portfolio. When the index moves up, it starts making losses.
Figure 5.4shows the payoff diagram for the seller of a futures contract.
Fig. The payoff diagram for the seller of a futures contract

The Fig. shows the profit/losses for a short futures position. The investor sold
futures when the index was at 2220. If the index goes down, his futures position starts
making profit. If the index rises, his futures position starts showing losses.
Trading strategies in stock futures
Below are four popular futures trading strategies, from the basic to the more
complex.

1. Going long

Going long — buying a futures contract — is the most basic futures trading strategy.
An investor buys a futures contract expecting the contract to rise in price by expiration.

Best to use when: Buying a futures contract is the most straightforward futures
trading strategy for speculating on an asset rising before the contract expires. The
futures contract offers a leveraged return on the underlying asset’s rise, so the trader
expects a clear move higher in the near future.

Risks and rewards: Going long offers the inherent promise of the futures
contract: a leveraged return on the underlying asset’s rise. It has uncapped upside as
long as the asset rises, making this futures trading strategy a potential home run. In
this example, if the contract increases 10 cents to $3.60 (a gain of 2.8%), then your
equity stake balloons from $4,000 to $6,500 for a return of nearly 63%. That is, the five
contracts are now worth $90,000, and the additional $2,500 is your gain.

2. Going short

Going short — selling a futures contract — is the flip side of going long. An investor
sells a futures contract expecting the contract to fall by expiration.
 Best to use when: Selling a futures contract is another straightforward futures
trading strategy, but it can be riskier than going long because of the potential for
uncapped losses if the underlying asset continues to rise. Investors going short a
contract want the full leveraged returns of an asset that is expected to fall.

Risks and rewards: Going short offers many of the same benefits that going
long does, most notably the leveraged return on the underlying asset’s decline.
However, unlike the long position, going short has uncapped downside.

3. Bull calendar spread

A calendar spread is a strategy that has the trader buying and selling contracts
on the same underlying asset but with different expirations. In a bull calendar spread,
the trader goes long the short-term contract and goes short the long-term contract. A
calendar spread reduces the risk in a position by eliminating the key driver of the
contract’s value — the underlying asset. The goal of this futures trading strategy is to
see the spread widen in favor of the long contract.

With a bull calendar spread, traders have multiple ways to win since the spread
can widen in a few ways: The long contract can go up, the short contract can go down,
the long can go up while the short goes down, the long can go up more than the short
goes up, and the long can go down less than the short goes down. The important point
is that the spread widens.

Best to use when: The trader must expect the long contract to move up relatively more
than the short contract, widening the value of the spread and creating a profit for the
trader. A bull calendar spread is a more conservative position that is less volatile than
going long. It also requires less margin to set up than a one-leg futures position, and
this is a significant advantage of the trade. Plus, this lower margin allows the trader to
achieve a higher return on capital.

4. Bear calendar spread

Like the bull calendar spread, the bear calendar spread has the trader buying
and selling contracts on the same underlying asset but with different expirations. A
calendar spread reduces the risk by neutralizing the key driver of the contract’s value
— the underlying asset. In a bear calendar spread, the trader sells the short-term
contract and buys the long-term contract. The goal of this futures trading strategy is to
see the spread widen in favor of the short contract.

With a bear calendar spread, traders have multiple ways to win since the spread
can widen in a few ways: The long contract goes down, the short contract goes up, the
long goes down while the short goes up, the long goes down more than the short goes
down, and the long goes up less than the short goes up. The important point is that the
short September contract becomes more expensive relative to the long December
contract.

Best to use when: The trader must expect the short contract to increase relatively
more than the long contract, widening the value of the spread and creating a profit. A
bear calendar spread is a more conservative position that is less volatile, requiring less
margin to set up than a one-leg futures position, and this is a significant advantage of
the spread trade. This lower margin requirement allows the trader to achieve a higher
return on capital.

Risks and rewards: The appeal of the bear calendar spread is that you can generate
nice returns on a conservative strategy while the broker requires lower margin. This
reduced margin helps boost your percentage return on a successful trade.

Settlement of futures

When a futures trader takes a position (long or short) in a futures contract, he

can settle the contract in three different ways.

1. Closeout: In this method, the futures trader closes out the futures contract even
before the expiry. If he is long a futures contract, he can take a short position in the
same contract. The long and the short position will be off-set and his margin account
will be marked to marked and adjusted for P&L. Similarly, if he is short a futures
contract, he will take a long position in the same contract to close out the position.

2. Physical Delivery: If the futures trader does not closeout the position before expiry,
and keeps the position open and allows it to expire, then the futures contract will be
settled by physical delivery or cash settlement (discussed below). This will depend on
the contract specifications. In case of the physical delivery, the clearinghouse will select
a counterparty for physical settlement (accept delivery) of the futures contract.
Typically the counterpart selected will be the one with the oldest long position. So, at
the expiry of the futures contract, the short position holder will deliver the
underlying asset to the long position holder.

3. Cash Settlement: In case of cash settlement (in case the contract has
expired), there is no need for physical delivery of the contract. Instead the
contract can be cash- settled. This can be done only if the contract specifies
so. If a contract can be cash settled, the trader need not closeout the position
before expiry, He can just leave the position open. When the contract
expires, his margin account will be marked-to market for P&L on the final
day of the contract. Cash settlement is a preferred option for most traders
because of the savings in transaction costs.