MARGIN MONEY To enter into these futures contract you need not put in the entire money. For example, reliance shares trades at Rs 1000 in the share market. If you want to enter into one lot of Reliance October futures contract which consists of 100 reliance shares, you need not put 100 x 1000. Instead, you would be required to maintain a small deposit (called margin) with the broker. Margin is decided by the exchange. This margin amount will keep varying with changes in daily prices. If the price goes up the buyer s margin is reduced and the seller s margin is increased by an equal amount. If the price comes down, the buyer s margin is increased and the seller s margin is reduced by an equal amount. Here s the link to know the margin money requirements of future contracts Here s an example- Let us assume you bought a Future contract of Infosys October (i.e, 100 shares of INFY at current future price of Rs. 2200 per share, settlement date being last Thursday of October).Let s further assume that the margin money required by the exchange is 20%. So, you pay Rs. 44,000. Now suddenly there is a crash and the price of INFY in the spot market dips to Rs. 1700. So you have lost Rs. 500 per share which, for 100 shares, is Rs. 50,000! This is greater than your margin of Rs. 44,000 so the broker will ask you to provide the extra Rs. 6,000 as an additional margin to keep your contract afloat. Futures are actively traded in the market, and the price of the future is not decided by you so once you have bought the future, you can SELL the contract to someone else. Let s say the contract you bought at Rs. 2,200 is now trading at Rs. 2,700 instead. You can sell the contract itself, and make the Rs. 500 as profit per share for 100 shares; that s Rs. 50,000 profit. You get a net profit of Rs 6,000 ( Rs 50,000 44,000) The exchange will also give your margin back, and take a margin from the new owner of the contract.
Futures Contracts 101 When you buy or sell a stock future, you're not buying or selling a stock certificate. You're entering into a stock futures contract -- an agreement to buy or sell the stock certificate at a fixed price on a certain date. Unlike a traditional stock purchase, you never own the stock, so you're not entitled to dividends and you're not invited to stockholders meetings [source:thachuk]. In traditional stock market investing, you make money only when the price of your stock goes up. With stock market futures, you can make money even when the market goes down. Here's how it works. There are two basic positions on stock futures:long and short. The long position agrees to buy the stock when the contract expires. The short position agrees to sell the stock when the contract expires. If you think that the price of your stock will be higher in three months than it is today, you want to go long. If you think the stock price will be lower in three months, then you'll go short. Let's look at an example of going long. It's January and you enter into a futures contract to purchase 100 shares of IBM stock at $50 a share on April 1. The contract has a price of $5,000. But if the market value of the stock goes up before April 1, you can sell the contract early for a profit. Let's say the price of IBM stock rises to $52 a share on March 1. If you sell the contract for 100 shares, you'll fetch a price of $5,200, and make a $200 profit. The same goes for going short. You enter into a futures contract to sell 100 shares of IBM at $50 a share on April 1 for a total price of $5,000. But then the value of IBM stock drops to $48 a share on March 1. The strategy with going short is to buy the contract back before having to deliver the stock. If you buy the contract back on March 1, then you pay $4,800 for a contract that's worth $5,000. By predicting that the stock price would go down, you've made $200. What's interesting about buying or selling futures contracts is that you only pay for a percentage of the price of the contract. This is called buying on margin. A typical margin can be anywhere from 10 to 20 percent of the price of the contract. Let's use our IBM example to see how this plays out. If you're going long, the futures contract says you'll buy $5,000 worth of IBM stock on April 1. For this contract, you'd
pay 20 percent of $5,000, which is $1,000. If the stock price goes up to $52 a share and you sell the contract in March for $5,200, then you make $200, a 20 percent gain on your initial margin investment. Not too shabby. But things can also go sour. If the stock price actually goes down, and ends up at $48 a share on April 1, then you have to sell the $5,000 contract for $4,800 -- a $200 loss. That's a 20-percent loss on your initial margin investment. If the stock drops considerably, it's possible to lose more than the price of the initial investment. That's why stock futures are considered high-risk investments. When buying on margin, you should also keep in mind that your stockbroker could issue a margin call if the value of your investment falls below a predetermined level called the maintenance level [source:money.net Inc.]. A margin call means that you have to pay your broker additional money to bring the value of the futures contract up to the maintenance level. Now let's look at some of the most common investment strategies using stock futures. Future Contracts: A future contract is effectively a forward contract which is standardized in nature and is exchange traded. Future contracts remove the lacunas of forward contracts as they are not exposed to counterparty risk and are also much more liquid. The standardization of the contract is with respect to Quality of underlying Quantity of underlying Term of the contract Let us understand it with the help of an illustration of a Reliance Future contract. What does the statement - I have bought 1 lot (250 shares) of Reliance July Future @ Rs 700 mean in theory? It means that the person has agreed to buy 250 shares of Reliance Industries on 26th July 2012 (the expiration date) at Rs 700 per share. Here, The underlying is the shares of Reliance Industries The quantity is 1 lot, i.e. 250 shares The expiry date is 26th July 2012 (last Thursday of July), and The pre-determined price is Rs 700 (and is called the Strike Price) If the actual price of Reliance is Rs 800 on the settlement day (26th July), the person buys 250 shares at the contracted price of Rs 700 and may sell it at the prevailing market price of Rs 800 thereby gaining Rs 100 per share (Rs 25,000 in total). On the other hand if the price falls to 650 he loses Rs 50 per share (Rs 12,500 in total) as he has to buy at Rs 700 but the prevailing market price is Rs 650. Stock Future Investment Strategies Single stock futures can be risky investments when purchased as standalone securities. There's a possibility of losing a significant chunk of your initial investment with only minimal market fluctuations. However, there are several strategies for buying stock
futures, in combination with other securities, to ensure a safer overall return on investment. One of the most effective stock future strategies is called hedging. The basic idea of hedging is to protect yourself against adverse market changes by simultaneously taking the opposite position on the same investment. Let's say you buy a share of traditional stock at $50. To make money with that stock, the price has to go up over time. But that's not necessarily true with stock futures. In addition to buying the stock, you could take a short position to sell the same stock on the futures market in three months. This way, even if your stock price goes down in three months, you'll make up some -- or even more -- of the money on the futures market. Another way to hedge stock futures investments is through something called a spread. A calendar spreadis when you go both short and long -- which we learned about earlier -- on the same stock future with two different delivery dates. For example, you could enter into two different contracts involving IBM stock. In the first contract, you agree to sell 100 shares after a month. In the other contract, you agree to buy 100 shares after six months. Using this strategy, you can make money off of both short-term losses and long-term gains. An intermarket spread involves going long and short on two different stock futures in a related market -- like gas and electric companies -- with the same delivery date. The hope is that one stock future's loss will be the other stock future's gain. A similar technique is a matched pair spread in which you enter a futures contract to buy shares in two directly competing companies. The idea is that Microsoft's loss is Apple's gain and vice versa. If this always happened, your investments would always break even. The hope is that one future will outperform the other without necessarily inflicting equal damage on the competition. If hedging and spreads lower the risk associated with investing in stock futures, then speculatingsubstantially increases it. With speculating, an investor is looking to quickly cash in on market fluctuations. By investing on margin with large amounts of
money, the speculator tries to predict short-term movements in stock prices for the maximum amount of gain. In the next section, we'll look at some of the advantages and disadvantages of stock futures in relation to traditional stocks. Stock Futures Versus Traditional Stocks The chief advantage of stock futures is the ability to buy on margin. Investing on margin is also called leveraging, since you're using a relatively small amount of money to leverage a large amount of stock. For example, if you have $1,000 to invest, you can by 10 shares of IBM stock. But with the same $1,000, you can buy a futures contract for 50 shares of IBM stock. It's true that you can also buy traditional stock on margin, but the process is much more complicated. When buying stock on margin, you're essentially taking out a loan from your stockbroker and using the purchased stock as collateral. You also have to pay interest to your broker for the loan [source:money.net Inc.]. The difference with stock futures is that you're not buying any actual stock, so the initial margin payment is more of a good faith deposit to cover possible losses [source: Money.net Inc.]. It's also much easier to go short on a stock future than to go short on traditional stocks. To go short on a futures contract, you pay the same initial margin as going long. Going short on stocks requires that you sell the stock before you technically own it. To do that, you need to borrow the stock from your broker first. You'll incur broker loan fees and dividend payments [source: Money.net Inc.]. Stock futures offer a wider array of creative investments than traditional stocks. Hedging with stock futures, for example, is a relatively inexpensive way to cover your back on risky stock purchases. And for high-risk investors, nothing is as potentially lucrative as speculating on the futures market. But stock futures also have distinct disadvantages. The high risk factor of a stock future can be just as dangerous as it is lucrative. If you invest in stock, the worst thing that can happen is that the stock loses absolutely all of its value. In that case, you lose the full
amount of your initial investment. With stock futures, since you're buying on margin, the potential exists to lose your full initial investment and to end up owing even more money. What's more, since you don't actually own any of the stock you're trading with futures contracts, you have no stockholder rights with the company. Because you don't own a piece of the company, you're not entitled to dividends or voting rights. Another disadvantage of stock futures is that their values can change significantly day to day. This isn't the type of security that you can purchase in January and check the price once a month. With such a high-risk security, there's a possibility that the value of your futures contract could drop like a hot potato from one day to the next. In that case, your broker might issue a margin call, which we discussed earlier. If you don't respond fast enough to the call, the contract will be liquidated at face value How to Buy and Sell Stock Futures Single stock futures are traded on the OneChicago exchange, a fully electronic exchange. Individual investors, also called day traders, can use Web-based services to buy and sell stock futures from their home computers. Dozens of companies offer online brokerage accounts to individuals with small fees -- like $0.75 per futures contract -- for each transaction. Day trading in stock futures should be limited to investors who have an in-depth understanding of how markets work and the risks involved in buying securities on margin. If you're up to the challenge, be prepared to put in significant time to research potential stock purchases and maintain margins on all existing futures contracts. You must be willing to invest many hours every day monitoring the prices of your investments to know the best time to sell or buy. This isn't like day trading in stocks, where price changes generally happen at a slower pace. A more conservative option would be to open a managed account with a stock brokerage firm. Shop around for brokers and do your research. You need to find someone who clearly understands your investment goals. Once you establish an account, this person will be actively trading with your money. In most broker-investor
relationships, the broker is given authorization to buy and sell futures without direct authorization for each trade. The advantage is that the broker is well-versed in the most effective investment strategies for stock futures. The disadvantage is that you'll have to pay a management fee for his or her services [source:drinkard]. An even more conservative strategy for investing in stock futures is to use a commodity pool. It functions like a mutual fund, where a large group of investors pool their money in the same portfolio. The fund or pool is managed by a team of brokers with expertise in the particular commodity -- like stock futures. Commodities pools are considered safer than an individual managed account because individual investors aren't responsible for margin calls How to trade in Futures The other day a friend told me that she made a killing trading in Stock Futures. On asking around, I discovered that many individuals are now trading in Futures, and doing well. Here's a primer to how it actually works. 3 ways to get rich this year How Futures work Buy a contract When you buy shares, you can buy any number you please, even if it is just one share. In Futures, you buy a contract which will have a specific lot size depending on the stock. Let's say you want to buy an Infosys Futures contract. This will comprise 100 shares. Or, you want to buy a HPCL Futures contract. This will be a lot of 650 shares. In Futures, you buy a lot. The lot size is set for each futures contract and it differs from stock to stock. Margin payment When you buy a Futures contract, you don't pay the entire value of the contract but just the margin. This margin amount too is prescribed by the exchange. Let's say you buy a HPCL Futures contract.
And the price of each HPCL share is Rs 311. This will amount to Rs 2,02,150 (Rs 311 x 650 shares). You don't pay the entire amount of Rs 2,02,150. You only pay 15% to 20% of that amount and this is called the margin amount. The margin depends on what the exchange sets for the day. Based on certain parameters, it declares the margin for each stock. So the margin for Infosys will vary from, say, HPCL. Let's say the margin for the HPCL Futures is 15%. So you end up just paying just Rs 30,322 (not Rs 2,02,150). How you make or lose money You purchased a HPCL Futures contract and the underlying price is Rs 311 per share. Let's say, the next day it moves to Rs 312. The difference is Rs 1 per share (312 311) You get a credit Rs 650 (Rs 1 per share x 650 shares). The following day, it dips to Rs 310. The difference is Rs 2 per share (312 310) Since the price has dipped, Rs 1,300 (Rs 2 per share x 650 shares) is debited from your account. This will go on till you sell the Futures contract or it expires (last Thursday of the month). So, on a daily basis you make and lose money. Why the bull run could turn in 2006 Why Futures are popular No delivery There is no delivery. When you buy in the cash segment (where investors buy and sell any number of shares and hold them in demat accounts), the shares are delivered to you and sent to your demat account. Over here, there is no delivery so you do not need a demat account. Lower brokerage The brokerage in Futures is much lower. It will be around 0.03% to 0.05% of the transaction. These are the rates given to regular investors. An occasional investor may end up paying up to 0.1% as brokerage.
In the cash segment, the brokerage will be around 0.25% to 0.75%. Margin payment When you buy shares in the cash segment, you have to make the entire payment to your broker. Let's say you buy 650 HPCL shares for Rs 311 per share. You end up paying Rs 2,02,150. Within two days, you will have to make the full payment to your broker. In Futures, you just pay the margin, not the entire amount. Can effectively short sell When you sell shares without owning them, it is known as short selling. You would do so if you believe that the price of the stock is going to drop. This way, you sell it at a higher rate and buy it at a lower rate later. With Futures, you do not have to square your transaction at the end of the day. You can square the transaction whenever you want or wait till it expires on the last Thursday of the month. But, in the cash segment, you have to square your transaction by the end of the day, so you can short sell just for a day. Stock picking is an art, not a science Where the cash segment scores Price differential It is worth noting that the price of the shares in the cash segment is mostly lower than the Futures price. So, if it is available for Rs 311 in the Futures segment, you should get it for Rs 308 in the cash segment. Though, on occasions it may even be slightly higher. Tax In Futures, you pay a tax of 33% on the your profit. In equity, it is a flat rate of 10% (short term capital gains) if you sell within a year and no tax if you sell after a year (long term capital gains). Flexibility in purchases In the cash segment, you can pick up however many shares you want starting from just one share. In Futures, you cannot buy less than the lot size prescribed.
If you want to buy more you can, but they must be in multiples of the lot. So, you can buy one or two contracts. Risk in Futures is higher If you are an investor who wants to buy shares and hold on to it, you should invest in the cash segment. Since Futures is a trading tool, the risk is also much higher. Let's say the shares of Infosys are going at Rs 2,700 per share. And, you buy 100 shares in the cash segment. You end up paying Rs 2,70,000. The price dips to Rs 2,200. If you sell the shares at this rate, you make a loss of 18.5% Now let's say you purchase an Infosys Futures at the underlying share price being the same. You pay the 20% margin of Rs 54,000. Let's say the price dips to Rs 2,200. You have to pay out Rs 50,000. Since you invested only Rs 54,000, you have incurred a loss of 92.5%. Hence, your losses can be much higher in Futures. How to save on tax Where can you trade? All stocks are not permitted for trading in derivatives. To check the list of stocks available for trading, go onto the National Stock Exchange website. You can also check the Bombay Stock Exchange website to read more about derivatives trading. But do note, to trade in futures, you will have to approach a broker who is authorised to trade in derivatives.