What is a Futures Market?

The futures market is a financial market where standardised or futures contracts are traded. Futures contract is an agreement to purchase or sell an asset at a future date for a price that is fixed today. The value in this case derives from underlying assets such as stocks, currencies, or commodities. This agreement or contract specifies the quantity of the asset, the delivery date, and the price at which the asset will be bought or sold. 

Key Players in the Futures Market

The main players in futures trading are the following:

• Hedgers: They are individuals or businesses who already have an existing position and wish to lower the impact of price changes on future operations. They can lock in a price for the underlying asset, irrespective of future fluctuations. Short hedging is about selling futures contracts to lock in the selling price and safeguard against declines in prices. On the other hand, long hedging is buying futures contracts to protect against price rises while ensuring a consistent cost of inputs. 
• Speculators: What role do speculators play in the futures market? They are institutions or individuals who trade in futures contracts, aiming to profit from movements in prices without always having an underlying interest in the futures market. Speculators often adopt long positions (buying) when they anticipate a rise in prices or short positions (selling) when they expect prices to go down. 

Some other participants in the market include arbitrageurs who simultaneously sell and purchase the same asset in different markets, profiting from the discrepancies in prices. Intermediaries like exchanges and brokers also play a role in enabling trading, order execution, and clearing and settlement services. Day and margin traders also have a role to play in the futures market. 

Types of Futures Contracts 

Before we get into the types of future contracts, it is important to tackle the cash market vs futures market debate. The difference between the two is the transaction timing. In the cash market, transactions are settled immediately, while in the futures market, transactions are settled at a predetermined date in the future and involve future delivery of contracts. 

Let us now check the types of contracts that you’ll come across:

• Commodity Futures: These are contracts covering physical commodities such as natural gas, crude oil, silver, gold, and agricultural products (coffee, corn, wheat). They are also helpful to manage price risks, enabling consumers and producers to hedge against fluctuations in prices. 
• Financial Futures: These include contracts for debt instruments like treasury bonds, currencies, and other financial instruments. They help hedge against fluctuations in currency exchange rates and risks related to interest rates. 
• Index Futures: Index futures contracts are linked to stock market indices like the S&P 500 and Nifty 50, helping investors hedge/speculate on the overall market performance. 
• Currency Futures: These are contracts where currency pairs are traded, enabling traders to hedge against foreign exchange-related risks. They may also be used to speculate on currency exchange rates. 
• Interest Rate Futures: These contracts are based on bonds, treasury bills, or other debt instruments. They help you hedge against interest rate risks, since the value of these instruments may be sensitive to changes in rates. 

Margin and Leverage in Futures Trading 

Understanding the concept of margin and leverage is vital in futures trading. Here’s a closer look at the same

• Margin: It is the initial amount that is deposited to open a position with a trader, functioning as collateral for covering possible losses. The margin requirement is a percentage of the total value of the contract, and it is set by the exchange where the contract is traded. 
• Leverage: This is the ability to control a bigger contract value with a smaller margin, enabling traders to amplify their exposure to the market. It may lead to substantial profits, although there are risks of losses as well. Leverage can be calculated by dividing the notional value of the contract by the margin requirement. 

Strategies for Profitable Futures Trading 

Several strategies can come in handy for futures trading. These include

• Trend Following: It is a strategy that involves identifying and trading in the direction of the prevailing trend in the market, whether it is downward/bearish or upward/bullish. The core philosophy is that when a trend gets established, it is likely to continue for some time, enabling traders to ride the trend for possible profits. Techniques like moving averages and entry and exit are used in this case. 
• Momentum Trading: This strategy is based on the principle that assets strongly move in one direction and could continue doing the same for a while. Hence, the focus is on trading assets that have higher relative strength, meaning they demonstrate stronger price movement momentum. Key indicators in this category include RSI (Relative Strength Index) and MACD (Moving Average Convergence Divergence). 
• Hedging with Futures and Options: Hedging aims to lower risks instead of maximising overall profits and is used by institutional investors and individual traders alike. This involves taking offsetting positions in the F&O (futures and options) market to lower risk exposure.
• Mean Reversion: Mean reversion implies that prices will ultimately come back to their historical average or mean over a period of time. This is based on the assumption that whenever prices shift from their average, they will eventually come back to normal levels, thereby opening up profitable trading opportunities. Key techniques used by traders include Bollinger bands. 
• Arbitrage: This is a strategy where traders take advantage of discrepancies in prices between two or multiple markets. Opportunities in this segment come up whenever there are price differences between related contracts or markets. The aim is to buy low in a market and sell high in another to lock in risk-free profits. Key techniques include calendar spread and intermarket arbitrage. 
• Spread Trading: It is a strategy of taking offsetting positions on two related futures contracts to tap the differences in prices. Traders thus build a spread instead of trading one futures contract, by purchasing one contract and selling another. 
• Options on the Underlying Asset: Options on futures combine the latter’s leverage with the former’s flexibility. This contract gives its holders the right (without the obligation) to purchase/sell a futures contract at a particular price before the expiration date of the option. 

Risks and How to Mitigate Them 

Some of the risks related to futures market investing include:

• Leverage Risk: Leverage may amplify not just your gains, but also losses, thereby leading to substantial risks in case the market goes against your position. The mitigation strategy here is to set stop-loss orders, while ensuring that you avoid risking more than you can safely afford to lose. 2% is a common thumb rule, where you do not stake more than 2% of your account equity for one trade. 
• Market Volatility: Futures markets may witness sizable volatility, leading to sudden price swings that deplete your capital. The mitigation strategy in this case is to diversify the portfolio across multiple asset classes, using stop-loss orders, and tracking market conditions carefully. 
• Liquidity Risks: Some futures contracts may have lower liquidity levels, making it tough to enter or exit your positions at the desired prices. You can counter this by selecting contracts with proper liquidity and considering strategies like iceberg orders for lowering the effect of illiquidity. 
• Basis Risks: It happens whenever the price of any futures contract does not move in sync with the spot price of any underlying asset. This may lead to a mismatch in your hedging strategy. The solution is to analyse the relationship between the spot price and the futures contract and use alternative hedging methods if needed. 
• Default Risks: The other party in any futures contract may default on obligations, making it a major risk for traders. You can mitigate this risk through exchange-based clearing systems, which function as intermediaries between sellers and buyers. 

Conclusion: Mastering Futures Trading 

Trading in the futures market requires discipline and emotional control along with continuous learning and developing an understanding of your risk appetite above everything else. You can consider taking professional advice before starting your futures trading journey.