There are various types of investment options available for investors and traders in the stock markets. These can belong to primary or secondary markets. The primary markets are the traditional form of investing or trading in stocks and the secondary markets are the derivative markets which include the futures and options contract, forward contracts, and swaps. These secondary markets are quite complex and require the investors and traders to understand them carefully.
To understand the trading model of the futures contract, it is important to understand the way it is priced. Given below are the meaning of the futures contract and the way it is priced.
What are stock futures?
Futures contracts are part of the derivative markets and are financial contracts where the underlying assets to be traded are the individual stocks. Unlike options, these are contracts that have a legal binding to be executed by the participants. These contracts are to buy or sell a fixed quantity of the underlying equity shares which is to be executed at the specified future date and at an agreed price. Future contracts have defined parameters like the lot size, the expiration date, tick size, unit of price quotation, as well as the method of settlement.
The prices of the futures contracts are determined by the price movements or the cost of the underlying asset. If the cost of the underlying asset increases, the cost of the futures contracts will also increase. However, it is to be noted that the cost of futures may not always be equal to the cost of the underlying asset. Also, the spot price of any asset can be different from the future price. This difference in the prices is known as the Spot-Future Parity. There are many reasons for the difference in prices like the dividends, the time of expiry, and the rate of interest. Therefore, it is important for investors and traders to understand the price calculations.
What is the formula for calculating future prices?
As mentioned above, the price of the futures contract is based on the price of the underlying stocks and is generally higher. There are various components that are used to calculate the prices of the futures contract. There is a specific formula that can be used by investors and traders to calculate the price of futures contracts.
The formula of calculating future prices is,
Future Price = Spot Price * (1+rf-d).
In the above formula, ‘rf’ stands for the risk-free return while ‘d’ is the dividend.
A risk-free rate of return is the rate at which investment provides returns without any risk i.e. at zero risks. Some examples of such risk-free investments are Government Securities, Treasury bills, etc.
The future pricing can also be adjusted to calculate the fair value of the future based on the number of days left for its expiry.
Let us consider the following example to understand the calculation of future pricing better.
The spot price of shares of Company A is Rs. 1000 and the prevailing risk-free rate is 8% and the number of days for expiry is 20. The company has not declared any dividend. The futures price in such a case
is calculated as under.
Futures Price = 1000 * [(1+ 8% * (20/365)]-1
Futures price = 1004.384
The difference between the spot price and the futures price is translated into the concept of premium or discount. If the futures price is higher than the spot price, it is considered to be traded at a premium. Similarly, if the futures price is traded lower than the spot price, it is considered to be at a discount.
What are the basic terms to understand in futures pricing?
In the futures market, the difference between the spot price and the futures price forms the basis of the spread. At the beginning of the futures contract, the variance is at the highest but as the contract nears its expiry, the difference between the spot price and futures prices reduces and are ideally equal at the time of expiry.
There are a few concepts that are important in understanding futures pricing. These concepts are highlighted below.
Futures are part of the secondary market and are traded through an exchange known as a clearinghouse. Traders can undertake futures trading in the futures Index through NSE.
Buying and selling the Futures contract
Futures contracts are legally binding documents that are to be honoured by both the buyer and the seller. In these contracts, the buyer usually has the long positions and the seller usually has the short positions.
Futures contracts require the traders to provide a margin to the clearinghouse (usually ranging between 3% to 12%) to initiate the trade. This margin acts as a surety that the parties will honour the contract. In the event that the margin money falls below the maintenance amount due to mark to market, the trader will receive a call to meet the difference known as a margin call.
Marking to Market
This is a process used to settle the futures prices on a daily basis as they fluctuate every day due to active trading. It is the practice of the clearinghouses to pay the price difference after each trading. It can be done by debiting or crediting such a differential amount from the margin amount deposited by the traders.
Futures pricing is an important concept for the traders to learn as it can help them understand the pricing model and the futures contract in a better manner. The difference between the strike price, spot price, and the futures price is ideal to create good hedging positions. Hence, understanding how the futures are priced will help them take better hedge positions and maximize their returns.
The different types of traders in the futures contracts are speculators and hedgers. Speculators form the majority of the futures markets.
The basic difference between the spot price and the futures price is that the former requires immediate buying or selling of the security along with payment and delivery while in the latter the participants can make the payment and delivery at a later date. Also, the spot price is usually lower than the futures price
The basic assumption of futures pricing at the time of expiry is that it will eventually match the spot price.
If the spot price is lower than the futures price, the markets are expected to rise in the future or indicate a bullish market. On the other hand, if the spot price is higher than the futures price, the markets are expected to fall in the future or indicate a bearish market.