Basics of Futures Trading and Its Role in Market Hedging

Futures trading consists of purchasing or selling contracts that bind the parties needing to buy or sell a given asset at a specified date in the future and price. These contracts include contracts for differences (CFDs) and options on physical and other financial instruments (e.g., commodities, currencies, and stock indices). This article looks into the fundamentals of futures trading strategies and explores their crucial role in market hedging.

How Futures Contracts Work?

On entering a futures contract, you agree to buy or sell an asset at a given price on a date in the future. For instance, if you believe the price of gold will rise, you might buy a gold futures contract. If gold’s price increases by the contract’s expiration, you profit from the difference.

Let’s consider an example. Suppose you buy a gold futures contract for 10 grams at ₹52,873 per 10 grams, with delivery in three months. If on expiration the price increases to ₹54,126, your profit would be ₹1,253 (minus any applicable fees).

The Role of Futures in Market Hedging

Futures trading strategies play an important role in market hedging, it is a risk management technique used to avoid possible investment losses by taking an opposite position in a related security.

Consider a scenario where you are a portfolio manager overseeing a large investment in ABC Industries stocks. You are concerned about potential market volatility in the coming months that could negatively impact the stock price.

To protect the investment, you decide to use futures contracts as a hedging tool. You short PQR Industries futures contracts equivalent to your stock position. In case the price of the stock dips from ₹2,500 to ₹2,300 in three months,  your investment will become worthless in three months. However, your short position in the futures market would profit from this price decrease and compensate for the loss of value on your stock holdings.

Popular Futures Trading Strategies in India

Here are the various futures trading strategies used by traders in India:

1. Trend Following: With this strategy, you determine and follow the overall direction of the market. Technical indicators like moving averages are used by traders to identify trends. If the Nifty 50 Index is bullish, the trader will buy Nifty futures to benefit from further upswing.
2. Spread Trading: It is a strategy that involves buying and selling future contracts in order to take advantage of the price difference between the two. For example, a trader may purchase June delivery contracts for XYZ Industries futures and sell July delivery contracts for XYZ futures, speculating on the price relationship between the two contracts changing.
3. Statistical Arbitrage: This approach takes advantage of price differences across related markets. For instance, if XYZ shares are trading at ₹1,452 in the cash market and XYZ futures are trading at ₹1,458. Then, a trader comes in, buys the shares, and sells the futures, earning a risk-free profit of ₹6 per share (less transaction costs).
4. Mean Reversion Trading: Mean reversion trading is a strategy where assets that deviate significantly from their historical average price are expected to return to their mean, allowing traders to capitalize on price corrections.

The Impact of Recent Regulatory Changes

The Securities and Exchange Board of India (SEBI) has recently come up with new future trading guidelines. The revised rules aim to improve market stability and protect investors through:

• Stricter position limits for stock derivatives
• Tighter norms for index derivatives
• Introduction of a pre-open session for futures trading

These regulations might affect how traders approach futures trading strategies in the coming years.

Risks and Considerations in Futures Trading

While futures offer significant opportunities, they also come with risks. The leverage in futures trading can strengthen both gains and losses. Here are some tips to help manage these risks better:

• Use stop-loss orders to limit potential losses
• Diversify your futures portfolio across different assets
• Regularly monitor and adjust your positions based on market conditions

Conclusion

Hedging and futures trading strategies are potent tools in the financial markets, offering opportunities for profit and risk management. As the Indian economic geography evolves, understanding these concepts becomes increasingly important for investors and traders. Educate yourself, stay informed about market trends and regulatory changes, and approach futures trading with a well-thought-out strategy.

FAQs

Are futures trading profits taxable in India?

Yes, profits from futures trading are considered speculative income and are taxable as per your income tax slab. Short-term capital gains tax rules apply if you hold positions for less than 12 months.

How to use futures for long-term investment?

Futures are generally used as short-term instruments, but they can also be used as part of a long-term approach to hedging or gaining exposure to certain assets. To achieve this, however, requires careful planning and continuous portfolio management.