What are the Advantages of Futures?

A futures contract is a right and obligation to buy or sell a contract at a future date at a price that is determined and agreed upon today. Futures are normally traded on a recognized stock or commodity exchange. Instead of buying Reliance stock, you can buy Reliance stock futures and instead of selling Reliance stock, you can also sell Reliance stock futures. In the equity market, the two most common types of futures are stock futures on individual stocks and index futures on select indices like Nifty, Bank Nifty, etc.

What are the benefits of futures trading? One of the key benefits of futures trading is leverage. In other words, one of the major advantages of trading futures is that you can pay a margin and get the same benefit of buying the entire quantity of stock. The other advantages of trading futures include speculation, arbitrage, hedging, etc. Let us now turn to the advantages of future contracts.

What are the advantages of futures contracts?

Futures are easy to trade and one of the big advantages of future contracts in the Indian equity market context is that they are fairly liquid. At least, if you look at the index futures and the top 25 stocks, the liquidity is fairly high so getting stuck in positions is hardly a risk. Here are some advantages of futures.

Take a consolidated view of markets or sectors

That is so much safer than trying to trade stocks with futures. For example, if you are positive in the banking sector due to a likely rate cut by the RBI, what do you do? Instead of selecting banking stocks, you can just buy the Bank Nifty Futures. You get all the advantages that banks will get from a rate cut but you will not expose yourself to a stock-specific risk. This is one of the biggest advantages of futures contracts in that it avoids the micro risk of stocks.

Future trading is agnostic to market direction

If you are positive about a stock, you can buy it. That is simple. However, if you are bearish, you can either sell your delivery or you can sell short for intraday. Beyond that, you need to give delivery. That is a big constraint in falling markets. One of the major advantages of futures contracts is that you are agnostic to direction. If you are positive, buy futures and if you have a negative view, then just sell futures.

Lower margins can be a force multiplier

To understand one of the most fundamental advantages of future contracts let us take a small example. If you want to buy 600 shares of Infosys at the current price of Rs.1475, it would cost you nearly Rs.900,000. Instead, you can buy one lot of Infosys futures with a margin of Rs.180,000. You are paying for 120 shares but getting virtual participation in 600 shares. In other words, your profits can be 5 times better. A word of caution. If you are not careful with risk, even losses can multiply.

Limit downside risk in stock positions with futures

Let us take a hypothetical example, You expect the market to correct by 10-12% due to macro concerns. However, you believe that would be temporary and markets would bounce back. You can hold on to your stocks and sell Nifty futures against that. When the market corrects, you just sell the futures and the profits will help you to reduce the cost of holding your cash market position. The big advantage of futures contracts is not that they can be used for speculation but that they can be used to hedge your risk.

There is no risk of default in trading futures

This is one of the huge advantages of future contracts in India. How does that happen? When you buy and another person sells, there is always the risk that one of you could default. On the stock exchange, the clearing corporation gives a counter-guarantee for every futures trade in the stock market. That will ensure that even if one party defaults, the exchange makes good the loss through the clearing corporation. That eliminates single-party default risk and you can trade with confidence.

Index futures can help diversify your portfolio

That sounds interesting, but how exactly does that work? It is slightly opportunistic. Let us assume that you are holding a portfolio predominantly biased in favor of financial stocks. However, you see the risk of RBI hiking rates. You believe that non-cyclical sectors like FMCG, pharma, and IT would not be perturbed. They would benefit. Instead of making your portfolio heavier by buying these stocks, you can simply go ahead and buy futures on FMCG or IT and automatically de-risk your portfolio. That is one more of the many advantages of future contracts.

Finally, remember that it is cheaper to trade futures

This point needs no reiteration. The commission rates and the STT rates on index futures are much lower compared to equities or even stock futures. Most brokers today offer you fixed brokerage packages on indices making it a lot more economical.

What are the different types of futures contracts?

Here is a quick look at different types of futures contracts available in India

1. Stock futures are contracts on select individual stocks
2. Index futures are contracts on select representative indices
3. Currency futures are contract on currencies vis-à-vis rupee i.e., USDINR, EURINR, etc
4. Cross currency futures are contracts on two currencies, other than INR
5. Commodity futures, a contract on key agricultural commodities, industrial commodities, oil & gas as well as precious metals
6. Interest rate futures, a future bet on government securities
7. VIX Futures, a futures trade on increase and decrease in volatility

How to start trading futures

To begin with, always use futures to hedge risk or do futures trading in very small lots. Ideally, you must not start by speculating in large quantities. Use futures to protect your risk of fall in price.

Frequently Asked Questions

What do you mean by liquidity?

Liquidity is the ease of entry and exit from a position in the market at low bid-ask spreads and without the trade impacting the price in a significant manner. Sufficient liquidity is a must before taking positions in futures.

How can speculators make money in futures?

Speculators take positions in futures based on their view. If they expect the stock or index to go up, they buy futures. If then expect to go down, they sell futures. They focus on booking short-term profits on such positions.