The derivatives market is one of the most liquid and often traded markets in India. The number of derivative contracts that are being traded every day is increasing at a rapid pace. Among derivatives, futures contracts are the simplest and easiest to understand and trade. In this article, we are going to focus on what futures contracts are and the different types of futures that are available for trading in India.
What are futures contracts?
Futures contracts are agreements between two parties to purchase and sell their underlying assets at a predetermined price on a future date, which is often the contract expiration date. The value of futures contracts is directly linked to the value of their underlying assets. For example, if the price of the underlying asset falls, the value of the asset’s futures contracts will also go down.
The futures contracts in India are standardised by the exchanges, meaning they have set terms and conditions that cannot be changed by either of the two parties. Both the buyer and seller of the contracts are obligated to perform their end of the contract on the expiration date. Failing to do so can lead to severe monetary penalties.
Categories of futures contracts
Now that we have answered what futures contracts are, let us move on to the different categories. There are two major categories of futures - contracts with mandatory physical delivery and contracts with no physical delivery.
In the case of contracts with mandatory physical delivery, the seller of the futures contract must deliver the agreed-upon quantity of the underlying asset to the buyer on the contract expiration date. Commodity futures and stock futures have mandatory physical deliveries.
Futures contracts with no mandatory physical delivery, on the other hand, are cash-settled. This essentially means that the difference between the price of the underlying asset and the futures contract is settled between the buyer and the seller. Index futures, currency futures and VIX futures are examples of contracts that are cash-settled.
For example, let us assume that you buy a futures contract worth Rs. 2,50,000. On the contract expiration date, the underlying asset’s price rises, leading to the futures contract increasing in value to Rs. 3,00,000. In this case, the difference of Rs. 50,000 (Rs. 3,00,000 - Rs. 2,50,000) will be paid by the seller to you.
Six types of futures contracts
Futures contracts are classified into different types depending on the underlying asset. Here is an overview of the six different types of futures contracts that you can find in India.
- Stock futures
Stock futures are one of the most common types of futures contracts. These contracts have equity stocks of companies as their underlying asset. All stock futures that are held until expiry must mandatorily be physically settled.
For example, when you purchase a stock futures contract, you essentially agree to purchase the underlying equity stock at a specified price on the contract expiration date. On the other hand, if you sell a stock futures contract, you agree to sell the underlying equity stock at the specified price on the contract expiration date. - Index futures
Index futures are also among the most popular types of futures contracts. Such contracts have market indices as their underlying assets. Nifty 50 futures and Bank Nifty futures are a couple of examples of index futures. Since an index is not an asset per se, it cannot be physically delivered. Therefore, all index futures are automatically settled in cash on the contract expiration date. - Commodity futures
Commodity futures are quickly becoming the most preferred types of futures contracts in India. As the name implies, these futures contracts have commodities as their underlying asset. The list of commodities includes both agricultural commodities and non-agricultural commodities. All commodity futures are mandatorily settled through the physical delivery of the commodities. - Currency futures
In currency futures contracts, currency pairs are the underlying asset. Some of the currency pairs that you can trade in include cross-currency pairs such as EUR-USD, GBP-USD and USD-JPY and INR pairs such as USD-INR, EUR-INR, JPY-INR and GBP-INR. All currency futures contracts are cash-settled on the expiration date. - Interest rate futures
Interest rate futures are one of the least popular types of futures contracts among retail traders. In such contracts, an interest-bearing bond is the underlying asset. Government securities and 91-day T-Bills are a couple of examples of the type of interest-bearing bonds that these futures contracts are linked to. Interest rate futures provide the option for both cash settlement as well as physical settlement. - VIX futures
VIX futures contracts have the India VIX index, which is a market volatility index, as their underlying asset. These futures gain in value if volatility in the market increases and lose value if market volatility drops. Since the volatility index is not an asset, all VIX futures are settled in cash. However, India VIX futures are no longer offered for trading by the stock exchanges due to their low popularity and liquidity.
Conclusion
With this, you must now be aware of the various types of futures contracts available in India. Futures contracts play a crucial role in the financial markets. They enable traders to capitalise on the short-term price movements of an asset. Even long-term investors can use futures to hedge against short-term risk on an asset. However, before you start futures trading, remember to conduct thorough research into the various types of futures contracts and the risks they pose. This will help you make better trading decisions.
