Futures: Understanding the Basic Terms

Futures are financial contracts that obligate the buyer to buy and seller to sell the underlying asset on a specified date for a predetermined price. Such contracts are standard and include the quantity and quality of the underlying asset. These are traded on the derivatives exchange. Some contracts may include physical delivery while others are settled in cash.

Here are some basic terms that will help you trade in futures and options.

  1. Underlying asset

The underlying asset provides value to the contracts and may be any financial product. Some of the underlying assets are stocks, currency, commodities, and market indices.

  1. Lot size

The derivatives exchange specifies lot sizes for each type of futures contract. You cannot divide the lot size and it is different for every underlying asset.

  1. Value of lot

The value of a single lot is calculated by multiplying the price of the underlying asset with the lot size.

  1. Margin money

When you trade in these contracts, you do not have to pay the entire amount upfront. You need to pay a small amount, which is known as the margin money. It is a percentage of the value of the lot.

  1. Life of a contract

Generally, the life of a contract is three months. At a particular point in time, the contracts are available for different time limit subject to expiry. These are one month (near month), two months (mid-month), and three months (far months).

  1. Open interest

Open interest means the number of ‘yet to be settled’ contracts. It is calculated by multiplying the lot size and the total number of open contracts.

  1. Marked to market

Because futures contracts are regulated by the authorities, prices are said to be marked to market. In simple terms, it means the change in the value at the end of the trading day, which is reflected in your account.

  1. Long and short positions

Unsettled purchase positions at a particular time are known as long positions. On the other hand, unsettled sales positions at a specific time period are referred to as short positions.

  1. Spot and spread

The current market price is known as the spot price and the price of the contract is referred to as the futures price. Spread is the difference between these two prices.

  1. Expiry date

All contracts expire on the last Thursday of each month. On this date, all contracts cease to exist and all obligations must be fulfilled. Moreover, all rights are invalid post this date. All contracts are automatically settled on the expiry date.

There is no actual delivery that occurs in such financial contracts. The derivativesmarket is characterized by the use of higher leverage relative to the underlying asset. These investments are used to either hedge or speculate the price of the underlying.