We as traders take exposure in Nifty Futures. Sometimes we loose money and sometimes we make money. But how exactly Nifty Future works. If we have deep understanding of this instrumnet may be our chances of profit will increase. Once we get a hang of this instrument we can also apply the same concept to stock futures. In this article let's try to find out how this instrument works. We will take an example of NIFTY index futures and see how it works.

Specification

Let’s look at the specification of NIFTY Index futures;

The listing of index futures in a newspaper on a date (Let’s say 11-Nov-2009) at NSE is as follows. The near month is November, mid-month is December, and far month is January. You can always have 3 contracts in NSE.

Futures: NIFTY

The numbers indicate the following:

Opening price * Days High * Days Low * Closing price * Open position * Number of contracts traded

How it works

We will now see a practical example of futures in action.

Decide to buy:

Suppose I go long on the NIFTY contract on 11-Nov-2009. This means I buy the NIFTY futures contracts on 11-Nov-2009 at 1:00 PM when the price was 5085. Since each NIFTY futures contract contains 100 units and hence the value of 1 contract is 5085 * 1 * 100 = 5,08,500. I will not have to pay the full amount as I am buying the futures contract and not the index. I will have to pay initial margin.

Margin payment:

The initial margin depends on type of financial instruments you choose. Some brokers may ask you for more margins though. Let’s say that the initial margin for me is 10%. This means I will have to set aside 10% of 5,08,500 = 50,850. This amount will go to my margin account.

Mark to market settlement:

Suppose the day closed at 5090. In this case, you earned the profit of 5 per unit. Hence your account will increase by 100*5 = 500. Your margin account will now have 50,850 + 500 = 51,350

This new price of 5290 will be now the price on which next settlement will be done.

On 12-Nov-2009, the NIFTY index futures closes at 5100. In this case, I gain 100*(5100-5090) = 1000. Observe that we are taking the profit or loss on 5090 (last day’s closing price) and not the price at which the contract was bought. Your account will now have 51,350 + 1,000 = 52,350

On 13-Nov-2009, the closing price of NIFTY index futures is 5095. Now since the price went down, my account will be deducted by an amount of 100*(5100-5095) = 500. Your account will have 52,350 – 500 = 51,850.

Suppose on the next day, the futures price went down to 4900. Your loss will be 100*(5095 – 4900) = 19500. Your account will have 51,850 – 19500 = 32,350. Your account now has 51,850 – 19,500 = 32,350. Since this is a big loss, the broker will look at my maintenance margin. Maintenance margin is typically 75% of the initial margin. This means you have to maintain at least 75% of initial margin (50,850) which is 38,137. Your account balance of 32,350 is less than 38,137 and hence the broker will give you a margin call and you have to deposit amount which brings the margin account to the level of initial margin. In this case, I have to deposit an amount of 50,850 – 32,350 = 18,500.

At the end when the contract is has to be settled, similar transaction happens and the contract is closed. Most of the futures end up in cash settlement than delivery as it is more convenient. In fact, in India, all index and stock futures are cash-settled.

Equity Futures:

Equity futures work the same way. The only difference is number of units in each contract. Moreover, while in index futures, there is no option to take delivery (what will exchange deliver if you want 1 unit of Sensex?), equity futures can be closed by delivery. But currently NSE is doing cash settlement instead of delivery settlement.