Having known what futures contract means as explained in last week's article, let us proceed to know how to invest in futures. Buying and selling futures contract is essentially the same as buying or selling a number of units of a stock from the cash segment, but without taking immediate delivery. Let us understand this with the help of an example.
Investing in futures more profitable
When you buy in the cash segment, you have to pay the entire value of the shares purchased. In case of derivatives, you pay a margin money. This helps reduce the risk that the exchange undertakes and helps in maintaining the integrity of the market.
For example, if we buy 3,000 shares of Indian Oil Corporation on September 12, 2018 it would have cost Rs 145 (stock price) X 3000 shares = Rs 4,35,000 in the cash segment. If price increases to 150 per share, the profit will be Rs 5 (per share profit) X 3000 = Rs 15,000. So, an investment of Rs 4,35,000 gives us a return of Rs 15,000. However, in derivatives we pay something called margin money. Let us assume this margin is 15 per cent.
So, a margin of Rs 65,250 is kept with the agent. On the assumption that the price of IoC stock has risen from Rs 145 to Rs 150. One gets a profit of Rs 5 X 3000=Rs 15,000. If the price has fallen from Rs 145 to Rs 140, you loose Rs 15,000. Since profit or loss is calculated on a daily basis till the contract expires, margin amount is supposed to be maintained. One can settle the contract on or before the expiry of the contract.
The contract is usually settled on the last Thursday of the month. If you buy a futures contract in the month of September, you get to select the contract till November. If you are in a loss on the last Thursday of September month, the advantage of staying in a future is you get a roll over to the next month if you wish.
In the above example we got a profit of Rs 15,000 on investing Rs 4.35 lakh in cash segment. Whereas in derivatives we invested just Rs 65,250 to get a same profit of Rs 15,000. Thus, investing in derivatives is definitely profitable when compared to cash segment but one needs to have a proper understanding of the movement of stocks or index futures as the losses are also in the same proportion. (The author is a home maker who dabbles in stock market investments in her free time)