How does Futures pricing work?
As we discussed earlier, a futures contract is an agreement to buy or sell an asset on a specific future date. Futures are exchange traded, highly regulated, and usually liquid. They offer individuals an easy way to invest in currencies, commodities, stock indices, and individual stocks.
Now let try to understand the mechanics of futures contracts.
The mechanics of trading futures
Let’s use a crude oil future as an example to illustrate the mechanics of trading futures. Assume that on 1st July the investor goes long one July crude oil contract at a price of Rs 3,500 on the MCX. Contract specifications are as follows:
- Expiry: 19th July
- Quotation: Rs. per Barrel
- Trading Unit: 100 Barrels
Initial Margin: 5% When I enter into the contract, the total value of the position is Rs. 3,50,000 (This is the price multiplied by number of barrels multiplied by number of contracts). I have to put up the initial margin which is 5% of the total contract value, i.e. Rs. 17,500. This money is held by the exchange as collateral in case the position loses money. At the end of the trading day, the exchange will mark to market the position. This means that they will pay me if the contract has increased in the value, or I will pay them if it has decreased in the value. The next day, I will again keep a margin deposited with the exchange to cover potential future losses. The profit/loss from this position will be the difference between Rs. 3,500 and the final spot price on 19th July multiplied by 100 barrels. Because I have gone long, if the spot price is higher (lower) than Rs. 3,500, I will make a profit (loss).
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