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Trading for a perfect future

Utpal K Choudhury

If you had known - or believed - two weeks ago that VSNL's share price was about to fall in the next few days, could you have made money from that knowledge? Well, you could sell the share short.

Selling short means selling the share with the idea of buying it later in the day at a lower price. The difference between the buying and selling price is the profit or loss from the transaction.

Under the present system investors can't carry a short position for more than a day. But the same transaction can be carried out for longer periods with the help of futures. Futures can be sold at any time and a short position can be carried for up to three months.

What's more, if you are certain about the direction the Sensex or the Nifty will take it is possible to buy futures and make a call on that too.

What are futures? Futures are contracts where two parties agree to trade in a particular asset - like a stock or an index - at a certain price on some future date. The future date on which the contract is exercised is called the 'expiry date' and the asset is called the 'underlying asset' or 'underlying'.

Thus, in futures trading the future price of the underlying is determined in advance on the day of trading. So, if you foresee a fall in the price of a share, it is worth selling a future of the share and vice versa.

Let's see an example of how this works. Say you sell a VSNL future, which is scheduled to expire on July 25, 2002, today at Rs 155. That means on July 25 you will sell VSNL at Rs 155 irrespective of its market price on that day. If the market price of VSNL on the expiry day is Rs 140, which is lower than the selling price, you will gain (Rs 155 - Rs 140 =) Rs 15.

On the other hand, if the market price of the stock on the expiry day is Rs 165, which is higher than the selling price, you will lose (Rs 165 - Rs 155 =) Rs 10. The opposite is true if you buy the contract. Importantly, you don't have to take or give delivery of the underlying share.

The trade is settled by transferring the price difference. So you need not maintain a demat account.

Though the calculation of profit and loss is very simple, the process of carrying a future position till expiry is not that simple.

A future trade is settled every day at the closing price and then carried forward to the next day at the same price. The daily profit/loss is credited/debited accordingly. This process is called 'marked to market'.

To take another example: if you sell a July VSNL future at Rs 155 and, say, VSNL closes the day at Rs 150. So you gain Rs 5, which will be transferred to your account and you are free to withdraw it. Your short future is now re-valued at Rs 150 - the closing price of VSNL.

Next day VSNL closes at, say, Rs 160. Being a future seller at Rs 150 (re-valued price) you lose (Rs 160 - Rs 150 =) Rs 10 and your broker may ask you to reimburse this amount immediately. Thus, the transaction is carried forward from one day to another till its expiry.

The price of a future contract is based on the price of the underlying stock. In a perfect market, the future price remains slightly above the price of the underlying share due to a factor called 'carrying cost'.

Futures contracts are traded in lots, where the size depends on the price of the underlying stock. For example, the Nifty future is traded in a lot of 200 contracts.

In India, the expiry date of the future contract on stock is fixed as the last trading Thursday of each month. And at a time there will be three different expiries - the current month, next month and the month after that. Currently, you will find futures with an expiry of July 25, August 29 and September 26.

Another attraction of futures trading is that market players need to deposit only a fraction of the total amount with their brokers as the margin money. For example, by depositing only around Rs 25,000 it is possible to trade in Nifty futures worth Rs 200,000.

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