A lot of you must be aware about the simple concepts of equity trading like buying and selling shares. So if you want to buy shares of any company you need to pay the complete amount and buy the shares. For example I will consider PNB(Punjab National bank) in this article to explain further.
So lets say I want to buy 100 shares (CMP Rs 141). I will need 141 X 100 = 1,41,000 + brokerages which may apply in my demat account and I can go ahead and buy the shares. Once I buy , I become the owner of the shares. So whatever it may be like 0.000000001 % or whatever % , I become that much % owner of the company. Pretty straightforward till this point. Now lets see what exactly are futures and how do they work.
A future is basically a contact between buyer and selling to buy (this will be buyers obligation) or sell(this will be sellers obligation ) a particular quantity (lot) of any share at the agreed price. And that agreed price is the price at which you buy or sell that share.
Lets see this in our example .
Trader A buys 1 lot(currently 7000 shares) of PNB March futures at Rs 141.5 from trader B who sells 1 lot. Now at the end of the contract which is generally last Thursday of the month Trader A agrees to buy 1 lot of PNB at 141.5 and trader B agrees to sell 1 lot for Rs 141.5. So if the price at the end of the contract is higher than 141.5 trader A will make profit and trader B will make loss since A can buy it from B at 141.5 and sell it in market for higher price. Alternately if the price falls Trader B shall make profits because he has sold something for 141.5 which costs less in the market on expiry day.
In general , traders do not actually exercise the contracts and just square off their positions which means buyer will sell his lot of future and sellers will have to buy the lot he has sold earlier. Also, a trader may square off his position in 5 mins, an hour, a day or few days before the contract expires. One may be in profit and the other may be in loss. For every buyer there is a seller and vice versa. That does not necessarily mean that if buyer is in profit seller is in loss because you don’t know if anyone has hedged their positions or if they have 7000 shares of PNB already in their account to cover the losses in future positions. There may be many different strategies in which future positions can be taken. Each one is a separate point of discussion and will require detail explanation with example. Wil try to write specific articles on some of the strategies soon.
I hope I am able to explain the concept of equity future in simple terms which a beginner can understand. Do add your views, suggestions and queries in the comments below and subscribe for more such articles.