Within the arena of futures trading, traders of various types exist. Some trade solely based on the nunches they have, going into a trade due to a ‘gut feeling’. Other traders involved in futures trading will trade in a more careful way, using a calculation to conduct and execute trades. Although all trading has, in its very nature, an element of risk, futures trading that is formula-based goes according to a ‘calculated risk’ method of trading.
To fully understand the futures pricing formula and its relevance to futures trading, you need to know what futures trading means. In the simplest way, a futures contract acts as an agreement to sell or buy an asset at a date in the future, at a price that has been agreed on. Typically, futures contracts involve trading on an exchange basis, wherein one party agrees to purchase a specific amount of a commodity or securities, taking delivery on a given date. The party who is the seller agrees to provide the commodity (commodities) or securities at that particular date.
The price of a future is determined by its underlying asset. The price may shift, going higher or lower, when the asset’s price shifts. However, a future’s price is not equal to the value of the asset itself. For example, the on-the-spot or ‘spot’ price of an asset will be different, perhaps, than its price in the future. The difference in the cost of a future currently and its price in the future is known as ‘Spot Future Parity’. Now, you may be wondering what causes prices to differ during different times. Differences in prices of futures are due to differences in rates of interest, dividends and the period to the expiry of the futures contract. All these factors are taken into account while making use of the futures pricing formula. A futures pricing formula is, thus, a mathematical representation of how a futures price changes according to changing variables of the market. It can be written as:
Futures Price = Spot Price x (1 + rf - d)
Here, rf is the risk-free rate and d represents the dividend. The risk-free rate is what you are able to earn throughout the year in perfect market conditions (without any risk).
It is important to note that when traders trade in the online share market in futures contracts, they are not looking to receive the underlying asset of a futures contract. It is the profit that it yields that is of interest to traders. Hence, they base their pricing on futures on the hunches they have or their intuition about the change in price of an underlying asset. This is what leads traders to base futures contracts on a futures price quote.
Trading in futures contracts requires a great deal of experience. However, understanding the futures pricing formula is a good way to begin your journey. You can always visit the Motilal Oswal portal for more information.
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