Futures contracts enable investors to use various tactics that can prove profitable while trading. One can resort to arbitrage, hedging and speculation depending on one's objectives.
While hedging safeguards against risks due to price variation, arbitrage results in risk-less profit and speculation aims at generating very large profits. However, a futures contract is an obligation and, consequently, the investor must fulfil it even if the asset price on the settlement date is not favourable for him.
So, one needs to understand the mechanism and risks involved before entering the futures market. Here are some terms that can help you.SPOT PRICE
This is the price at which the futures contract trades in the market. It is determined by the equilibrium between the forces of demand and supply of buy/sell orders on the exchange.
This is also known as lot size and is the minimum quantity of an asset (stocks, indices, commodities) that one needs to buy or sell to trade in futures.
The difference between the futures price and spot price is called basis. Its major determinants are demand and supply, because of which it keeps changing, and can be either positive or negative. If the demand is stronger than supply, the spot price will rise relative to the futures price, which, in turn, will strengthen the basis. On the other hand, if the supply is higher, the spot price will fall and the basis will weaken. The basis tends to reduce as the futures contract approaches its date of expiration.
COST OF CARRY
The futures price of an asset is determined using the concept of 'cost of carry'. It is the cost associated with holding a position. In case of commodities, such as wheat and rice, there is a cost associated with storage. Similarly, in case of financial assets, the cost of carry includes interest and dividends. The fair futures price of an asset is determined by adding the cost of carry to the spot price.