Futures and forwards, and the price you actually agree to
The answer
A future is a contract to buy or sell something at a fixed price on a fixed future date. Both sides are obliged. You are not paying for the goods today; you are agreeing the price today, putting down a deposit called margin, and settling the difference every single day until the contract ends.
Why this costs you money
Most people who lose money in futures were right about direction and wrong about one of 3 things: the daily settlement, the deadline, or the size.
The daily settlement is the one that surprises people. A futures position is not settled at expiry. It is settled every evening. If the price moves against you today, money leaves your account tonight. If you do not have the money, the broker asks for it by the next morning, and if you cannot pay, the position is closed at whatever price exists at that moment.
That mechanism has a consequence people do not expect. You can be completely correct about where the price ends up and still be removed from the trade before it gets there. The market does not need to prove you wrong. It only needs to go against you far enough, for long enough, that you run out of cash.
The deadline is the second thing. A future expires. When it does, the contract is settled — in cash for index contracts in India, and by actual delivery for many commodity contracts. If you want to keep the position, you must close the expiring contract and open the next one. That is called rolling, and it is not free. The next contract usually trades at a different price. Over a year of rolling, that difference can be larger than the price move you were trying to capture.
The size is the third and it is the biggest. Because margin is a fraction of the contract's value, a futures position is much larger than it feels. Buying 1 lot does not feel like committing several lakh rupees, or several tens of thousands of dollars. It is.
Here is the honest description of what a futures position loses money on. It loses when the price moves against you, by the full notional amount. It loses when the roll is unfavourable, even if the price does not move at all. It loses when your cash runs out before the thesis plays out. And it loses to costs on every roll, in a segment where the position must be renewed month after month.
How it works
Start with the forward, because it is the simpler idea and it came first.
A forward is a private agreement. A wheat farmer and a flour mill agree in June that in December the mill will buy 100 tonnes at Rs 2,400 per quintal. Whatever the December price turns out to be, that is the price they use. The farmer now knows their revenue. The mill now knows its input cost. Both have given up the chance of a better outcome in exchange for certainty.
A forward has 2 problems. First, the terms are custom, so neither side can easily get out of it. Second, and worse, each side depends on the other actually performing. If the December price is Rs 3,000 and the mill has gone bankrupt, the farmer has a piece of paper, not a price. That dependency is called counterparty risk.
A future is a forward with those 2 problems engineered away.
- Standardisation. The exchange fixes the quantity, the quality, the delivery date and the delivery location. Every contract is identical, so anybody can trade with anybody.
- A clearing house in the middle. After a trade is agreed, the clearing house becomes the buyer to every seller and the seller to every buyer. You do not depend on the person who took the other side. You depend on the clearing house.
- Margin. Both sides post a deposit. The clearing house holds it.
- Daily settlement, called mark to market. Every evening, gains and losses are paid in cash. Nobody is allowed to accumulate a large unpaid loss.
Those 4 features together are why an exchange can let strangers make binding promises to each other about a price 3 months away.
Margin, precisely
Two numbers matter, and confusing them is a common and expensive mistake.
Initial margin is what you must deposit to open the position. It is set to cover a large single-day move, using a risk model. In India this is the SPAN margin plus an exposure margin. In the United States, futures exchanges publish an initial performance bond per contract.
Maintenance margin is the level your account must stay above. If daily losses take you below it, you receive a margin call: pay the difference, or the position is reduced or closed.
Margin is not a cost and it is not a payment. It is a deposit you get back. But the loss is not limited to it. If the market gaps far enough, your account can go negative and you owe the broker money.
Why the futures price is not the current price
A futures price is not a forecast. It is arithmetic.
If you could buy an index future for less than it costs to buy the shares and hold them, somebody would buy the future, sell the shares and lock in a riskless profit. That trade removes the gap. So the futures price settles at roughly:
Futures price ≈ Spot price + cost of carrying the position to expiry
For an index, the cost of carry is the interest you forgo by tying up money, minus the dividends you would have received. For a commodity, add storage and insurance.
The difference between the futures price and the spot price is called the basis. It shrinks to zero at expiry, because on expiry day the contract and the thing are the same. That convergence is not a hope. It is enforced by the settlement rule.
Two market shapes get named:
- Contango — the further-dated contract is more expensive than the near one. Normal for storable commodities and for equity indices. A buyer who keeps rolling pays a little each time.
- Backwardation — the further-dated contract is cheaper. Usually a sign of present scarcity. A buyer who keeps rolling is paid a little each time.
This matters enormously to anybody holding a futures position, or a fund that holds futures, for months. In persistent contango, the roll cost alone can consume the entire return even when the spot price rises.
What it tells you, and what it does not
The futures price tells you the market's agreed price for a future date given today's spot price and today's carrying cost. It is a statement about arithmetic and financing, not about where anybody thinks the price will go.
This is the most common misreading in the whole subject. If the Nifty future trades above the Nifty, that is not the market being bullish. It is the cost of carry. When you hear "futures are pointing higher", check whether the speaker has subtracted the carry. Usually they have not.
Futures also tell you something real about positioning. Open interest — the number of contracts outstanding — combined with price movement is genuine information about whether money is entering or leaving a view. Rising price with rising open interest means new buying. Rising price with falling open interest means shorts closing. That distinction is useful and it is available free on every exchange website.
What futures do not tell you is direction. A large open interest is not a prediction. It is a count of disagreements.
The decision rule
A futures position is only appropriate when you can answer 4 things without checking anything.
- The notional value of 1 lot. Not the margin. The exposure.
- What a 3% adverse move costs you in cash, tonight.
- How much free cash you hold to meet 3 consecutive adverse days without
being forced out.
- What you will do on the roll date, and roughly what the roll will cost.
If your answer to number 3 is "the margin covers it", you have misunderstood the mechanism. Margin is what lets you open the position. Free cash is what lets you keep it.
For a hedger the rule is different and simpler. Hedge the exposure you actually have, in the quantity you actually have, for the period you actually have it. A hedge larger than the underlying exposure is not a hedge. It is a bet with a respectable name.
Try this now
Five minutes on your own screen, and it produces 2 numbers most futures traders have never calculated.
- Open your broker app and find the futures chain for the main index in your market. You should see at least 2 expiries — the current month and the next month.
- Write down 3 prices: the spot index level, the current-month futures price and the next-month futures price.
- Compute the near basis: current-month futures minus spot. Divide by spot, multiply by 100. That is the basis as a percentage.
- Now annualise it. Count the days left to that expiry. Multiply your percentage by 365, then divide by the days remaining. That is the annualised cost of carry built into the contract.
- Do the same for the gap between the current-month and next-month contracts. That is roughly what one roll will cost you, or pay you.
What you should see. For an equity index, a small positive basis that annualises to something in the region of a short-term interest rate, less the dividend yield of the index.
Two conclusions follow immediately, and they are the point of the exercise.
First, a long futures position that you roll for a year pays that annualised carry, whether or not the index moves. The index has to rise by more than the carry before you have made anything.
Second, if the basis is unusually wide or negative, something is happening in financing or in dividends, and it is worth knowing what before you assume the market has an opinion.
Now the risk half, which takes 60 seconds. Multiply the notional value of 1 lot by 3%. Compare that number to the free cash in your account, not to the margin. That is what one ordinary bad day asks of you tonight.
Three real cases
1. Metallgesellschaft, 1993 — right about the price, wrong about the cash The German industrial group's American subsidiary sold long-dated fixed-price contracts to deliver oil products to customers over up to 10 years. It hedged that obligation with short-dated futures that it rolled forward. When oil prices fell through 1993, the long-dated obligations became more valuable, but the short-dated hedges lost money immediately and had to be settled in cash daily. The hedge was economically defensible and the cash requirement was not survivable. The group reported losses of roughly $1.3 billion and the positions were closed. The lesson is exact and it applies at every size: a hedge that is correct over 10 years still has to be funded every single night.
2. Amaranth Advisors, September 2006 — size relative to the market The hedge fund held very large positions in natural gas futures spreads, run by a trader named Brian Hunter. When the spreads moved against the fund, the positions were too large to exit without moving the price further against itself. Amaranth lost roughly $6.6 billion in a matter of weeks and closed. A US Senate subcommittee published a report on the episode in June 2007. The position was not wrong in an obvious way. It was simply larger than the market could absorb, which turns an exit into a second loss.
3. WTI crude oil, 20 April 2020 — the contract must be settled somehow The expiring May 2020 West Texas Intermediate contract settled at about minus $37.63 per barrel. Holders of the contract were obliged to take physical delivery at Cushing, Oklahoma, where storage was effectively full, so they paid others to take the obligation away. CME Group had issued a notice days earlier confirming its systems could process negative prices. Retail investors were affected around the world through funds and structured products that held the front-month contract, including a product sold by Bank of China to individuals. The general lesson is not about oil. A futures contract is an obligation with a delivery mechanism attached, and on expiry day the mechanism is what sets the price, not the news and not the chart.
The question that resolves it
A novice asks: which way will the price go?
An expert asks: can I fund this position every night until the answer arrives?
Direction determines whether you were right. Funding determines whether you were still holding the position when it happened. Metallgesellschaft was right about direction.
What would make this wrong
If a futures position behaved like an equal-sized cash position, then everything about margin calls and rolls would be a technicality. It does not. But this article can be wrong at its edges in 3 ways.
Cost of carry does not fully explain every futures price. In commodities, supply and demand for immediate physical delivery can push the front contract far from any carry calculation. Backwardation in a shortage is not an arbitrage opportunity; it is a real scarcity price.
Rolling is not always a cost. In persistent backwardation, a long position that rolls is paid to do so. Commodity index funds have gone through long periods of both. The direction of the roll is an empirical question, not a rule.
Futures are genuinely efficient for some jobs. For a large institution that needs index exposure for 2 months, futures are usually cheaper and cleaner than buying and selling hundreds of shares. Criticism of futures as an instrument misses that most futures volume exists because it is the low-cost way to move a known exposure.
The narrow, correct conclusion: futures are an excellent tool for transferring an exposure and a poor tool for expressing a slow opinion.
In India
Equity index and single-stock futures trade on the NSE and the BSE. Commodity futures trade principally on the MCX, with agricultural contracts on the NCDEX. Currency futures trade on the NSE and BSE.
Index futures are cash-settled. Nobody delivers the Nifty. At expiry the exchange computes a settlement value and the difference is paid in cash. Single-stock futures are physically settled, so an open position at expiry results in shares being delivered or received.
Lot sizes are large and fixed. You cannot take a fractional position. SEBI's October 2024 measures raised the minimum contract value for index derivatives, and lot sizes were revised upward accordingly. The consequence for a small account is decisive: the smallest position available may risk far more than a sensible fraction of the account, and there is no way to buy less.
Margin is collected upfront and enforced intraday. SEBI moved the market to upfront collection of margin and to peak margin reporting during the day, which removed the earlier practice of brokers extending intraday leverage beyond the exchange requirement.
Securities Transaction Tax applies to futures sales as a percentage of the sale value. Add exchange transaction charges, GST, stamp duty, SEBI turnover fees and brokerage. For a position rolled monthly, these costs recur 12 times a year and they are a certainty, unlike the profit.
Tax treatment. Income from exchange-traded derivatives is generally treated as business income rather than capital gains for Indian residents.
In the United States
Futures are regulated by the CFTC and trade principally on the CME Group's exchanges, which include the CME, CBOT, NYMEX and COMEX. The main equity index contracts are on the S&P 500, the Nasdaq 100, the Dow and the Russell 2000, each in a full-size and a smaller version.
Four features differ in practice.
Contract sizing has small versions. The E-mini S&P 500 contract is large, and the Micro E-mini, introduced in May 2019, is one-tenth of it. An American beginner can therefore take an index futures position at roughly a tenth of the smallest Indian index position. That is a structural difference in who can learn safely.
Trading is nearly 24 hours for the major index and commodity contracts, Sunday evening to Friday afternoon US central time, with a short daily break. Overnight moves therefore happen in a live market rather than as a gap, which changes how a stop behaves.
Tax has a specific rule. Under Section 1256 of the Internal Revenue Code, regulated futures contracts are marked to market at year end and gains are generally taxed 60% as long-term and 40% as short-term regardless of holding period.
There is no transaction tax equivalent to STT. Costs are commissions and exchange fees, and they are small relative to the notional.
Where they differ, and what that tells you
Minimum size. This is the difference that changes behaviour. The smallest US index futures position is a fraction of the smallest Indian one. An American can learn the mechanics of margin, mark to market and rolling with an amount of money they can afford to lose entirely. An Indian cannot, at least not in index derivatives. What that tells you is that the standard advice — "start small and learn by doing" — is not executable in Indian index derivatives, and pretending otherwise is how beginners end up sized 4 or 5 times larger than they intended. The honest Indian alternative is to learn the mechanics on paper and on the exchange's own margin calculator, and to accept that the first real position will be a large one.
Settlement. Indian index contracts cash-settle, so the delivery mechanism never touches an individual. American commodity contracts physically settle, and the negative price of April 2020 was a delivery event, not a price event. Indian commodity contracts on the MCX include both cash-settled and deliverable contracts, and which is which is a specification detail worth checking before expiry week.
Trading hours. A US index futures position experiences news continuously. An Indian equity futures position experiences it as a gap at the open. The same stop-loss order is a much weaker promise in India, for a reason that has nothing to do with the trader's skill.
Carry this
- Both sides of a future are obliged. There is no walking away.
- Margin is a deposit, not a cost, and not a limit on your loss.
- Mark to market means the loss is demanded in cash tonight, not at expiry.
- Futures price minus spot price is carry, not opinion.
- A rolled position pays or receives the roll every month, whatever the price does.