Profit and Loss Calculation in Futures Contracts: A Comprehensive Guide
When it comes to trading futures contracts, understanding how profits and losses (PL) are calculated is crucial for any trader. This guide aims to provide a clear and comprehensive explanation of the process, focusing on the concept of 'mark to market'. We will also discuss market mechanisms and examples using popular contracts such as oil and currency futures.
Understanding Futures Contracts
Futures contracts are financial derivatives used for speculation, arbitrage, and hedging. Essentially, they represent an agreement to buy or sell an asset at a predetermined price on a specified future date. These contracts enable traders to profit from price fluctuations in underlying assets without the need for physical delivery.
Mark to Market: Key to Calculating PL in Futures Contracts
The term 'mark to market' refers to the process of adjusting the value of open positions in a futures contract to reflect the current market price. This adjustment is made on a daily basis, allowing traders to see their real-time gains or losses for the day. Here, we will illustrate this concept using oil and currency futures contracts.
A Practical Example: Oil Futures Contract
Let's consider an example with oil futures. If you buy a December oil contract at ￡80, the current market price for December oil is ￡81. Assuming you choose to sell your contract at this price, your profit and loss (PL) would be ￡1 per contract. Conversely, if the market price drops to ￡79, you would experience a loss of ￡1 per contract. This fluctuation in market price affects your PL instantly and transparently.
Futures Contracts as Derivatives: Understanding the Mechanism
Futures contracts operate as derivatives, meaning their value is derived from an underlying asset. In the case of oil futures, the underlying asset is physical oil. Similarly, currency futures involve the underlying asset being a particular currency. The principle of trading futures is to buy low and sell high (or sell high and go short initially, then take a long or buy position when the price decreases).
Examples of Futures Payoffs
To better understand the payoffs, it is beneficial to go through a video tutorial. The video will cover the specific outcomes of entering a futures position, based on the direction of the underlying asset's price movement.
Risks and Legal Implications of Trading Futures Contracts
Despite the potential rewards, trading futures contracts comes with significant risk. For instance, if a company involved in a futures contract undergoes a major scandal that is revealed in the night, the price of the stock or commodity can plummet. This can result in substantial losses for futures traders, even if they only have a small portion of the contract.
As an illustration, consider a scenario where you buy a Dec 100 Rs stock futures contract with a lot size of 5000. If the stock price drops to 50 Rs due to a major scam, you would be required to make up the difference and pay 5 Lakhs to the broker, even if you only bought the contract with 1 Lakh. This can put traders in a precarious legal position if the contract is not properly managed.
Futures contracts require a solid understanding of market dynamics and risk management. Many beginners enter the market without proper knowledge, leading to significant financial losses. It is crucial to be well-informed and prepared before engaging in futures trading.
Conclusion
Profit and loss calculations in futures contracts are directly tied to the 'mark to market' principle. Understanding this concept is essential for traders to effectively manage their positions and mitigate risk. By leveraging futures contracts, traders can take advantage of price fluctuations in underlying assets, but it is vital to approach this market with a comprehensive understanding of its mechanics and potential risks.
Additional Resources
To gain a deeper understanding of futures trading, consider watching tutorial videos and reading related articles. Engaging in further education and practice will help prepare you for the challenges and opportunities in this dynamic market.