Chapter Notes

Chapter 3: Introduction to Forwards & Futures

NISM Series VIII — Equity Derivatives | 20% weightage | ~20 exam questions

What this chapter is about

Along with CH4, this is the most important chapter in the exam. 20% weightage, 60 questions in the bank, 8 numericals. Futures are how most professional traders and institutions manage risk in equity markets. This chapter covers what futures are, how they're priced, how you make or lose money on them, and all the key terminology you need to navigate the market. Expect heavy numerical questions here — P&L calculations, contract value calculations, margin calculations.

Key concepts

Forward Contract — private agreement between two parties to buy/sell an asset at a future date for a price agreed today. Bilateral, customised, settled between the two parties, NOT traded on an exchange. Main problem: counterparty risk and difficulty exiting before maturity (illiquid).

Futures Contract — standardised forward contract traded on an exchange. Key differences from forwards:

Contract specifications — must know:

• Lot size: Nifty = 75 units. Varies per stock.
• Expiry: Last Thursday of every month (NSE changed to Tuesday from September 2025)
• Contract cycles: 3 series always available — near month, next month, far month
• Settlement: Index futures = cash settled always. Stock futures = can be physical delivery.
• Tick size: Minimum price movement = ₹0.05 (5 paise) for Nifty futures

Key terminology:

Open Position — contracts bought or sold but not yet squared off or expired

Squaring Off — closing an existing position by doing the opposite trade (bought → sell same contract; sold → buy same contract)

Long Position — you have bought futures. You profit when price rises.

Short Position — you have sold futures. You profit when price falls. You do NOT need to own the underlying to sell futures — only margin is required.

Calendar Spread — simultaneous long and short in futures of the SAME underlying but DIFFERENT expiry months. Carries only basis risk, very low market risk, hence lower margins. When near month expires, the far month leg becomes a naked/open position.

Open Interest — total number of outstanding contracts in the market. Rising price + rising OI = strong trend (new longs entering). Rising price + falling OI = short covering (weak move, shorts exiting).

Near Month / Far Month — near month = current expiry month. Far month = third month out.

Basis = Futures price − Spot price. Usually positive (futures > spot) = Contango. Occasionally negative (futures < spot) = Backwardation.

Futures pricing — Cost of Carry model:

Futures Price = Spot Price + Cost of Carry

Cost of carry = interest cost of financing the purchase of the underlying asset.

Example: Nifty spot = 24,000. Annual interest rate = 12% (1% per month). One month futures fair value = 24,000 + (24,000 × 1%) = 24,240.

Contango — futures price > spot price (normal market, cost of carry positive) Backwardation — futures price < spot price (happens when near-term demand is unusually high, or in commodities with storage costs)

Payoff from futures — this is where numericals come:

Long futures (bought):

• Profit = (Sell price − Buy price) × Lot size
• Price rises → profit. Price falls → loss.

Short futures (sold):

• Profit = (Sell price − Buy price) × Lot size
• Price falls → profit. Price rises → loss.

Contract value = Futures price × Lot size

Real market examples

P&L Calculation: You buy 2 lots of Nifty futures at 24,000 (lot size 75). Nifty rises to 24,300 and you square off.

Profit = (24,300 − 24,000) × 75 × 2 = 300 × 150 = ₹45,000

Short futures: You sell Nifty futures at 24,500 expecting it to fall. It falls to 24,200.

Profit = (24,500 − 24,200) × 75 = 300 × 75 = ₹22,500

Calendar Spread: You buy March Nifty futures and sell April Nifty futures simultaneously. You're not betting on direction — you're betting on the spread between the two contracts narrowing or widening. If March expires, your April short becomes a naked short position.

Trap Alert

Trap 1: "A long futures position can only be reversed with the SAME counterparty" → FALSE Futures are anonymous — you don't know who's on the other side. The clearing corporation is the counterparty to ALL trades. You square off by selling to ANY buyer on the exchange.

Trap 2: "You must own the underlying to sell futures" → FALSE You only need to deposit margin. No ownership of underlying required. This is what makes short selling easy in futures.

Trap 3: "Futures P&L is only settled at maturity" → FALSE Futures are marked to market DAILY. Profits and losses are credited/debited to your margin account every day. Not just at expiry.

Trap 4: "Calendar spread margin is high because of double the risk" → FALSE Calendar spread carries ONLY BASIS RISK (no market risk), so margins are LOWER than two naked positions. The two legs offset each other's market risk.

Trap 5: "If far month futures price < near month futures price, it's contango" → FALSE That's backwardation. Contango = far month > near month (normal). Backwardation = far month < near month (unusual).

Trap 6: "In futures trading, only the seller pays initial margin" → FALSE BOTH buyer and seller pay initial margin in futures. (In options, only the seller pays initial margin — buyer pays premium instead.)

Numericals — formulas to memorise

Contract Value = Futures Price × Lot Size

P&L (Long)  = (Exit Price − Entry Price) × Lot Size × No. of Lots
P&L (Short) = (Entry Price − Exit Price) × Lot Size × No. of Lots

Initial Margin = Contract Value × Margin %

Futures Fair Price = Spot Price + (Spot Price × Rate × Time/12)

Calendar Spreads possible = n(n-1)/2 where n = number of series
(3 series → 3×2/2 = 3 spreads: 1&2, 2&3, 1&3)

Must-remember rules

• Forwards = bilateral, OTC, counterparty risk, hard to exit
• Futures = exchange traded, standardised, no counterparty risk, easy to exit
• Both buyer AND seller pay initial margin in futures
• Squaring off = opposite trade in same contract (same underlying, same expiry)
• You do NOT need to own underlying to sell futures
• Index futures = always cash settled (no delivery)
• Last Thursday = expiry (NSE shifting to Tuesday from Sep 2025)
• 3 contract series always available: near, next, far month
• Contango = futures > spot (normal) | Backwardation = futures < spot
• Rising price + falling OI = short covering (not a strong trend)
• Calendar spread = same underlying, different expiry, carries only basis risk

Weightage note

20% of exam = ~20 questions. Expect 6-8 numericals involving P&L calculations, contract values, and margin calculations. The rest are definitional questions on terminology. This chapter combined with CH4 determines whether you pass or fail.

Quick revision — 60 second scan

• Futures = standardised forward on exchange, daily MTM settlement
• Long = buy futures, profit when price rises
• Short = sell futures, profit when price falls (no ownership needed)
• P&L = price change × lot size × number of lots
• Both buyer AND seller pay initial margin
• Index futures = cash settled always
• Contango = futures > spot | Backwardation = futures < spot
• Calendar spread = same underlying, diff expiry, low margin
• 3 series: near month, next month, far month
• Expiry = last Thursday (shifting to Tuesday from Sep 2025)