Hi, A futures contract is a legal agreement for buying or selling an asset at a particular price and time in the future.

Hi, A futures contract is a legal agreement for buying or selling an asset at a particular price and time in the future. Futures are used by traders as a hedging strategy. By hedging strategy, we mean strategies that are taken by the traders to reduce the risk arriving from unfavorable movements in the underlying asset, that can be any financial instrument such as commodities, natural gas, crude oil etc. Now, you must be wondering how hedging prevents losses.

Let us understand this with the help of an example: Suppose there is an anticipation that the markets will remain volatile due to upcoming key events like Monetary policy. Suppose we are long on SBI in the cash market, with the stock being bought at Rs. 300 for long term investment, and it is currently trading at Rs. 385. Yet, there is an expectation that the RBI will increase the Cash Reserve Ratio (CRR) by 25 basis points. This may affect the banking stocks negatively, and there is a probability that the Prices of SBI might retrace down in the short term. As the stock is bought with a vision of long term holding, it is not feasible to sell the stock for noises in the short run.

So, in order to protect the investment from short term losses, one may short SBI futures at a current market price of Rs. 385, in order to lock profits, in case the price falls due to the RBI announcement. By doing this, one is assured of profits of Rs. 85 per share, irrespective of the movement of the share price. Retracement in the prices of SBI from this juncture will provide losses in the cash market, yet equivalent profits in futures, and if the prices move up due to the unchanged CRR, one will suffer losses in futures whereas will have an equivalent gain in the cash market. In either case, the profits are locked, and the risk of downside movement is minimized. Derivatives usually come with higher risks, but if we do proper hedging, we can limit losses in our trading. When we have an unhedged long or short position, we carry unlimited gain or loss possibilities in a theoretical sense. If we are short in Nifty, and there is some announcement of tax cut post-market, the index can open gap-up on that news.

In case of an unhedged position, this is a huge loss. So, a trader should adopt good risk management practices to limit losses and optimize gains through various hedging methods. There can be many more methods of hedging than the ones discussed here. For this, the understanding of futures is very important.