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The Futures Pricing

by

Forward Market

• Forwards market
• Futures contract
• Future trades
• Leverage & payoff
• Margin & M2M
• Margin calculator
• Open interest

• How to short
• Nifty futures
• Nifty futures
• Futures pricing
• Hedging with futures
• Notes

learning sharks stock market institute

10.1 – The Pricing Formula

If you were to enroll in a traditional futures trading course, you would presumably learn about the futures pricing formula pretty early on in the program. However, we purposefully chose to discuss it now, at a much later time. The explanation is straightforward: you don’t really need to understand how futures are  if you’re trading them based on technical analysis, which I presume the vast majority of you are. However, having a solid understanding would be beneficial. However, you must be aware of this if you intend to trade futures using quantitative strategies like Calendar Spreads or Index Arbitrage. In reality, we will cover some of these methods in a module on “Trading Strategies,” thus the discussion in this chapter will serve as a basis for the ensuing modules.

If you recall, we occasionally covered the “Futures Pricing Formula” in some of the earlier chapters as the main cause of the discrepancy between the spot price and the futures price. I suppose it’s time to pull the curtain and disclose the “Future Pricing Formula” at this point.

We are aware that the respective underlying determines the value of the futures instrument. We are also aware of the future instrument’s synchronic movement with its underlying. The futures price would decrease if the actual price did, and vice versa.

However, the fundamental price and the futures price are not truly the same and different. As I write this, the Nifty Spot is trading at 8,845.5, while the comparable current month contract is trading at 8,854.7. For context, please see the snapshot below. “Basis or spread” refers to the price differential between the futures price and the actual price. The spread is 9.2 points (8854.7 – 8845.5) in the case of the Nifty sample below.

The “Spot – Future Parity” is responsible for the price discrepancy. The discrepancy between the spot and futures prices that results from factors like interest rates, dividends, a time before expiration, etc. is  as the spot future parity. In a very broad sense, it is just a formula that compares the underlying price to the matching futures price. The formula for futures pricing is another name for this.

The futures pricing formula reads as follows:

Futures Price is equal to Spot Price *(1+ RF)-D.

Where,

The risk-free rate is rf.

d: Dividend

It should be  that “rf” stands for the risk-free rate that you can earn for the entire year (365 days); given that the expiration is at 1, 2, and 3 months, you might want to scale it proportionately for time periods other than the precise 365 days.

Consequently, the following formula is more general:

Futures Price is equal to Spot Price plus [1 + rf*(x/365)].

– d

Where,

x is the number of remaining days.

The 91-day Treasury note issued by the RBI serves as a stand-in for the short-term risk-free rate.

The current rate is 8.3528 percent, as seen in the graphic above. In light of this, let’s work on a pricing example. What price should the current month futures contract for Infosys be set at if Infosys spot is now trading at 2,280.5 with 7 days left till expiration?

Futures Price: [1+8.3528 percent (7/365)] = 2280.5 – 0

Please take note that Infosys is not to pay a dividend over the following seven days, therefore I’ve assumed there would be none. The answer to the preceding equation is 2283, which is the predicted price. This is  to as the future’s “Fair value.” However, as you can see from the figure below, the actual futures price is 2284. The “Market Price” refers to the actual price at which the futures contract trades.

The difference between the fair value and market price mainly occurs due to market costs such as transaction charges, taxes, margins, etc. However by and large the fair value reflects where the futures should be trading at a given risk-free rate and the number of days to expiry. Let us take this further, and figure out the futures price for mid-month and far-month contracts.

Mid-month calculation

Number of days to expiry = 34 (as the contract expires on 26th March 2015)

Futures Price = 2280.5 * [1+8.3528 %( 34/365)] – 0

= 2299

Far month calculation

Number of days to expiry = 80 (as the contract expires on 30th April 2015)

Futures Price = 2280.5 * [1+8.3528 %( 80/365)] – 0

= 2322

From the NSE website let us take a look at the actual market prices –

It is obvious that the determined fair value and the market price are different. This is what I would put down to the relevant expenses. Additionally, the market might be accounting for some dividends paid at the conclusion of the fiscal year. The important thing to remember is that the gap between fair value and market value expands as the number of days till expiration increases.

In reality, this introduces us to the discount and the premium, two crucial terms utilized in the market.

The futures market is  to be at a “premium” if the futures are trading higher than the spot, which, mathematically speaking, is the natural order of events.

Although the term “Premium” is  in the equity derivatives markets, the term “Contango” is preferred in the commodity derivatives markets. The fact that the Futures are trading higher than the Spot, however, is what both contango and premium allude to.

Here is a graphic of the January 2015 series’ Nifty spot and associated futures. As you can see, throughout the entire run, the Nifty futures traded above the spot price.

I wish to focus your attention, in particular, on the following few points:

  1. The difference between the spot and futures is relatively large at the beginning of the series (shown by a black arrow). This is due to the large x/365 component in the futures price methodology and the high number of days till expiration.
  2. Throughout the series, the futures maintained a premium over the spot price.
  3. The futures and the spot have come together at the end of the series (shown by a blue arrow). In actuality, this constantly occurs. On the day of expiration, the futures and spot prices will always converge, regardless of whether the future is at a premium or a discount.
  4. If you have a futures position and don’t close it out by expiration, the exchange will do it for you and settle it at the spot price since both futures and spot prices converge on the day of expiration.

Futures trading is not necessarily more profitable than spot trading. There may be times when the futures trade at a lower price than the corresponding spot, primarily due to short-term imbalances in supply and demand. In this scenario, it is  that the futures are trading at a discount to the spot. A similar circumstance is as “backwardation” in the realm of commodities.

10.2 – Practical Application

Let’s put the formula for futures pricing to work before we wrap up this chapter. As I had previously indicated, the futures pricing formula is highly helpful if you want to trade using quantitative trading strategies. Please be aware that the conversation that follows is just a sneak peek into the realm of trading methods. When we start the module on “Trading Strategies,” we will go into deeper detail about all of these topics and more. Think about this scenario:

650 Wipro Spot

8.35 percent Rf

x = 30

d = 0

As a result, the futures ought to be trading at –

Futures Price is equal to 653*(1+8.35% (30/365)) – 0

= 658

In order to account for market fees, the futures should trade at or near 658. What if the price of the futures contract is dramatically different instead? How about 700? There is definitely a trade going on. In an ideal world, there should only be a 5-point gap between spot and futures, but due to market imbalances, that disparity has increased to 47 points. We can use trade to deploy and capture this spread.

The futures market price is  as being expensive in relation to its fair value since the futures contract is trading over its fair value. Alternately, we may state that the spot is trading less expensively than the futures.

The general rule for any kind of “spread trade” is to purchase the less expensive asset and sell the more costly one. As a result, using this as our guide, we can sell Wipro Futures on the one hand while concurrently buying Wipro on the spot market. Let’s enter the numbers and see what happens.

Purchase Wipro on-site for $653

Offer to sell Wipro futures at 700

Now we are aware that the spot and futures prices converge into a single price on the expiry day (refer to the Nifty graph posted above). Let’s assume a few arbitrary values where the spot and futures converge: 675, 645, 715

As you can see, after you execute the deal at the anticipated price, the spread is basically locked in. Profits are thus assured, regardless of where the market moves by expiry! It goes without saying that it makes sense to close out the bets right before the futures contract expiration. You would have to sell Wipro on the spot market and then purchase it back on the futures market to do this.

The term “Cash & Carry Arbitrage” also refers to this type of trade between futures and spots in which the goal is to extract and profit from the spread.

Spreadsheet Calendars 10.3

The calendar spread is a straightforward development of cash and carries arbitrage. The goal of a calendar spread is to extract and benefit from the spread that results from two futures contracts with the same underlying asset but different expiration dates. Continue using the Wipro example to better grasp this –

Wipro Spot currently trades at = 653.

30 days until expiration, current month futures fair value = 658

Futures for the current month are actually worth 700.

The fair value for mid-month futures (65 days to expiration) is 663

Mid-month futures actually have a market value of 665.

The current month’s futures contract is trading much over its anticipated theoretical fair value, as seen by the example above. The mid-month contract, however, is trading rather close to its real fair value estimate.

Based on these facts, I’ll assume that the basis for the current month’s contract will eventually contract and that the mid-month contract will continue to trade fairly.

The current month contract now seems to be more expensive than the mid-month contract. So, instead of buying the pricey contract, we sell the expensive one. I would therefore need to buy the mid-month futures contract at 665 and sell the current-month contract at 700 in order to execute the deal.

What do you believe the spread is in this case? The spread, or 700 – 665 points, is the difference between the two futures contracts.

The trade is set up as follows to catch the spread:

Sell the futures for the current month at 700

Keep in mind that because this is a hedged trade, the margins are significantly decreased because you are buying and selling the same underlying futures with different expires.

One must now wait for the current month’s futures to expire after starting the trade. We are confident that the spot price and the current month’s futures will converge at expiration. Of course, from a more pragmatic standpoint, it makes sense to close off the deal right before expiration.

Naturally, keep in mind that the crucial presumption we have made in this case is that the mid-month contract would remain relatively close to its fair value. According to my trading expertise, this occurs frequently.

Most importantly, keep in mind that this chapter’s study of spreads is really a brief introduction to the realm of trading methods. These methods will be  in a separate session that will provide you with a detailed examination of how to use them in a professional setting.

CONCLUSION

  1. The formula for calculating futures prices is Futures Price = Spot price *(1+Rf (x/365)) – d.
  2. The basis, also referred to as the spread, is the distinction between futures and spots.
  3. The term “Theoretical fair value” refers to the futures price as determined by the pricing algorithm.
  4. The term “market value” refers to the price at which futures trade on the market.
  5. Theoretically, the market value and the fair value of futures should be about equal. However, there can be a small variation, primarily because of the accompanying expenditures.
  6. Futures are to be at a premium if they are wealthy to spot, otherwise, they are said to be at a discount.
  7. Using commodities lingo Discount = Backwardation and Premium = Contango.

  8. One can buy in the spot market and sell in the futures using the spread as “cash and carry.”

  9. When one buys one contract and simultaneously sells another contract (with a different expiry but the same underlying), this is as a calendar spread.

The Nifty Futures

by
learning sharks stock market institute

Forward Market

• Forwards market
• Futures contract
• Future trades
• Leverage & payoff
• Margin & M2M
• Margin calculator
• Open interest

• How to short
• Nifty futures
• Nifty futures
• Futures pricing
• Hedging with futures
• Notes

9.1 – Basics of the Index Futures

The Nifty Futures holds a very particular place in the world of Indian derivatives. The most liquid contract in the Indian derivative markets is the “Nifty Futures,” which is the most commonly traded futures product. Nifty Futures is really among the top 10 index futures contracts traded globally, which may surprise you. Like many of us, I would anticipate that once you become familiar with futures trading, you will start actively trading the Nifty Futures. It would make sense to fully comprehend Nifty futures in light of this. However, before we continue, I would like you to review the Index as we have already talked about it here.

I’m going to talk about the Index Futures or the Nifty Futures now that I’m assuming you are familiar with the index’s fundamentals.

The futures instrument, as we are aware, is a derivative contract whose value is derived from an underlying asset. The Index itself serves as the underlying for Nifty futures contracts. The Nifty Index is where the Nifty Futures derive their value from. This implies that as the Nifty Index’s value increases, so will the value of Nifty futures. The Index futures would also decrease in value if the Nifty Index’s value dropped.

Nifty Futures are  in three variations: current month, mid-month, and far month, much like any other futures product. For your reference, I have highlighted the same phrase in red. Additionally, I have highlighted the Nifty Futures price, which was Rs. 11,484.9 per unit of Nifty at the moment I took this picture. 11,470.70 rupees were the corresponding underlying value (index value in the spot). The futures pricing formula is the reason why there is, of course, a discrepancy between the spot price and the futures price. In the following chapter, we shall comprehend the ideas pertaining to futures pricing.

The lot size is 75 if you’ve noticed. The contract’s value is  to be –

CV is Futures Price times Lot Size

= 11484.90 * 75

= Rs.861,367/-

These facts ought to provide you with a fundamental overview of the Nifty Futures. Its liquidity is one of the primary characteristics of Nifty Futures that contributes to its popularity. Now that we have a better understanding of what liquidity is and how to quantify it, let’s move on.

9.2 – Impact Cost

24th August 2021 update – The fee that a buyer or a seller must suffer while completing a transaction in certain security is  as Impact Cost by the NSE. In comparison to the bid-ask spread, it gives a far more realistic picture of the costs traders incurs while executing a trade. It is a measure of market liquidity. It fluctuates depending on the magnitude of the transaction and is  separately for the buy-side and the sell-side. Due to its dynamic nature, the Impact cost is always shifting in response to the order book. One of the requirements for eligibility for companies to be  in indexes (such as Nifty 50, and Nifty 500) is that the impact cost must be below a specific threshold.

The effect cost is  using the following formula:

(Best Buy Price in Orderbook + Best Sell Price in Orderbook) / 2 is the ideal price.

Actual Buy Price = Total Quantity – (Quantity * Execution Price)

Impact Cost (for that specific quantity) is  as follows: Ideal Price * 100 / (Actual Buy Price – Ideal Price).

Let’s say someone wishes to purchase 350 units of Infosys. Let’s now determine the transaction’s impact cost.

Ideal Price =(1657.95+1658)/2 = 1657.975 ~ 1657.98

Actual Buy Price is  as follows: (15*1658) + (335*1658.20) / 350 = 1658.19143 1658.19

((1658.19 – 1657.98) / 1657.98) * 100 = 0.012 percent) is the impact cost for purchasing 350 shares.

The following are a few essential lessons I want you to learn from our discussion:

  1. Giving a perception of liquidity through impact cost
  2. Impact cost decreases when a stock’s liquidity increases.
  3. Another sign of liquidity is the difference in the price at which something is bought and sold.

1. The impact cost is larger the wider it is.

2. The effect cost is smaller the narrower it is

4. Liquidity increases and reduces volatility.

5. Placing market orders is not a good idea if the stock is not liquid.

9.3 – Why trading Nifty makes sense

The Nifty Index, as you are aware, consists of 50 stocks. These stocks were  to cover a broad spectrum of India’s economic sectors. Because of this, the Nifty is a good indicator of India’s overall economic activity. This naturally suggests that if overall economic activity is increasing or is anticipated to increase, the Nifty’s value will increase as well, and vice versa. Additionally, compared to trading single stock futures, trading Nifty Futures is a far superior option. There are numerous causes for this; here are a few:

It is  – From a risk perspective, it can occasionally be difficult to make a direct call on a single stock. Let’s imagine, for illustration purposes, that I decide to purchase Infosys Limited in the anticipation of positive quarterly results. In the event that the results don’t satisfy the markets, my P&L and the stock would undoubtedly suffer. On the other hand, Nifty Futures features a diverse portfolio of 50 stocks. The movement of the Index does not truly depend on a single stock because it is a portfolio of stocks. Of course, occasionally a few stocks (index heavyweights) can somewhat affect the Nifty, but not regularly.

In other words, when trading Nifty futures, “unsystematic risk” is entirely eliminated, and only “systematic risk” is dealt with. I am aware that we are introducing a new language here, however, we will go into more detail about these concepts when we discuss hedging.

Nifty’s movement is a reaction to the overall movement in India’s top 50 companies, making it difficult to manipulate (by market capitalization). As a result, there is almost no room for manipulating the Nifty index. The same cannot be  about certain stocks though (remember Satyam, DHCL, Bhushan Steel, etc)

High Liquidity (Easy Fills, Less Slippage): Earlier in the chapter, we covered liquidity. You can basically transact any amount of Nifty because it is so highly liquid, and you won’t have to worry about losing money on the impact fee. Plus, there is so much liquidity available that you may essentially transact any quantity of contracts.

Margin requirements are significantly lower for Nifty futures compared to individual stock futures. Nifty’s margin requirements range from 12 to 15 percent, while individual stock margins can be as high as 45 to 60 percent.

Taking a broader economic prediction is necessary when trading Nifty futures as opposed to making company-specific directional calls. I’ve found that the former is considerably simpler to do than the latter.

Application of technical analysis – On liquid instruments, technical analysis is most effective. Since liquid equities are difficult to manipulate, their movements are typically determined by the market’s dynamics of supply and demand, which is obviously what a TA mostly depends on.

Less volatile – When compared to individual stock futures, Nifty futures are less volatile. To put things in perspective, the annualized volatility of the Nifty futures is about 16–17%, whereas that of individual stocks, like Infosys, can reach 30%.

CONCLUSION

  1. The Nifty Index in spot, which serves as its underlying, determines the value of Nifty Futures.
  2. The Nifty futures lot size is 75 at the moment.
  3. The most liquid futures contract in India is the Nifty futures contract.
  4. Nifty Futures contracts are available with three different expiration options, just like other futures contracts (Current month, Mid Month, and Far Month)
  5. An arbitrarily quick instantaneous deal known as a “round trip” entails buying at the best sell price and selling at the best buy price.
  6. A round-trip trade is always unsuccessful.
  7. Impact cost calculates a round-trip loss as a percentage of the average bid and ask.
  8. Fewer liquidity results from higher impact costs, and vice versa.

  9. Due to impact cost, when you place a market order to transact, you could lose some money.

  10. The most liquid contract to trade is Nifty, which has an effective cost of about 0.0082 percent.

All about Shorting

by
learning sharks stock market institute

Forward Market

• Forwards market
• Futures contract
• Future trades
• Leverage & payoff
• Margin & M2M
• Margin calculator
• Open interest

• How to short
• Nifty futures
• Nifty futures
• Futures pricing
• Hedging with futures
• Notes

8.1 – Shorting in a nutshell

Shorting was briefly covered in Module 1. However, we shall examine shorting in more detail in this chapter. Because we don’t typically short things in our day-to-day transactions, shorting is a difficult idea to understand. Imagine this transaction, for instance:

Let’s imagine you purchased an apartment today for Rs. X and sell it for Rs. X+Y two years later. The added value above and above Rs. X, which just so happens to be Rs. Y is the transaction’s profit. This transaction is straightforward to understand and uncomplicated. In fact, the majority of daily transactions call for us to first buy something before later selling it (maybe for a profit or a loss). We are  to these straightforward transactions. However, when doing a short sale or simply “shorting,” we carry out the transactions in reverse, i.e., sell first and buy later.

So what would force a trader to first sell something before later buying it? Well, it’s actually fairly straightforward: When we anticipate that the price of an item, like a stock, would rise, we buy the stock first and sell it later. However, we typically sell the stock first and then buy it later if we think its price will decrease.

Confused? In order for you to grasp the basic idea at this point, let me try to give you a crude comparison. Consider that you and your friend are watching a thrilling India-Pakistan cricket match. You two are in the mood for a quick wager. Your friend bets that India will lose the game, while you wager that India will win. Naturally, this implies that you profit if India triumphs. Likewise, if India lost the game, your friend would profit.

For the time being, imagine India (in this context, the Indian cricket team) as a company that trades on the stock exchange. When you do this, your wager is the same as saying that you will profit if the stock increases (India wins the game) and your friend will profit if the stock decreases (India loses the match). According to market jargon, you are long India while your friend is short the country.

Still, perplexed? Perhaps not, but there are probably a few unsolved questions niggling at the back of your mind. Just keep in mind this one thing for the time being if you are brand new to shorting stocks: whenever you believe a stock’s price is about to decrease, By selling the stock short, you can profit. You must sell your stock or futures initially and then purchase them back later to short them. In actuality, the P&L of actually shorting a stock or pair of futures is the best method to understand how to short. However, I’ll try to cover everything you should know in this chapter before you short stocks or futures.

8.2 – Shorting stocks in the spot market

Prior to learning how to short a stock in the futures market, it is important to comprehend how shorting operates in the spot market. Consider the following fictitious circumstance:

  1. A trader notices the formation of a bearish Marubuzo on HCL Technologies Limited’s daily chart.
  2. Other checkpoints on the checklist (covered in the TA module) comply in addition to the bearish Marubuzo.

1. higher than normal volume

2. the resistance level is present

3. Manifestations support

4. The risk-to-reward ratio is acceptable.

3. The trader believes HCL Technologies will decrease by at least 2.0% the following day as a result of the analysis.

The trader now hopes to profit from the  price fall in light of this view. He decides to short the stock as a result.

As is common knowledge, when one shorts a stock or stock futures, they anticipate that the stock price will decline and that they would be able to profit from the decline in value. The goal is to short the stock at Rs. 1990 based on the table above.

You only need to highlight the stock (or a futures contract) you want to short on your trading platform and press F2 when you have to short it. By doing this, the sell order form is . Before clicking submit, input the amount and other information. As soon as you click “Submit,” the order is sent to the exchange, and if it is filled, you will have opened a short position for yourself.

Anyway, consider this: Under what conditions would you incur a loss if you had a trading position? Naturally, you would lose money if the stock price moved in the opposite direction of what you had . So,

1. What way should a stock move in if you short it?

  1. The directional view is downward since it is that the stock price will decrease.

2. So when would you begin to lose money?

  1. when the stock moves counter to expectations

3. What would that be, then?

  1. This indicates that if the stock price begins to rise rather than decline, you will begin to lose money.

The stop loss price is always greater than the price at which you have shorted the stock whenever you have a short position. So, as you can see from the table above, the short trade entry price is Rs.1990, and the stop loss price is Rs.2000, which is Rs.10 more than the entrance price.

After starting the short trade at Rs.1990/-, let’s now speculatively consider two possible outcomes.

Situation 1: The stock price reaches the desired level of Rs.1950.

In this instance, the stock movement matched expectations. The stock price decreased from Rs. 1990 to Rs. 1950. The trader is  to close the position since the aim has been met. As is well known, in a short position, the trader must:

  1. initial sale at Rs. 1990, and
  2. Later purchase at Rs.1950

The merchant would have earned a profit throughout the entire procedure equivalent to the difference between the selling and buying prices, or Rs. 40/- (1990 – 1950).

If you approach it from a different perspective, such as the typical purchase first and sell later perspective, this is just as advantageous as purchasing at Rs. 1950 and selling at Rs. Just that the trader’s order of transactions has been flipped, with sales coming first and purchases coming last.

Scenario 2: The stock price rises to 2000 rupees.

In this instance, the stock price has risen over the Rs. 1990/- short price. Keep in mind that if you short a stock, the price must fall for you to profit. A loss would result if the stock price increased in place of falling. In this instance, the stock has increased, hence there will be a loss.

  1. The trader made a short sale for Rs.1990. The stock increased after being shorted, contrary to the trader’s anticipation.
  2. When the stock reaches Rs. 2000, the stop loss is triggered. The trader must finish the position by repurchasing the stock in order to stop further losses.

The trader would have lost Rs. 10 over the entire procedure (2000 – 1990). This transaction is equivalent to buying at Rs. 2000 and selling at Rs. 1990, if you approach it from the traditional buy first, sell later perspective. Likewise, if we reverse the sequence, it would be sold first and purchased later.

Hopefully, the two examples above have convinced you that when you short something, you profit when the price declines and lose money when the price rises.

8.3 – Shorting in spot (The stock exchange’s perspective)

One restriction applies to shorting in the spot market: it must be  exclusively intraday. The short transaction can be  at any moment during the day, but you must purchase back the shares (square off) before the market closes. The short position cannot be  over for a number of days. We must comprehend how the exchange handles the short position in order to comprehend why shorting in the spot market is purely an intraday activity.

Recall the discussion from above occasionally. Let’s imagine for a moment that you have shorted stock with the anticipation of profiting from the price decrease. You decide to wait another day because the price has not dropped as much as you had hoped after you shorted it. However, the exchange would determine at the end of the day that you had sold shares during the day, so you would need to retain these shares available for delivery.

However, you cannot fulfill your delivery commitment with these shares. This indicates that you will break your responsibility, which will result in a severe penalty. This circumstance is also known as “Short Delivery.”

In the event of short delivery, the exchange would raise the matter and resolve it in the auction market. You should read this Z-Connect article, which outlines the auction market procedures and how a client is penalized for failing to meet a delivery commitment. Here’s some advice: never engage in “short delivery” transactions, and always terminate your short trades before the market closes to avoid penalties that might be as much as 20% above your short price.

This also brings up a crucial point: the exchange already checks for commitments after the market ends. Therefore, if one were to cover the short position (by squaring off), there would be no obligation at all at the end of the day before the exchange can perform the “obligation check.” So, in order to avoid actually bringing forward the delivery obligation, shorting in the spot market must be  exclusively as an intraday trade.

Does that imply that all short positions must be settled by the end of the day? Actually, no. In the futures market, a short position can be maintained overnight.

8.4 – Shorting in the Futures Market

Shorting a stock in the futures segment has no restrictions like shorting the stock in the spot market. In fact this is one of the main reasons why trading in futures is so popular. Remember the ‘futures’ is a derivative instrument that just mimics the movement of its respective underlying. So if the underlying value is going down, so would the futures. This means if you are bearish about a stock then you can initiate a short position on its futures and hold on to the position overnight.

 

Similar to depositing a margin while initiating a long position, the short position also would require a margin deposit. The margins are similar for both the long and short positions and they do not really change.

 

Let’s use the following example to better illustrate the “Mark to Market” (M2M) perspective while shorting futures. Assume you sold a short position in HCL Technologies Limited at Rs. 1990. Lot dimensions are 125.

 

The two lines marked in red highlight the fact that they are loss-making days. To get the overall profitability of the trade we could just add up all the M2M values –

 

+ 1000 + 875 – 625 – 1125 + 2375 + 625

= Rs.3125/-

 

Alternatively, we could look at it as –

 

(Selling Price – Buying price) * Lot Size

 

= (1990 – 1965) * 125

= 25*125

=Rs.3125/-

 

Therefore, starting a long futures position and shorting futures are quite similar, with the exception that when you short, you only make money if the price drops. In addition, the M2M calculation and the margin need are unchanged.

 

Active trading involves a significant amount of shorting. You should become as confident starting a short trade as you would starting a long one, in my opinion.

CONCLUSION

  1. When shorting, we must sell first and then buy.
  2. Only when the closing price is lower than the entry price is a short trade profitable.
  3. A loss occurs when the price rises above the level at which one has shorted it.
  4. When trading short, the stop loss is always set higher than the price at which the trade was initiated.
  5. In the spot market, only intraday shorting is permitted.
  6. In the spot market, the short positions cannot be maintained overnight.
  7. The futures market allows for the overnight carrying forward of short positions.
  8. The margin requirement is the same for long and short trades.
  9. Both short and long trades use a similar M2M algorithm.

Margin Calculator

by

Forward Market

• Forwards market
• Futures contract
• Future trades
• Leverage & payoff
• Margin & M2M
• Margin calculator
• Open interest

• How to short
• Nifty futures
• Nifty futures
• Futures pricing
• Hedging with futures
• Notes

learning sharks stock market institute

The trade Information

This chapter will begin with me asking the same old question once more: Why do you think margins are charged? Let me post the solution before you become irritated and chase after me.

 

From the standpoint of risk management, margins are charged. It aids in avoiding any unfavourable counterparty default. The whole risk management is supervised by the broker’s risk management system, also known as the RMS system.

 

You might find it interesting to know that the RMS is a computer programme. All customer orders only reach the exchange when this software approves them (which takes a split second), and people are watching to see if everything is done correctly or incorrectly.

 

  1. The agreement you want to purchase (like TCS futures, IDEA futures etc.)
  2. The amount you want to purchase ( number of lots)
  3. The cost at which you wish to purchase (market or limit)

 

The RMS system checks the margin requirement after you make the order and approves the deal (provided you have the required margin amount).

However, the following details are those that you typically avoid giving the RMS system:

  1. The number of days you want to keep your transaction open—is it intraday or do you want to keep it open for a few days?
  2. The stoploss point is the price at which you would like to book a loss and close the position if the trade were to go against you.

 

What would happen if you gave the RMS system these extra details now? Obviously, your risk appetite would be better defined with the additional information streaming to the RMS system.

 

The algorithm may learn how much volatility you are exposed to, for instance, by providing information on the deal duration. You are only vulnerable to 1-day volatility if you trade intraday. However, if your deal lasts for several days, you have exposed to both the “overnight risk” and volatility over a number of days.

 

The risk of holding the investment overnight is known as overnight risk. For illustration, let’s say I overnight held a long position in BPCL futures, a significant oil marketing company in India. BPCL is quite susceptible to changes in the price of crude oil.

 

Assume that the crude oil market surges by 5% overnight while I own the BPCL futures. It is apparent that this will hurt BPCL the following day as it will become more expensive for BPCL to purchase crude oil from the global markets. As a result, if I hold a BPCL position overnight, I will lose money. thus, an M2M cut. This is known as an “overnight risk.” Regardless, the argument I’m trying to make is simple: from the standpoint of the RMS system, the longer you want to hold the trade, the more the risk you are exposed to.

 

Therefore, both the term and the stop loss of the trade provide the RMS system with more information about your risk tolerance. So, as a trader, what does this mean?

 

Consider this: The RMS method creates greater clarity the more information you supply about the risk you face. Less margin is needed the more clarity it has!

 

Consider this to be somewhat like purchasing a television from a consumer electronics store. Although the following analogy may not be particularly appropriate, I believe it conveys the intended meaning.

 

He will drop both his jaws and the pricing even further if you tell him you have the cash on hand and are ready to complete the sale right immediately. The key point is that the price becomes more appealing as and when the shopkeeper learns more details about the transaction.

 

Product types

One thing is certain at this point: the less margin is necessary, the more risk information you are willing to provide with the RMS system. It goes without saying that you can accomplish more with your capital the lower the required margins are. What is the best way for a trader to provide this data to the RMS system? Well, there are particular product categories designed for this use. You can select the product type when submitting an order (to buy or sell). There are many different Product kinds, and they are different from one another primarily in terms of their functionality and the data they provide to the RMS system. Although the basic operation of these product types is the same across all brokers.

 

NRML – NRML is a common product category. Use this if you want to buy a futures trade and hold it.

 

Keep in mind that when you utilize NRML, the risk management system has no further knowledge of your trade length (because you can hold the contract until it expires) or the stop loss. You experience losses (and therefore continue to pump in the required margins). As a result, the broker’s RMS system charges you the entire margins due to the lack of transparency (i.e. SPAN and Exposure).

 

When buying futures with the intention of holding the position for several days, use NRML. But keep in mind that you can also utilize the NRML product type for intraday trading.

 

Margin Intraday Square off (MIS) is a pure intraday product offered by Zerodha, which means that any trades entered into using this product type will be for a single day only. You cannot choose MIS as an order type and anticipate the position being kept for the following day. By 3:20 PM, you are required to cut the position; if you don’t, the RMS system will do the same.

 

The RMS system clearly recognises that it is an intraday deal now that the product type is MIS, making it a step beyond NRML in terms of information flow. Keep in mind that the trader is only exposed to one day’s volatility while trading intraday. As a result, the margin need is lower than NRML margins.

 

Cover order (CO): The idea behind cover order is straightforward. First, the cover order (CO), like MIS, is an intraday product. However, the CO provides extra stop-loss information. This means that you must also indicate the stop loss when placing a CO. As a result, CO transmits both of the essential details:

 

  1. The trade’s duration, which is one day
  2. The utmost loss you will tolerate in the event that the trade goes against you is known as the stop loss.

The buy CO form is depicted in the image below.

 

The stop loss must be specified in the section that is highlighted in black.

Obviously, I won’t get into the logistics part and describe how to place a CO from the trading terminal because we have covered that in a z-connect article.

 

I want you to be aware of the fact that when you place a CO, you are also communicating the maximum loss you are willing to accept in addition to the fact that your trade is intraday. Therefore, under this, the margins should decrease significantly (even lower than MIS).

 

Bracket Order (BO): This format is very flexible. Think of the BO as a cover order improvisation. A BO is obviously an intraday order, which means that by 3:20 PM on the same day, all BO orders must be settled. You will also need to include the following information when placing a BO:

  1. The stop loss is the point at which you want to exit a trade in the event that it goes against you.
  2. Trailing stop loss: You can optionally track your stop loss with this function. The topic of “The Trailing Stop Loss” has not yet been covered. At the conclusion of this chapter, we will talk about the same. But for the time being, keep in mind that a BO allows you the option to trail your stop-loss; in fact, this is one of a BO’s most well-liked characteristics.

  3. Target – The BO also asks you to pick the price at which you want to book the profits if the trade turns out well.

 

 

Your order is sent to the exchange by the BO, where you may also set a target price and a stop loss. For active traders, this is a tremendous comfort as it benefits them in numerous ways.

 

Of course, if you’re interested in the specifics of how to place a BO, you can read this post, which outlines what needs to be done in great detail.

 

The green box highlights the SL placements in the image below, which shows the BO buy order form.

 

If you consider a bracket order, the trader transmits to the RMS system the identical data that a CO transmits. Additionally, the trader is communicating the goal price through the BO. What impact does the target price information have on the RMS system, then? From the perspective of risk management, it practically makes no difference. Keep in mind that the RMS is only concerned with your risk, not your return. The margin charged for BO and CO is therefore the same as a result of this.

 

Now that the previous conversation has been put into context, let’s explore some of the other possibilities offered by Zerodha’s margin calculator.

Back to the Margin Calculator

A short recap: we presented Zerodha’s margin calculator in the last chapter. The margin calculator’s goal is simple to understand. It aids the trader in determining the amount of margin needed for the contract he wants to trade. We also gained an understanding of the terms expiry, rollover, and spread margins in our endeavour to comprehend the same. We can now understand how information flows into the RMS system and how it affects the relevant margins thanks to the guidance provided in this chapter. Keep these in context as we examine the other two choices in the margin calculator, “Equity Futures” and “BO&CO,” which are indicated in red. Here is a picture emphasising these aspects. –

 

Equity Futures – The margin calculator’s equity futures component is a ready reckoner because it enables traders to comprehend the following:


1. The margin in NRML needed for a specific contract

2. The minimum MIS margin necessary for a specific contract

3. How many lots a trader can purchase with a certain quantity of money in his trading account

 

Nearly 475 futures are included in the Equity Futures area (as of January 2015). Let’s complete a few tasks in order to better comprehend this. Using the margin calculator’s Equity Futures section, we will complete these tasks. In the process, ideally, you will gain a better understanding of how to use the section.

 

A trader has Rs. 80,000 in his trading account for Task 1. He want to purchase and hold for three trading sessions ACC Cements Limited Futures with an expiration date of February 26, 2015. the margin needed for this deal; find out what it is. What margin is necessary for him to trade Infosys January futures on an intraday basis? Does he own enough margin to open both trades?

 

Solution: Let’s start by taking care of the ACC futures. We must search for NRML margins because the trader expects to hold the futures contract for three working days. Be aware that the SPAN calculator can also be used to complete this operation. This was covered in the prior chapter. The Equity Futures calculator, however, offers a few more benefits than a SPAN calculator.

 

Visit the Equity Futures section, and you can see all the contacts listed here; scroll till you find the desired contract. I have highlighted the same in green. Do notice; that the calculator is also listing the contract’s expiry date, lot size, and the price at which the contract is trading.

 

The black vertical box highlights the NRML margin for each contract.

 

From the table, it is clear that the ACC Feb 2015 requires a margin of Rs.48,686/-.

 

To determine the margin requirement for Infosys, I need to scroll down till I spot Infosys January contracts or type “Infy” in the search box provided.

 

As we can see, Infy’s NRML margin is Rs.67,698/-(highlighted in the black arrow), and MIS margin is Rs.27,079/-(highlighted in the red arrow). Do note the MIS margin amount is drastically lower compared to the NRML margin,

 

Since the deal is intraday, it is obvious that the trader can select the MIS product type and take advantage of the lower margin requirement of Rs. 27,079/-. Please take note that the trader may choose the NRML product type even for intraday; doing so poses no risk. However, doing so results in a blockage of the NRML margin amount. It makes sense to choose MIS and utilize the available cash effectively if one is certain about intraday trading.


Anyhow, the total margin needed by the dealer would be –

 

  1. 48,686 in payment for the ACC contract (NRML margin as the trader wishes to hold the position for 3 days)
  2. toward the Infosys contract: $27,079 (MIS margins as it is a pure intraday product).
  3. Margin total of Rs. 75,765 (48,686 + 27079)

 

Obviously, the trader can start both deals because he has Rs. 80,000 in his account.

 

A trader has Rs. 120,000 in his trading account for Task 2. On both an intraday and multiple-day basis, how many Wipro January Futures may he purchase?

 

Solution: Use the given search bar to look up Wipro. There is a “Calculate” button next to the MIS margin column (highlighted in a green arrow). Press the same button.

 

When you click on it, a form-like window appears, and you must enter –

  1. The quantity of money in your trading account, which is by default set to Rs. 100,000 but can be changed to suit your needs.
  2. The contract’s current market price (in fact, this is pre-populated)

 

Given that NRML margin is Rs. 36,806 per lot, the calculator implies that I can trade up to 3 lots of Wipro futures under the NRML product type. I can trade up to 8 lots using the MIS product type because the margin required is only Rs. 14,722 per lot.

 

And with that, we are familiar with all the features of the margin calculator’s Equity Futures section. The BO&CO calculator is now our next stop.

 

BO&CO Margin Calculator

For the reasons we mentioned before, the margin requirements for bracket order and cover order are comparable. The BO&CO calculator is very similar to the SPAN calculator in that it is easy to use. I’m attempting to determine the margin need for Biocon Futures that expire in February 2015 in the following screen shot. You’ll see that I’ve chosen everything I needed to choose besides the stop loss.

 

I go and click the “compute” button without selecting the stop-loss. When I do this, the calculator determines the default stop loss one can use as well as the necessary margin. The calculator now computes the amount as indicated below once I mention the stop loss.

 

One may select Rs. 403 as the stop-loss using the BO&CO calculation. Naturally, the margins will alter depending on where you set the stop loss. However, the needed margin of Rs. 9,062 is significantly less than the NRML margin of Rs. 26,135 and the MIS margin of Rs. 11,545.

The trailing stoploss

Let’s briefly explore the “trailing stop-loss” before we wrap up this chapter. In bracket orders, the idea of a trailing stop loss is used, and it is fundamental to trading in general. So, I suppose it’s crucial to understand how to trace your stop-loss. Consider the following scenario, which most of us would have been in: You purchase a stock at Rs. 250 with the hope that it will eventually reach Rs. 270. You hope for the best and set your stop loss at Rs. 240 (just in case the deal goes against you).

 

Things go as planned; the stock advances all the way from Rs. 250 to Rs. 265 (just a few Rupees short of your target of Rs. 270), but because of market instability, it begins to retrace back, reaching your stop loss at Rs. 240. In other words, you briefly saw revenues coming in before being compelled to record a loss.

 

How do you handle such a circumstance? We are frequently placed in situations where we are correct about the general trend but are “stopped out” by market volatility.

 

Well, you can avoid being in this predicament by using the method known as “trailing your stop loss.” In fact, trailing stop loss occasionally provides you the possibility of earning more money than you anticipated.

 

Using a trailing stop loss is an easy idea. All that is required is a simple stop-loss adjustment based on stock movement. Let me give you an illustration of this. Here is an example of a trading setup:

 

It is obvious that the plan is to buy at Rs. 2175 and maintain a stop loss at Rs. 2150. As and when the price moves in the desired direction of the trade, the stop loss is to be adjusted. The SL can be changed precisely for every 15 points of price movement in the trading direction. Any level can be chosen for the SL with the intention of locking in the earnings. “Trailing Stop Loss” refers to the process of adjusting the SL with the goal of locking in earnings.

 

I was hoping you would take note of the fact that, although I chose at random a 15-point move for this example, it could actually be any price move. Please review the following table; as the pricing fluctuates fact, it might be any price movement, as it is in this example. Please take a look at the following table. I trail my stop loss to lock in a particular amount of profit whenever the price moves 15 points in favor of the trade.

 

Please take note that even while the trailing stop loss approach allows me to ride the momentum and close in on a greater profit, the original price goal was Rs. 2220.

 

 

CONCLUSION

  1. The RMS system will require less margin the more information one provides regarding trade duration and stop losses.
  2. When you wish to start a trade and carry it overnight, use the NRML product type.
  3. The highest margins (SPAN + Exposure) are for NRML.
  4. A pure intraday trade is MIS. The MIS margin is, therefore, smaller than the NRML margin.
  5. Only time information (intraday) and not stop-loss information is communicated in a MIS trade.
  6. An additional intraday product is a cover order (CO), where the stop loss must be specified.
  7. Both the time and the SL information are communicated by a CO. Margin is, therefore, lower than MIS.
  8. A CO’s margins are comparable to a Bracket Order’s (BO) margins.

  9. One can simultaneously set the SL and target price for a BO product type. Additionally, one can trace the stop loss.

  10. A trailing SL approach necessitates adjusting the SL as the script shifts in the trader’s favor.

  11. A trailing SL is a fantastic method to capitalize on a script’s momentum.

  12. There are no set trailing guidelines; the trailing SL can be chosen dependent on the state of the market.

     

Margin Calculator

by

Forward Market

• Forwards market
• Futures contract
• Future trades
• Leverage & payoff
• Margin & M2M
• Margin calculator
• Open interest

• How to short
• Nifty futures
• Nifty futures
• Futures pricing
• Hedging with futures
• Notes

Margin Calculator (Part 1)

6.1 – The Margin Calculator

learning sharks stock market institute

We will now talk about the margin calculator as a follow-up to our chapter’s topic on margins. We will talk about the margin calculator and discover a few related subjects in the following two chapters.

Do keep in mind that we learned about the different kinds of margins  to start a futures trade in the previous chapter. Because margins are  on the volatility of the underlying, they differ from one future contract to another. Remember that volatility varies from one underlying to another, which causes margins to differ from one underlying to another. We will discuss volatility in more detail in the following lesson. So how can we find out what a specific contract’s margin requirements are? Well, if you trade with Zerodha, you probably already know about the “Margin Calculator.”

One of our most well-liked products is the Zerodha margin calculator, and for good reason. It is an easy-to-use tool with a highly advanced engine in the background. The margin calculator will be  to you in this chapter, along with the margin requirements for the contract you select. When we finish the chapter on options in the following module, we will go over this subject again and fully comprehend the adaptability of Zerodha’s margin calculator.

Let’s consider a scenario where someone chooses to purchase IDEA Cellular Limited’s futures contract, which expires on January 29, 2015. Now, one  to deposit the initial margin amount in order to start this trade. Additionally, the InitialSPAN Margin plus Exposure Margin equals Margin (IM). You only to complete the following to learn more about the IM requirement:

First, go to https://zerodha.com/margin-calculator/SPAN/ to see the margin calculator. Numerous possibilities are possible, as shown in the image below (I have  the same in black). But for the time being, we’ll concentrate on the first two choices, “SPAN” and “Equity Futures.” You will really get on the red- SPAN Margin Calculator subpage by default.

The SPAN Margin Calculator has two primary elements; let’s look at both of them in Step 2.

There are 3 drop-down menu selections in the red section. Choosing the exchange you want to run is essentially what is  of you in the ‘Exchange’ dropdown option. Decide –

  1. MCX if you want to trade commodities futures on MCX,
  2. NFO if you want to trade futures on NSE.
  3. To trade currency futures on the NSE, you must use CDS.

If you want to trade a futures contract, select Futures from the ‘Product’ drop-down menu on the right. If you want to trade options, select Options. The symbols for all of the futures and options contracts are  in the third drop-down menu. Select the contract you want from this drop-down menu.

Step 4: The Net Quantity is automatically set to 1 lot when you choose the futures contract. You must manually enter the new quantity if you want to exchange more than one lot. As you can see in the screenshot below, the net quality adjusted to the appropriate lot size, 2000, as soon as I chose the IDEA futures contract. I must enter 6000 (2000 multiplied by three) if I want to trade, say, three lots. After completing this, select the appropriate radio button (buy or sell, depending on what you want to do), and  click the blue “Add” button.

The split between the SPAN, Exposure, and total starting margin will be  once you have instructed the SPAN calculator to apply the margins. This is  in the red box in the illustration below:

The following are suggestions made by the SPAN calculator:

SPAN Margin = 22.160 Rupees

Exposure Margin = 14 730 rupees

Initial Margin = Rs. 36,890 (SPAN + Exp).

It’s that simple; now you know how much cash is  to start a futures trading on IDEA Cellular. The “Equity Futures” component of the margin calculator is the next intriguing section. The identical topic will be covered in the following chapter. To swiftly understand these three additional topics—Expiry, Spreads, and Intraday order types—we must first understand them. Once we understand these topics, we will be  better to understand the “Equity Futures” on the margin calculator.

6.2 – Expiry

The meaning of a futures contract’s “Expiry” was briefly explained in prior chapters. The contract’s expiration date, after which it will no longer exist, is by the term “expiry.” If I buy a futures contract for IDEA Cellular Limited at 149/- with an expiration date of January 29, 2015, anticipating that it will reach 155, it simply means that the move to 155 must occur by January 29, 2015. It goes without saying that I must book a loss if the price of IDEA drops below 149 before the expiration. It is useless to buy IDEA futures even if the price reaches 155 on January 30, 2015 (or any price above 149 in general).

Should it really be so rigid? Is there any leeway when it comes to extending the expiration date? As an example of what I mean:

Approximately one month from now, in the last week of February 2015, the Central Government is  to release its budget (considering today is 19th Jan 2015). This time around, I anticipate a strong budget, and in light of the ‘Make in India’ campaign, I’m optimistic that it will have a substantial positive impact on the manufacturing industry. Given this, I’m willing to wager that major manufacturer Bharat Forge will profit greatly from the incoming budget.To be more specific, I anticipate Bharat Forge to increase until the budget (pre-budget rally). I would like to purchase Bharat Forge’s futures right now in order to take advantage of my directional outlook on the company. Look at the illustration below:

Bharat Forge’s January 2015 contract is currently selling at Rs.1022/-, however given the current circumstances, in my opinion, Bharat Forge will increase in value from this point till the final week of February 2015. However, if I purchase the futures contract as indicated above, it will expire on January 29, 2015, leaving me stranded in the middle.

It is obvious that I am not  to purchase the January expiry contract because my directional view extends beyond that time frame. In fact, NSE gives you the option to choose a contract that satisfies the expiry criteria for reasons similar to these.

The NSE gives us the option to purchase a futures contract with three distinct expirations at any time. For instance, we have three Bharat contracts because it is January.

  1. 29 January 2015 – Also as the current month contract or near month contract.
  2. 2015-02-26 – This is to as the mid-month contract.
  3. March 26, 2015 – The far month contract is what it is as.

Look at the illustration below:

As you can see, depending on my particular , I may select any contract from the drop-down option for expiry that falls within the current month, mid-month, or far-month. It goes without saying that in this situation, I would select the mid-month contract that expires on February 26, 2015. (as shown below) –

The price change for futures is one element that comes out particularly clearly. The contract that ends on February 26, 2015 is currently trading at Rs. 1,032, while the contract that expires on January 29, 2015 is currently trading at Rs. 1,022.8. In other words, the mid-month contract costs more than the current-month contract. This is always true; the price increases as the expiration date approaches. In fact, the March contract for Bharat Forge Limited, which expires on March 29, 2015, is currently trading at Rs. 1,037.4/-.

For the time being, keep in mind that the price of the current month’s futures should be smaller than the prices of the mid-month and far-month futures. This has a mathematical basis, which will be .

Another crucial idea you should keep in mind is that, as I already indicated, the NSE always makes sure that three futures contracts—the current, mid, and far month—are available for trading. As of today, we are aware that the Bharat Forge contract will expire on January 29, 2015. This indicates that the January contract will no longer be valid for trading after 3:30 PM on January 29, 2015. Does that imply that starting on January 29, 2015, only the February and March contracts will remain in the system?

Not actually; the January contract is still in effect as of 3:30 PM on January 29th, 2015, after which time it will expire. NSE will launch the April 2015 contract on January 30 at 9:15 AM. Thus, we will have three contracts in effect as of January 30.

The February contract would now transition from the mid-month contract to the day before to the contract for the current month.

The mid-month contract would now be the March contract (graduated from being the far month the previous day to a mid-month now)

The recently adopted April contract is  to the far month contract.

The May contract will be  by NSE when the February contract ends. As a result, the market will be able to trade futures for March, April, and May. I could go on forever.

Anyway, sticking with the Bharat Forge Limited futures contract example, I can purchase the contract that expires on February 26, 2015 and hold it till I think it’s appropriate because I have a slightly longer time horizon. There is, however, yet another choice. I can purchase the January contract instead of the February contract, keep it until it expires or is extremely near to expiring, and  sell it. I can pay off the contract from January and purchase the one from February. This is  as a “rollover.”

If you frequently watch business news, the TV anchor will frequently discuss the “rollover statistics” right before the expiration time. Don’t be too perplexed by this, though; the process is actually fairly simple. They are attempting to convey a percentage measurement of the number of traders who have “rolled over” (or carried over) their current holdings to the mid-month. It is  as bullish if numerous traders are extending their open long bets into the following month; conversely, it is  as bearish if numerous traders are extending their open short holdings into the following month. That’s all there is to it. Is this a tried-and-true method for inferring specific market information? No, it’s only a perspective of the market.

So why would someone choose to roll over rather than purchase a long-dated futures contract? The liquidity, also as the ease of buying and selling, is one of the primary causes of this. To put it another way, more traders at any given time favour trading the current month contract than the mid or distant month contract. It goes without saying that the convenience of buying and selling improves when more traders are trading the same contract.

6.3 – Sneak Peek into Spreads

We are currently in a thrilling phase. The debate that follows may seem a little complex at times, but please read it through and make an effort to understand as much as you can. We will go into more information about this at the appropriate time in the future.

Just consider these two agreements:

  1. Futures on Bharat Forge Limited that expire on January 29, 2015
  2. Futures on Bharat Forge Limited that expire on February 26, 2015

For all intents and purposes, they are two distinct contracts with slightly different prices that receive their value from the same underlying, namely Bharat Forge Limited. As a result, they both behave similarly. Both the price of January futures and the price of February futures would increase if the spot market price of Bharat Forge stock increased.

Occasionally, circumstances arise whereby one can profit by simultaneously purchasing the current month’s contract and selling the mid-month contract, or vice versa. These kinds of opportunities are  as “Calendar Spreads.” The best way to spot these chances and put up transactions is a completely different subject. We’ll talk about this soon. But for now, I want to emphasise the importance of the margins.

We are aware of the rationale behind margin charges, which is mostly risk management. What amount of risk would there be if we bought the contract and sold the same kind of contract at the same time? The risk is significantly decreased. Let me use numbers to demonstrate.

First scenario: Trader purchases only January Futures from Bharat Forge Limited.

Spot Price for Bharat Forge is Rs. 1021 per share.

January contract price for Bharat Forge = Rs.1023/- per share

Size of Lot: 250

Assume that after purchasing, the current price falls to Rs. 1011/- (10 point fall)

Futures price as close as = Rs. 1013/-

P&L = (10 * 250) Equals loss of Rs. 2500

Scenario 2: Trader purchases January futures and sells them for February.

Spot Price for Bharat Forge is Rs. 1021 per share.

Long on the January contract for Bharat Forge at Rs.1023/- per share.

At Rs.1033/- per share, short the February Bharat Forge contract.

Size of Lot: 250

Assume that after placing this transaction, the spot price falls to 1011. (10 point fall)

January futures are approximately priced at Rs. 1013/-.

February futures are approximately priced at Rs.1023/-.

P&L on the January Contract equals (10 * 250) = a loss of Rs.

P&L on the February Contract is 10 * 250 for a profit of Rs.

Net P&L = – 2500 + 2500 = 0

A trader sells January futures and buys February futures in scenario three.

Spot Price for Bharat Forge is Rs. 1021 per share.

In the money on the January Bharat Forge contract at Rs.1023/- per share

Long on the February Bharat Forge contract at Rs. 1033 per share.

Size of Lot: 250

Assume that after this transaction is set up, the spot price rises to 1031. (10 point increase)

January futures are approximately priced at Rs.1033/-.

February futures are approximately priced at Rs.1043/-.

P&L for January Contract = (10 * 250) = Loss of Rs. 2500

P&L for February Contract = (250/10) = Rs. 2500 in profit

Net P&L = – 2500 + 2500 = 0

Clearly, the point that I’m trying to make here is that when you are long on one contract and short on another contract, the risk is virtually reduced to zero. However, it is not completely risk-free; one has to account for the liquidity, volatility, execution risk, etc. But by and large, the risk reduces drastically. So when risk reduces drastically, the margins should also reduce drastically.

In fact, this is what happens, have a look at the following snapshots –

This is the margin requirement (Rs.37,362/-) when we intend to buy January contracts of Bharat Forge.

The margin requirement (Rs. 37,629) is applicable when we plan to sell Bharat Forge’s February contracts.

And the margin  (Rs. 7,213/-) is as follows when we plan to simultaneously buy the January contract and sell the February contract.

As you can see, the January and February contracts each call for a payment of Rs. 37,362 and Rs. 37,629, respectively. Therefore, the total is Rs. 74,991. However, the risk is significantly reduced when a futures contract is bought and sold at the same time, thus the  for margin. As seen in the aforementioned graphic, the combined position only  a margin of Rs. 7,213/-. Another way to look at it is to say that the Margin Benefit (highlighted in black) is lowered from a total of Rs. 74,991 to Rs. 67,658 and is  passed on to the client. But keep in mind that a simultaneous long and short position is only created when chances present themselves. The “Calendar Spread” is the name given to these possibilities. There is no purpose in starting such trades if there is no calendar spread opportunity.

CONCLUSION

  1. You can easily determine the margin for a futures contract using the margin calculator.
  2. The built-in features of the margin calculator are very flexible.
  3. The SPAN and Exposure margins are divided up by the margin calculator.
  4. NSE makes sure there are always three contracts with the same underlying that expire in three separate (but consecutive) months at any one time.
  5. On the basis of the expiration date, a trader can select the contract of his choice.
  6. The contract for this month is to as the “Current Month Deal,” the contract for the following month as the “Mid Month Contract,” and the contract for the third month as the “Far Month Contract.”

  7. The current month contract expires with each renewal, and a new far month contract is initiated. The mid-month contract would eventually transition to the current month contract throughout this process.

  8. A trading strategy as a calendar spread is simultaneously purchasing one month’s contract and terminating another month’s contract for the same underlying.

  9. The margins needed to start a calendar spread are lower because the risk is so much lower.

Margin & M2M

by
learning sharks stock market institute

Forward Market

• Forwards market
• Futures contract
• Future trades
• Leverage & payoff
• Margin & M2M
• Margin calculator
• Open interest

• How to short
• Nifty futures
• Nifty futures
• Futures pricing
• Hedging with futures
• Notes

5. Margin & M2M

5.1 Things you should be aware of by now 

Margins undoubtedly play a significant part in futures trading because they provide for leverage. Margin is actually what provides a “Futures Agreement” the necessary financial twist (as compared to the spot market transaction). Therefore, it is crucial to comprehend margins and all of their varied aspects.

However, before we continue, let’s make a list of items you should be aware of by this point. These are ideas that we have learned during the previous four chapters; repeating these key points will help us integrate all we have learned. You must go back to the earlier chapters and review them if you are unclear about any of the following things.

  1. Over the Forwards is an improvisation called Future.
  2. The forwards market’s transactional framework is over into futures agreements.
  3. You can gain financially from a futures agreement if you have a precise sense of where the asset price is going.
  4. The comparable underlying in the spot market provides the futures agreement with its value.
  5. In the spot market, the underlying price is by the futures price.
  6. The lot size and expiration date of a futures contract, which is a standardised contract, have already been decided upon.
  1. The minimum quantity stipulated in the futures contract as the lot size.
  2. Value of the Contract = Futures Price * Lot Size
  3. Expiry is the final day on which a futures contract may be held.

7. One must deposit a margin amount equal to a specified percentage of the contract value in order to enter into a futures agreement.

1. Through the use of margins, we can leverage a transaction by making a little initial deposit and taking exposure to a transaction with a high value.

8. We digitally sign the contract with the counterparty when we transact in a futures transaction, obliging us to honor the deal at expiration.

9. The futures contract can be . Therefore, you are not  to keep the agreement until it expires.

  1. If your opinion of the asset’s direction changes, you can cancel the futures contract. You can retain the futures contract until you are of it.
  2. If the price changes in your favour, you can even hold the futures agreement for a short period of time and profit financially.

  3. Buying Infosys Futures at 9:15 AM for 1951 and selling them by 9:17 AM for 1953 would be an illustration of the aforementioned point. Given that the Infosys lot size is 250, one might earn Rs. 500 (2 * 250) in under two minutes.

  4. Even better, you can decide to keep it till it expires or cling onto it overnight for a few days.

10. Equity futures contracts settle in cash.

11. A modest change in the underlying has a significant impact on the P&L when there is leverage.

12. The buyer’s earnings are comparable to the seller’s losses, and vice versa.

13. Transferring money from one pocket to another is possible using futures instruments. As a result, it is  as a “Zero Sum Game.”
14. The risk increases as leverage increases.

15. A futures instrument’s payout structure is linear.

16. The Securities and Exchange Board of India regulates the futures market (SEBI). . There haven’t been any instances of counterparty default in the futures market because SEBI is keeping a close eye on things.

If you can clearly comprehend the previously given things, I’d say you’re currently headed in the right direction. You should go back and read the first four chapters again if you have any queries about any of the aforementioned things.

Anyway, if you understand up to this point, let’s concentrate more on the ideas of margins and mark to market.

5.2 – Why are Margins charged?

Let’s go back to the forward market scenario we used earlier (chapter 1). In the cited example, ABC Jewelers agrees to purchase 15 kg of gold from XYZ Gold Dealers for Rs. 2450 per gram in three months.

Now it is obvious that any change in the price of gold will negatively impact either ABC or XYZ. If the price of gold rises, ABC will profit and XYZ will lose money. Likewise, if the price of gold drops, ABC loses money while XYZ profits.

A forward agreement also relies on a gentleman’s word, as we all know. Imagine that the price of gold has significantly increased, putting XYZ Gold Dealers in a terrible position. Obviously, XYZ has the option to claim they are unable to pay the  amount and renege on the agreement. Obviously, what comes next will be a protracted and difficult judicial battle, but that is not the area of our concern.The important thing to remember is that a forward agreement has a very large scope and incentive to default.

Given that the futures market is an evolution of the forwards market, the default perspective is handled carefully and strategically. The margins come into play in this situation.

There is no regulation in the forwards market. There is essentially no third party overseeing the transaction between the two parties when they come to an agreement. In contrast, all trades in the futures market go through an exchange. In exchange, the exchange assumes responsibility for ensuring the settlement of all trades. When I say “onus of guaranteeing,” I mean that the exchange is responsible for ensuring that you receive your money if you are eligible. This also means that they make sure to collect the funds from the responsible party.

How does the exchange ensure that everything runs well then? They accomplish this by using –

1, Taking notes on the margins

2, putting a market price on daily gains or losses (also called M2M)

In the preceding chapter, we only skimmed the topic of margin. To completely understand the dynamics of futures trading, it is necessary to have a parallel understanding of the concepts of margin and M2M. I would like to pause briefly on margins and go on to M2M, though, because it is challenging to describe both concepts at once. We’ll fully comprehend M2M before returning to margins. Then, while keeping M2M in mind, we will revisit margins. However, before we go on to M2M, I want you to keep the following things in mind:

  1. Margin in your trading account is when you start a futures position.
  2. The “Initial Margin” is another name for the margins that are.
  3. The SPAN margin and the Exposure Margin are the two parts that make up the initial margin.
  4. SPAN Margin + Exposure Margin = Initial Margin
  5. Your trading account’s initial margin will be frozen for the number of days you decide to keep the futures trade open.

1. The initial margin’s value changes every day because it is  on the futures price.

2. Keep in mind that the initial margin equals a percentage of the contract value.

3. Futures price times lot size equals contract value.

4. Although the lot size is set, the futures price changes daily. This implies that the margins change daily as well.

So, for now, focus on these few ideas. We’ll move on to understanding M2M before returning to the margins to finish this chapter.

5.3 – Mark to Market (M2M)

As we all are aware, the futures price changes every day, and depending on the circumstances, you could earn or lose money. Marking to market, often known as M2M, is a straightforward accounting process that entails modifying your daily profit or loss and granting you the same. M2M is effective while the futures contract is still in your possession. Let’s use a clear example to illustrate this.

Let’s say you decide to purchase Hindalco Futures on December 1st, 2014, at a price of Rs. 165. The Lot is 2000 square feet. You choose to square off the position at 2:15 PM on December 4, 2014, for Rs. 170.10/-, 4 days later. The formula below clearly demonstrates that this is a profitable trade.

Buy Price = Rs.165

Sell Price = Rs.170.1

Profit per share = (170.1 – 165) = Rs.5.1/-

Total Profit = 2000 * 5.1

= Rs.10,200/-

But the transaction was  for four working days. The profit or loss on the futures contract is  to market every day it is held. The prior day’s closing price is  as a benchmark when marking to market in order to determine gains or losses.

The price movement of futures over the four days the contract was in force is  in the table above. Let’s examine daily events to better grasp how M2M functions.

The futures contract was  on Day 1 at 11:30 AM for Rs.165. It is obvious that the price increased after the contract was  because it closed that day at Rs.168.3. Thus, the daily profit is 168.3 minus 165, or Rs. 3.3 per share. The lot size is 2000, hence the daily net profit is equal to 3.3 * 2000, or Rs. 6600.

Therefore, the exchange makes sure that Rs. 6,600 is  to your trading account at the end of the day (via the broker).

  1. But from where does this money come?

1. It is without a doubt originating from the counterparty. It follows that the exchange is also making sure the counterparty pays Rs. 6,600 toward his loss.

2. But how does the transaction make sure they receive payment from the obligated party?

  1. Obviously, through the margin deposits made at the moment the deal is. But more on that in a moment.

Another crucial point that you should be aware of is that the futures buy price will no longer be treated as Rs. 165 but rather as Rs. 168.3/- from an accounting standpoint (closing price of the day). You may wonder why that is the case. You have already received the day’s profit by crediting your trading account. As a result, you are  to be in the right for the day, and tomorrow is  as a new day. As a result, the buy price is now set at Rs. 168.3, the day’s closing price.

The futures finished at Rs. 172.4/- on day 2, indicating another profitable day. The net profit for the day would be Rs. 8,200, or Rs. 4.1 per share, less the day’s profit of Rs. 172.4. Your trading account will be  with the earnings you are  to, and the buy price will be changed to the previous day’s closing price of 172.4/-.

Day 3‘s closing price of Rs. 171.6 indicates that there was a loss of Rs. 1600 compared to day 2’s close price (172.4 – 171.6 * 2000). Your trading account will be automatically debited for the lost amount. Additionally, the buy price has been changed to Rs. 171.6.

On day 4, the trader chose to close the position at 2:15 PM, or midday, at a price of Rs. 170.10 instead of holding it throughout the day. As a result, he suffered a loss for the day’s close. This would result in a loss of Rs. 171.6/- less Rs. 170.1/-, or Rs. 1.5/- per share, and a net loss of Rs. 3000/- (1.5 * 2000). Naturally, since the trader has squared off his position, it makes no difference where the futures price goes after the square off. By the conclusion of the day, Rs. 3000 is also debited from the trading account.

The amount we initially calculated, which is -, will remain the same if you add up all the M2M cash flow.

Purchase Price: Rs. 165

Sell Price = 170.1 rupees

Profit per share is (170.1 – 165), which equals Rs.5.1.

Profit total = 2000 * 5.1

= Rs.10,200/-

Therefore, a daily accounting adjustment where –

  1. Depending on how the futures price responds, money is either or debited (also as the daily obligation).
  2. The current M2M is by taking into account the previous day’s close price.

Why, in your opinion, is M2M necessary in the first place? Consider the fact that M2M is a daily cash adjustment through which the exchange significantly lowers the risk of counterparty default. The exchange by the M2M ensures both parties are daily fair and square as long as a trader keeps the contract.

Let’s go back and revisit margins while keeping in mind the fundamentals of M2M to see how the deal changes over the course of its existence.

5.4 – Margins, the bigger perspective

Let’s take another look at margins while keeping M2M in mind. The margins needed to start a futures trade are known as “Initial Margin (IM),” as was previously noted. A specific percentage of the contract value is the first margin. Additionally, we are aware of

Initial Margin (IM) = SPAN Margin + Exposure Margin

 

 

Few financial intermediaries operate behind the scenes each time a trader initiates a futures deal (or any trade, for that matter). They make sure the trade goes through without a hitch. The broker and the exchange are the two important financial intermediaries.

Of course, the broker and the exchange will suffer financially if the client breaches a contract. Therefore, proper coverage utilising a margin deposit is required if both financial intermediaries are to be  against a potential customer default.

In actuality, this is exactly how it operates: “SPAN Margin” refers to the minimum required margins  in accordance with the mandate of the exchange, and “Exposure Margin” refers to the margin  above and above the SPAN to protect against potential MTM losses. Keep in mind that the exchange specifies SPAN and Exposure margin. Therefore, the client must abide by the first margin requirement while starting a futures trade. The full initial margin (SPAN + Exposure) is  by the exchange.

Between the two margins, SPAN Margin is more crucial because failure to have it in your account would result in a penalty from the exchange. To carry a position overnight or the following day, the trader must adhere strictly to the SPAN margin requirement. The “Maintenance Margin” is another name for SPAN margin that is sometimes used.

How does the exchange determine what the SPAN margin requirement for a specific futures contract should be ? The SPAN margins are  each day using an advanced algorithm. The ‘Volatility’ of the stock is one of the important inputs that this algorithm takes into account. Volatility is a highly important subject, and we shall go into great detail about it in the following module. Just keep in mind this for the moment: if volatility is anticipated to increase, the SPAN margin required increases as well.

The additional margin known as exposure margin ranges from 4% to 5% of the contract value.

You may already be aware if you trade with Zerodha that the SPAN and exposure margin requirements are  clearly in our margin calculator. Of course, we’ll go into more depth about the usefulness of this handy tool later on. However, you may look at this margin estimator for the time being.

Keeping the aforementioned transaction specifics in mind, let’s examine how margins and M2M interact concurrently during the course of the trade. The table below illustrates how the dynamics alter daily.

I hope the table above doesn’t overwhelm you; in reality, it is pretty simple to understand. Let’s go through everything day by day in order.

10th Dec 2014

The HDFC Bank futures contract was  for Rs. 938.7 at some point in the day. There are 250 square feet on the land. The contract’s value is therefore Rs. 234,675/-.

As we can see from the box on the right, SPAN makes up 7.5 percent of CV while Exposure makes up 5 percent. As a result, 12.5 percent of the CV is set aside for margins (SPAN + Exposure), which comes to a total margin of Rs. 29,334/-. The first margin is sometimes regarded as the initial sum of money the broker has .

HDFC will now close for the day at 940. The CV has increased to Rs. 235,000 at 940, making the total margin needed Rs. 29,375, a slight increase of Rs. 41 above the margin needed at the time the transaction was ]. The client is not  to add this money to his account because he would have an M2M profit of Rs. 325 that will cover his needs.

Cash Balance + M2M equals the total amount of cash in the trading account.

= Rs.29,334 + Rs.325

= Rs.29,659/-

There is no issue because the cash amount clearly exceeds the whole margin requirement of Rs. 29,375. Additionally, the reference rate for the M2M for the following day is now set at Rs. 940.

11th Dec 2014

The M2M was negatively affected by Rs. 250 the day after HDFC Bank’s share price dropped by Rs. 1 to Rs. 939. This sum is  from the available cash (and will be  to the person making this money). The new cash balance will therefore be –

= 29659 – 250

= Rs.29,409/-

Additionally, a new margin need of Rs. 29,344 is . There is no need to worry because the cash balance is bigger than the necessary margin.

Additionally, the reference rate for the M2M for the following day is reset to Rs.939.

12th Dec 2014

It’s a fascinating day today. The futures price decreased by Rs. 9 to become Rs. 930 per share. The margin needed also decreases at Rs.930/- to Rs.29,063/-. The cash balance falls to Rs. 27,159/- (29409 – 2250), which is less than the whole margin need, due to an M2M loss of Rs. 2,250. Is the client compelled to put up the extra cash because the cash balance is less than the overall margin requirement? Actually, no.

Keep in mind that the SPAN margin is the more revered of the two margins, followed by the Exposure margin. As long as you have the SPAN Margin, most brokers will let you keep your holdings (or maintenance margin). When the cash balance is lower than the maintenance margin,You will receive a call from them requesting additional funding. If not, they will compel the positions to shut on their own. This call from the broker asking you to deposit the necessary margin funds is also known as the “Margin Call.” Your cash balance is too low to maintain the trade if your broker is sending you a margin call.

Returning to the example, there is no issue because the cash balance of Rs. 27,159 is greater than the SPAN margin of Rs. 17,438. The M2M loss is deducted from the trading account, and the reference rate is then reset to Rs. 930 for the M2M transaction the next day.

Well, I hope you now have a better understanding of how margins and M2M interact. I also hope you can see how effectively the exchange can deal with a potential default threat thanks to the margins and M2M. The margin plus M2M combination is essentially a surefire way to prevent defaults.

I’ll take the liberty of skipping the next days and going straight to the last trading day in the event that you’re beginning to understand how margins and M2M calculations work.

19th Dec 2014

The trader makes the decision to cash out and settle the contract at 955. The closing rate from the day before, which is Rs. 938, serves as the M2M reference rate. Therefore, the M2M profit would be Rs. 4250, which is added to the cash amount of Rs. 29,159 from the previous day. When the trader squares off the trade, the broker will release the remaining cash amount of Rs. 33,409 (Rs. 29,159 + Rs.

What about the trade’s overall P&L? Well, there are numerous methods for calculating this:

Method 1: Add up all M2Ms.

P&L = the total of all M2Ms

= 325 – 250 – 2250 + 4750 – 4000 – 2000 + 3250 + 4250

= Rs.4,075/-

Second Approach: Cash Release

P&L = Total Cash Flow (released by broker) – Cash Was Initially  (initial margin)

= 33409 – 29334

= Rs.4,075/-

Procedure 3: Contract Value

P&L is equal to Final Contract Value less Initial Contract Value.

= Rs.238,750 – Rs.234,675

=Rs.4,075/-

Fourth Approach: Futures Price

P&L is (difference between the futures buy price and sale price) * Lot Size.

Buy at $938.7, sell at 955, and have a 250-piece lot.

= 16.3 * 250

= Rs. 4,075/-

As you can see, using either method of calculation results in the same P&L value.

5.5 – An interesting case of ‘Margin Call.’

Let’s pretend for a second that the trade was not closed on December 19 and was instead carried over to December 20. Let’s further say that HDFC Bank experiences a significant decline on December 20 — perhaps an 8 percent decline that causes the price to drop from 955 to 880. What do you anticipate happening? Can you actually respond to these inquiries?

 

  1. What is the P&L for M2M?
  2. How does it affect the cash balance?
  3. What SPAN and exposure margin is necessary?
  4. How does the broker proceed?

 

I hope you can figure these out on your own, but if not, I’ll give you the answers:

The M2M loss is calculated as (955 – 880)*250 or Rs. 18,750. The cash balance as of December 19 was Rs. 33,409; the M2M loss would be subtracted from this amount to leave a cash balance of Rs. 14,659 (Rs. 33,409 – Rs. 18,750).

  1. Because the cost has decreased, the new contract value is Rs. 220,000 (250 x 880).
  2. SPAN equals 7.5 percent times 220000, or Rs. 16,500.

1. Exposure equals $11,000.

2. Total Margin = 27,500 rupees

 

3. The broker will obviously issue a margin call to the client because the cash balance (Rs. 14,659) is less than the SPAN Margin (Rs. 16,500), and some brokers will actually close the transaction as soon as the cash balance falls below the SPAN requirement.

 

CONCLUSION

  1. As long as the futures trade is active, a margin payment is necessary (which your broker will prohibit).
  2. The initial margin refers to the margin that the broker stopped when the futures trade was first initiated.
  3. The initial margin deposit will be required from both the buyer and the seller of the futures contract.
  4. The amount of margin obtained serves as leverage by enabling you to deposit a modest sum of money and participate in a transaction with a high value.
  5. The M2M method, which entails crediting or debiting the daily obligation funds in your trading account depending on how the futures price behaves, is a straightforward accounting adjustment.

  6. The closing price from the day before is used to determine the M2M for the current day.

  7. Exposure Margin is collected in accordance with the broker’s requirements, while SPAN Margin is collected in accordance with the exchange’s instructions.

  8. The SPAN and Exposure Margin are calculated in accordance with exchange standards.

  9. The Maintenance Margin is the common name for the SPAN Margin.

  10. If the investor wants to continue forward the future position, he must deposit more money into his account if the margin account falls below the SPAN.

  11. When the cash balance falls below the necessary level, the broker will issue a “margin call” and ask the trader to inject the necessary margin money.

Leverage & payoff

by
learning sharks stock market institute
image by WikiFinancepedia

Forward market

• Forwards market
• Futures contract
• Future trades
• Leverage & payoff
• Margin & M2M
• Margin calculator
• Open interest

How to short
• Nifty futures
• Nifty futures
• Futures pricing
• Hedging with futures
• Notes

Leverage & payoff

4.1 – A quick recap

We were able to understand the operation of futures trading with the use of the Tata Consultancy Services (TCS) example from the previous chapter. In the hypothetical futures deal, we were forced to buy Tata futures since we believed the stock price would eventually rise. Additionally, we made the decision to square off the contract for a profit the very next day. You may remember, though, that we asked a crucial question right at the start of the example. I’ll restate it here for your convenience.

 

The idea that TCS stock price had overreacted to the management’s announcement was the foundation of the rationale for going long on TCS. I anticipated that the stock price would rise eventually. A futures transaction was started once a directional view was created. The question was: Considering that it is expected that the stock price would increase, why bother buying futures when one could simply buy the shares on the open market?

 

In fact, signing a digital contract with the counterparty is a requirement for purchasing futures. A futures agreement is also time-bound, which means the directed perspective must come true within the allotted time frame. One must experience a loss if it does not materialise within the allotted time (as in the expiry). Compare this (purchasing futures) to simply purchasing stock and letting it sit in your DEMAT account. There is no time constraint or contractual duty. Why then do people actually need futures? Why is it so appealing? Why not simply purchase the stock without paying attention to the price or the time?

 

The financial leverage present in all financial derivatives, including futures, provides the answers to all of these queries. Leverage, as they say, is a true financial innovation that can produce wealth if applied appropriately. Let’s quickly examine this aspect of futures trading.

 

 

4.2 – Leverage in perspective

We all employ leverage at some point or another in our lives. We don’t approach it the right way when we think about it. We fail to see behind the numbers and, as a result, never fully understand leverage.

 

This is a prime illustration of leverage, and many of you may be able to identify.

 

My friend is a real estate trader; he enjoys purchasing homes, land, and structures to hold onto for a while before selling them. He thinks this is preferable to trading stocks, and I beg to differ. We could argue about this for hours, but maybe another time.

 

Anyway, below is a synopsis of a recent real estate deal he completed. Popular builders in Bangalore, Prestige Builders, located a plot of land in South Bangalore in December 2013. They revealed a brand-new undertaking: an opulent residential building with cutting-edge features. For the price of Rs. 11,000,000/-, my friend jumped in and reserved a two-bedroom, hall, and kitchen apartment that was supposed to be built on the ninth level. By the middle of 2018, the project is supposed to be finished. The prospective purchasers only needed to pay 10% of the actual buy value because the flat had just been notified and no work had begun. When it comes to purchasing brand-new apartments, this is essentially the standard. Scheduled for payment was the remaining 80%.

 

So, in December 2013, my friend was able to purchase a house worth Rs. 11,000,000 for an initial financial outlay of Rs. 11,000,000 (10 percent of 11,000,000). In fact, the property was so popular that it only took two months after Prestige Builder announced the brand-new project for all 120 flats to be snapped up like hotcakes.

 

When December 2014 rolled around, my friend’s apartment had a potential buyer. My acquaintance, who trades real estate, seized the chance. A brief survey found that the area’s real estate had increased in value by at least 25% (well, that’s how crazy Bangalore real estate is there). My friend’s apartment, which was on the ninth floor, was now worth Rs. 12,500,000. The sale price was agreed upon by my friend and the prospective buyer at Rs. 12,500,000.

 

It is obvious that not much about this deal stands out.

 

  1. By contributing just 10% of the transaction value, my friend was able to take part in a significant deal.
  2. My acquaintance had to pay 10% of the total amount to participate in the transaction (call it the contract value)
  3. In terms of the “Futures Agreement,” the initial value he pays (10 lakhs) can be viewed as a token advance, or it would be the initial margin deposit.
  4. A slight change in asset value has a significant influence on return.
  5. It should be clear that a 25% rise in asset value led to a 250% return on investment.
  6. This kind of transaction is known as a “Leveraged Transaction.”

Because all futures transactions are leveraged, please make sure you fully comprehend this example. It is extremely similar to a futures trade. As we return to the TCS trade, do remember this scenario in perspective.

4.3 – The Leverage

Let’s rework the TCS example with additional specifics because we previously examined the overall framework of the futures contract. The transaction information is as follows for the sake of simplicity: We’ll assume there’s a chance to purchase TCS on December 15 at a price of Rs. 2362 per share. Furthermore, we’ll presume that the opportunity to square off this position at Rs. 2519 on December 23rd presents itself. Additionally, we’ll presumptively find no distinction between the spot and futures prices.

 

With Rs. 100,000 in hand and a strong outlook for the price of TCS stock, we must choose between Option 1 — buying TCS stock on the open market — and Option 2 — buying TCS futures from the derivatives market. Let’s assess each choice in order to comprehend its dynamics.

 

Option 1: Purchase TCS shares on the open market.

 

We must determine the price at which TCS is trading on the spot market and determine how many other equities we can afford to purchase (with the capital at our disposal). It takes at least two working days (T+2) after purchasing the stock on the spot market for the funds to be credited to our DEMAT account. We merely need to wait for the best chance to sell the equities once they are in the DEMAT account.

 

Several key benefits of purchasing stocks on the spot market (based on delivery) include:

 

  1. We must wait for at least two working days after we purchase the stock (for delivery to DEMAT) before deciding whether or not to sell it. This implies that we are unable to actually sell the shares, even if a good opportunity to do so arises the very following day.
  2. Depending on the amount of capital we have available, we can purchase the shares. Meaning that if we have Rs. 200,000 available for spending, we can only spend up to this amount and not more.
  3. There is no time constraint; if one has the patience and leisure, they can put off selling for a very long period.

Specifically, on December 15th, 2014, we can purchase It with Rs. 200,000 in our pocket.

 

=2,00,000/250

~ 80 shares

 

Now, on December 23, 2014, at a price of Rs. 2600, we can close off the trade for a profit.

=80 * 2600

=2,08,000

 

=[6000/2,00,000]*100

=3%

 

An amazing return of 3.00% over a period of 9 days. In actuality, an annualized 9-day return of 3% gives roughly 215 percent. This is amazing!

 

How does this compare to choice 2 though?

 

Option 2: Purchase TCS Stock on the Futures Exchange.

 

Variables for recall in the futures market are predetermined. For instance, TCS requires that 150 shares or multiples of 150 shares be purchased as the minimum number of shares (lot size). The “contract value” is determined by multiplying the lot size by the futures price. Given that we are aware of the futures price per share of Rs. 2500, the contract value is.

 

=125 * 2500

=3,12,500

 

Does that imply that I need Rs. 3,12,500 in total funds to engage in the futures market? No, the contract value is Rs. 3,12,500; however, in order to trade in the futures market, one only needs to deposit a margin amount that represents a specific percentage of the contract value. With respect to TCS futures, we require roughly 15% margin. All we require to enter into a futures arrangement is Rs. 46,875 at a margin of 15% (15% of Rs. 3,12,500). You might have the following inquiries at this point:

 

  1. What happens to the remaining funds? Specifically, Rs. 2,65,625 (Rs. 3,12,500 minus Rs. 46,875).
  • Actually, that money is never disbursed.

2. When I say “never really paid out,” what do I mean?

  • When we get to the chapter on “Settlement – mark 2 marketplaces,” we will comprehend this more clearly.

3. Is the 15% fixed across all stocks?

  • No, it changes depending on the stock.

Let’s now examine the futures trade in more detail while keeping these aforementioned points in mind. The amount of money in hand is Rs. 200,000. However, the cash requirement for the margin is only Rs. 46,875 ($).

 

This suggests that we might buy two lots of TCS futures rather than just one. The number of shares with 2 lots of TCS futures would be 250 (125 * 2), costing Rs. 82,670/- as the margin required. We would still have cash remaining after committing Rs. 82,670 as margin for 2 lots, which is Rs. 17,330. But since we truly can’t do anything with this money, it is best to leave it alone.

 

The TCS futures equation now looks like this:

 

Size of Lot: 125

No of lots – 2

 

Futures Buy price – Rs. 2362/-

Futures Buy Price * Lot Size * Number of Lots = Futures Contract Value at the time of purchase.

 

= 125 * 2 * Rs. 2362/-

= Rs. 590,500/-

 

Margin Amount – Rs.82,670/-

 

Futures Sell price = Rs.2519/-

 

Futures Contract Value = 125 * 2 * 2519 at the time of sale.

 

= Rs.629,750/-

 

This translates to a profit of Rs. 39,250/-!

 

Do you notice the distinction? In the spot market, a move from 2361 to 2519 yielded a profit of Rs. 5,798; nevertheless, the same move yielded Rs. 39,250. Let’s take a peek at the percent return to see how juicy this appears.

 

Recall that we invested Rs. 82,670 in the futures deal; therefore, the return must be calculated using this as the base.

 

[39,250 / 82,670]*100

 

This equals a staggering 47 percent spread across 9 days. Compare that to the spot market’s 5.79 percent. This amounts to a 1925% yearly return for the purpose of annualization. I hope I’ve persuaded you by now as to why short-term traders favour transactions on the futures market over those on the spot market.

 

Alternatives to a standard spot market transaction include futures. You need a lot less money to enter into a comparably significant transaction because “Margins” exist. Your gains could be very high if your point of view is correct.

 

Leverage is the ability to take positions that are significantly larger than the available money. Leverage has two sharp edges. Leverage may build wealth if employed with the proper mindset and expertise; if not, it can destroy it.

 

We have talked extensively about the benefits of trading futures, but what about the risks? What if the direction is not as clear-cut as anticipated? We need to comprehend how much money we stand to make (or lose) dependent on the underlying movement in order to comprehend both sides of a futures trade. “Futures Payoff” is the name given to this.

 

 

4.4 – Leverage Calculation

How much leverage are you exposed to is a question that is frequently addressed when discussing leverage. Leverage affects risk and potential reward in a positive feedback loop.

 

Calculating leverage is quite easy –

 

[Contract Value/Margin] = Leverage. Consequently, the leverage for TCS trade is

 

= [295,250/41,335]

= 7.14, which is read as 7.14 times or simply as a ratio – 1: 7.14.

 

This means every Rs.1/- in the trading account can buy upto Rs.7.14/- worth of TCS. This is a very manageable ratio. However, if the leverage increases, then the risk also increases. Allow me to explain.

 

To lose the entire margin amount with a leverage ratio of 7.14, TCS must decline by 14%; this may be computed as –

 

1 / Leverage

= 1/ 7.14

= 14%

 

Let’s pretend for a while that the margin required was only Rs. 7000 instead of Rs. 41,335 at this time. The leverage in this situation would be –

 

= 295,250 / 7000

= 42.17 times

 

There is no doubt that this leverage ratio is exceedingly high. If TCS declines by – one will forfeit all of his capital.

 

1/41.17

= 2.3%.

 

Therefore, danger increases as leverage does. When leverage is excessive, the margin deposit can be lost with just a slight change in the underlying.

 

To double your money, however, you only need a 2.3 percent change in the underlying at about 42 times leverage.

 

Personally, I dislike using too much leverage. I limit my trading to trades with leverage of no more than 1:10 or 1:12.

 

4.5 – The Futures payoff

Consider the following scenario: I purchased TCS futures with the hope that the stock price would increase, allowing me to profit from the futures trade. But what if the price of TCS stock declined instead of rising? I would undoubtedly lose money. After starting a futures trade, consider it. I would either stand to make a profit or a loss at any price point. A futures transaction’s payout structure only illustrates the degree to which I gain or lose money at various potential price points.

 

Let’s construct one for the TCS trade to better understand the reward structure. Keep in mind that this was a lengthy trade started on December 16th at Rs. By December 23rd, after the trade has started, the price of TCS could change drastically. As I said, I will either earn a profit or a loss at any pricing point. While a result, as I create the structure’s pay, I will make a variety of price point assumptions that could materialize by December 23. I will then examine the P&L situation for each of these assumptions.

 

You should view this table this way: Provided you are a buyer at Rs. 2362, the P&L by Dec. 23 would be Rs. 2160, assuming TCS is trading. According to the table, you would experience a loss of Rs. 202 per share (2362 – 2160).

 

What would your P&L look like if TCS was trading at 2600 as well? As the table indicates, you would earn Rs. 238 ($0.38) per share (2600 – 2362). I could go on forever.

 

If you remember from the last chapter, we actually indicated that if the buyer is making a profit of Rs. X, then the seller is losing Rs. X. Therefore, if 23rd Dec TCS is trading at 2600, the buyer will gain a profit of Rs. 238 per share and the selling will suffer a loss of Rs. 238 per share, assuming the seller shorted the share at Rs. 2362 per share.

 

Another way to look at this is that the buyer is receiving the money that was previously in the seller’s pocket. It is only a money transfer, not the creation of new money!

 

Another way to look at this is that the buyer is receiving the money that was previously in the seller’s pocket. It is only a money transfer, not the creation of new money! Transferring money and making money are two different things. When value is created, money is produced. For instance, if you purchased TCS shares with the long term in mind, the company’s performance would result in higher profits and margins. It goes without saying that a share price undervaluation will be advantageous to you as a shareholder. This is wealth production or the creation of money. In contrast to futures, money is not created in this situation; rather, it is transferred from one pocket to another.

 

Futures (or financial derivatives in general) are known as “Zero Sum Games” for precisely these reasons.

 

Let’s now create a graph showing the potential price on December 23 in relation to the buyer P&L. Also known as the “Payoff Structure,”

 

As you can see, a profit is made at any price above the buy price (2362), while a loss is experienced at any price below the buy price. A 1 point rise (from 2362 to 2363) in the value of the trade, which required buying 2 lots of futures (250 shares), results in a profit of Rs. 250. The same goes for a 1 point downturn (from 2362 to 2361), which results in a loss of Rs. 250. There is definitely a sense of proportionality at play here. The proportionality results from the fact that the seller’s loss is equal to the buyer’s gain when they both buy or sell at the same price.

 

Most importantly, because the P&L is a smooth straight line, it is said that the futures are a “Linear Payoff Instrument”.

 

 

 

 

CONCLUSION

  1. The use of leverage is crucial when trading futures.
  2. By using margins, we can take a tiny initial investment and participate in a high-value transaction.
  3. Typically, margins are levied as a percentage of the contract value.
  4. We can only deal with the amount of our capital on the spot market because it is not leveraged.
  5. A modest change in the underlying has a significant impact on the P&L when there is leverage.
  6. The buyer’s earnings are comparable to the seller’s losses, and vice versa.
  7. Leverage increases risk and, as a result, increases the likelihood of financial success.
  8. Futures instruments merely enable money transfers between pockets. As a result, it is known as a “Zero Sum Game.”
  9. A futures instrument’s payout structure is linear.
    512 remarks.

Appreciation

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Because we believe each student should be successful. Since our program is so powerful. So, we encourage and invite more applications, therefore. Of course, we feel proud to invite the differently abled students too. Moreover, the stock market does not care about any race, religion, family background or religion also. Then, again, We are there to assist you with the best education. Finally, head over to our contact page to speak to our counsellor. For one thing, we do not want our students to fail, which is why give regular and repeated classes too.

 

Forward Market

by

Forward Market

• Forwards market
• Futures contract
• Future trades
• Leverage & payoff
• Margin & M2M
• Margin calculator
• Open interest

• How to short
• Nifty futures
• Nifty futures
• Futures pricing
• Hedging with futures
• Notes

Future Trades

Before the Trade

We learned a variety of futures market-related ideas in the previous chapter. Keep in mind that any trader who enters into a futures agreement is doing so with the intention of earning money. The trader needs to be able to predict the direction of the underlying asset’s price. 

Perhaps it’s time to use a real-world futures deal as an example to show how this is . Let’s look at an example with stocks as we depart from the gold example.

Today (15th Dec 2014), Tata Consultancy Services (TCS) management, a leading Indian Software Company, had investors meet, wherein the TCS management announced that they are cautious about the revenue growth for the December Quarter.  The markets do not like such cautious statements, especially from the company’s management. 

After the statement, the markets reacted to it, and as we can see from the TCS’s spot market quote, the stock went down by over 3.6%. In the snapshot below, the price per share is  in blue. Ignore the red highlight; we will discuss it shortly.

As a trader, I believe that the TCS stock price reaction to the management’s statement is . 

Here is my rational – If you follow TCS or any Indian IT sector company in general, you will know that December is usually a lacklustre month for the Indian IT companies. December is the financial year-end in the US (the biggest market for the Indian IT companies) and the holiday season; hence the business moves quite slowly for such companies. This furlough has a significant impact on the IT sector revenues. 

This information is already known and factored in by the market. Hence, I believe the stock sinking by 3.6% is unwarranted.  I also feel this could be an opportunity to buy TCS, as I believe the stock price will eventually go up. Hence I would be a buyer in TCS after such an announcement.

Notice, based on my thoughts (which I perceive as rational), I have developed a ‘directional view’ on the asset’s price (TCS). I believe the TCS (underlying asset) stock price will increase in due course of time from my analysis. In other words, I am bullish about TCS at the current market price.

I choose to purchase TCS Futures rather than TCS Shares on the Spot Market (for reasons I will discuss in the next chapter). I only need to look at the price at which the TCS Futures are trading after deciding to purchase futures. On the NSE website, the contract information are easily accessible. In reality, the spot market quotes have a link to access specifics for a TCS futures contract. In the picture above, I’ve  the same thing in red.

Remember that the futures price ought to constantly mirror the spot price, thus if the spot price has decreased, the futures price ought to decrease as well. Here is a screenshot of the TCS Futures price from the NSE website.

Because the futures price has, as anticipated, followed the spot price, the TCS Futures are likewise down 3.77 percent. Now, you might have two inquiries:

  1. TCS is down 3.61 percent in the spot market. TCS futures, however, are down 3.77 percent. Why the distinction?
  2. TCS spot price is at Rs.2362.35, but Futures price is at Rs.2374.90? Why the difference?

Both of these are legitimate questions at present moment, and the answers to them depend on the “Futures Pricing Formula,” a subject we shall cover later. But the most crucial thing to remember at this time is that the spot price and the futures price have moved in lockstep and are both down for the day.

 Let’s take another look at the futures contract and analyse a few crucial components before moving on. I’ll re-post the futures contract with a few key points .

The box indicated in red at the top contains three crucial details, beginning at the top:

  1. Instrument Type: Keep in mind that the underlying asset is a company’s stock, and that we are in the future contract for the asset. As a result, the type of instrument in this case is “stock futures.”
  2. Symbol – This draws attention to the stock’s name, in this case TCS.
  3. Expiry Date – This is the date on which the contract ceases to exist. As we can see, the TCS futures contract specifies 24th Dec 2014 as the expiry. You may be to know that all derivative contracts in India expire on the last Thursday of the month. We will discuss more what happens on the expiry date at a later point.

The blue box, which just displays the future price, is something we had briefly examined earlier.

Finally, the black box draws attention to two crucial variables: the market lot and the underlying value.

  1. The price at which the underlying is on the spot market is as the underlying value. TCS was reportedly trading at Rs. 2362.35 a share when I took the above picture, but it had since dropped by a few more points. Consequently, the share price we see here is Rs. 2359.90.
  2. Remember that a futures contract is a standardised contract with a market lot (lot size). It prefixes the parameters. The minimum number of shares we must buy or sell in order to reach an agreement is as the lot size. The TCS futures’ minimum lot size is 125 shares, hence in order to trade TCS futures, a minimum of 125 shares (or a multiple of 125 shares) must be.

Recall that the “contract value,” which is equal to the “Lot size” times the “futures price,” was  in the previous chapter. Now, we can determine the contract value for TCS futures using the formulas below.

Lot size times futures price equals contract value.

=150x 2500.00

=3,75,000

Let’s quickly look at another “Futures Contract” to cement our understanding before moving on to the TCS futures deal. Here is a screenshot of the “State Bank of India (SBI)” futures contract.

You might be able to provide answers to the following queries using the above snapshot:

  1. What kind of instrument is it?
  2. What is the futures price for SBI?
  3. How does the future price of SBI compare to the current pricing?
  4. What is the expiry date of the Futures contract?
  5. What are the lot size and the contract value of SBI futures?

The Futures Trade

Returning to the TCS futures trade, the plan is to purchase a futures contract because I anticipate an increase in the stock price of TCS. I would purchase TCS Futures at a cost of Rs. 2374.9 per share. Keep in mind that I must purchase a minimum of 125 shares. A more common term for the bare minimum of shares is “one lot.”

How do we purchase the “Futures Contract” then? It’s really easy to do; we can either phone our broker and ask him to purchase 1 lot of TCS futures at a cost of Rs. 2374.99 or we can do it ourselves using the trading platform.

I like using the trading terminal to place my own transactions. I advise reading the chapter on the Trading terminal if you are unfamiliar with it. The only thing I have to do to buy the contract is press F1 once TCS Futures has loaded on my market watch.

Several things take place in the background as soon as I press the F1 key on my trading terminal to indicate my want to purchase TCS futures.

1. Margin Validation- Keep in mind that we must always deposit a margin amount (sort of a token advance) when we engage into a futures agreement. This amount is merely a percentage of the contract value. Margin will be  shortly. If the margin is insufficient, we cannot concur. Therefore, the risk management system or software of the broker verifies as the first step that I have enough funds in my trading account to satisfy the margin requirement to engage into a futures agreement.

2. The counterparty search- Following margin validation, the system looks for a suitable counterparty match. It is necessary to match the seller of TCS futures with me as the buyer of TCS futures. Keep in mind that the stock market is a “financial supermarket” with a wide range of players who have different opinions on how much an asset should be worth. The seller of TCS futures clearly believes that the price of TCS futures will continue to decline. The seller has a similar justification for his directional perspective as I have for my prediction that the price of TCS stock would increase. Thus, he desires to work as a seller.

3. The signoff – The buyer and seller digitally sign the futures agreement after Steps 1 and 2, which involve validating the margin and identifying the counterparty, are complete. The majority of this process is symbolic. By deciding to purchase (or sell) the futures agreement, each party authorises the other to abide by the terms of the contract.

4. The margin block –The necessary margin is  in our trading account after signoff is complete. The  margin cannot be  for any other purpose. As long as we continue to hold the futures contract, the money will be .

I now hold 1 lot of TCS Futures Contract after completing these 4 procedures. You might be  to learn that all of the aforementioned procedures take place consecutively in the real markets in a matter of seconds!

What does it imply when it says, “I now possess 1 lot of TCS Futures Contract,” exactly? Simply put, it means that by acquiring TCS futures on December 15th, 2014, I have digitally negotiated with a specific counterparty to acquire 125 TCS shares from me (the counterparty) at Rs. 2374.9/- each share. The counterparty and I have a futures contract that expires on December 24, 2014.

The 3 possible scenarios post the agreement

After agreeing, 3 possible scenarios can pan out by 24th Dec 2014. We know what these scenarios are (we studied them in chapter 1) – the price of TCS can go up, the price of TCS can come down, or the price of TCS could stay the same. Let us arbitrarily take up a few possible price situations and see the price’s impact on both the parties involved.

Scenerio 1- TCS stock price goes up by 24th Dec.

In this instance, my prediction about the trajectory of TCS shares was correct. I therefore stand to gain from this.

Consider that on December 24, 2014, TCS’s stock price increased from Rs. 2374.9 to Rs. 2450 per share. As a result of the increase in the spot price, the futures price would likewise rise. 

This indicates that I am  to purchase TCS shares at Rs. 2374.9/- per share, which is significantly less than the going market rate. (Rs. 2450 – Rs. 2374.9) My profit per share will be Rs. 75.1. Since there are 125 shares involved in the transaction, my entire profit will be Rs. 9387.5 (Rs. 75.1 * 125).

The seller plainly loses money since he is  to sell TCS shares at Rs. 2374.9 per share rather than at the substantially higher price of Rs. 2450 per share on the open market. Without a doubt, the vendor loses out to the buyer.

Scenario 2: The TCS stock price declines by December 24.

This is an instance where my analysis of the direction of TCS stock was incorrect. I would therefore stand to lose.

Assume that on December 24th, 2014, TCS’s stock price drops from Rs. 2374.9/- to Rs. 2300/- per share; as a result, the futures price will likewise drop to a level that is roughly equivalent. 

As a result, I am  to purchase TCS shares at Rs. 2374.9/- a share, which is significantly more expensive than the market price. My loss will be Rs. 75 (Rs. 2374.9 – Rs. 2300) per share. Since there are 125 shares involved in the deal, my overall loss will be Rs. 9375 (Rs. 75 * 125).

As I am  to purchase Tata shares for Rs. 2374.9 per share rather than purchasing them on the free market for a far lower price of Rs. 2300 per share, I will undoubtedly suffer a loss. It is obvious that the seller’s benefit is the buyer’s loss.

Situation 3: The Tata stock price stays the same.

In such a case, neither the buyer nor the seller gain, hence no party is financially impacted.

Utilising a trading chance

Following agreement, three potential outcomes could occur by December 24th, 2014. These possible outcomes are known to us because we studied them in chapter 1; the price of TCS may increase, decrease, or remain unchanged. Let’s arbitrarily choose a few different price scenarios and examine how the prices affect the two sides.

 

Scenario 1: Tata stock price increases by December 24.

In this instance, my prediction about the trajectory of TCS shares was correct. I therefore stand to gain from this.

Consider that on December 24, 2014, TCS’s stock price increased from Rs. 2374.9 to Rs. 2450 per share. 

As a result of the increase in the spot price, the futures price would likewise rise. This indicates that I am  to purchase TCS shares at Rs. 2374.9/- per share, which is significantly less than the going market rate. (Rs. 2450 – Rs. 2374.9) My profit per share will be Rs. 75.1. Since there are 125 shares involved in the transaction, my entire profit will be Rs. 9387.5 (Rs. 75.1 * 125).

The seller plainly loses money since he is  to sell TCS shares at Rs. 2374.9 per share rather than at the substantially higher price of Rs. 2450 per share on the open market. Without a doubt, the vendor loses out to the buyer.

Scenario 2: The Tata stock price declines by December 24.

This is an instance where my analysis of the direction of TCS stock was incorrect. I would therefore stand to lose.

Assume that on December 24th, 2014, TCS’s stock price drops from Rs. 2374.9/- to Rs. 2300/- per share; as a result, the futures price will likewise drop to a level that is roughly equivalent. As a result, I am  to purchase TCS shares at Rs. 2374.9/- a share, which is significantly more expensive than the market price. My loss will be Rs. 75 (Rs. 2374.9 – Rs. 2300) per share. Since there are 125 shares involved in the deal, my overall loss will be Rs. 9375 (Rs. 75 * 125).

I will undoubtedly lose money since I am  to purchase TCS shares for Rs. 2374.9 instead of doing it on the open market for Rs. 2300. The seller’s gain is unquestionably the buyer’s loss.

Situation 3: The Tata stock price stays the same.

In such a case, neither the buyer nor the seller gain, hence no party is financially impacted.

Exploiting a trading opportunity

So let’s look at the situation: after purchasing TCS futures on December 15 for Rs. 2374.9/-, the price of TCS increased the following day, on December 16. It is currently trading at Rs. 2460. What shall I do? Clearly, I stand to gain a lot from the price hike. I am currently sitting at a profit of Rs. 85.1 per share, or Rs. 10,637.5 (Rs. 85.1 * 125) as an overall profit, at the time the picture was .

Suppose I am happy with the money that I have made overnight. Can I close out the agreement? Or rather, at Rs.2460 per share, what if my view changes? What if I no longer feel bullish about TCS at Rs.2460? Do I really need to hold on to the agreement until the contract expiry date, i.e. 24th Dec 2014, by which time if the price goes down, it could lead to a loss?

Well, the futures agreement is tradeable, as I had already mentioned in the previous chapter. By transferring the futures agreement to another party, I can easily exit the agreement at any time after entering it. As a result, I am able to close my open TCS futures position and make a profit of Rs. 10,637.5. Not bad for a day’s work, huh?

“Squaring off” refers to the closing of an existing futures position. I offset an existing open position by squaring off. I initially purchased 1 lot of TCS futures in the TCS example, and when we square off, I must sell 1 lot of TCS futures (so that my initial buy position is offset). The idea of square off is  in the following table in general:

When I want to square off a position, I may either use the trading terminal to do it myself or phone my broker and ask him to do it. In the illustration, we are long TCS futures with an open trade (1 lot). The square off position would be to “sell 1 lot of TCS futures” in order to balance this open position. When I choose to square off the TCS position, the following things take place:

  1. The broker searches for a counterparty prepared to purchase my futures position via the trading terminal. To put it another way, “my current purchase position will just be to someone else.” By purchasing the contract from me, that “someone else” now assumes the risk of the Tata price fluctuation. As a result, this is known as the “Risk Transfer.”
  2. Keep in mind that the transfer will occur at the market’s current futures price, or $2460 per share.
  3. After the trade is, my position is regarded as offset (or squared off).
  4. The margins that were previously barred would be after the trade is. I can use this money for other purchases.
  5. The transaction’s profit or loss will be or debited to my trading account that very same evening.

The futures trade is now likely to be  with this.

Note that I might keep holding the stock futures if, at Rs. 2460, I start to believe that the price will go considerably higher. In fact, I can keep the futures until the contract’s expiration, which is December 24th, 2014. I will continue to be exposed to the risk of TCS price volatility as long as I keep the futures. In actuality, the TCS futures snapshot shown here was obtained on December 23, 2014, one day before the contract’s expiration. Since TCS futures are currently trading at Rs. 2519.25 per share, my returns would have been significantly larger had I chosen to hold the futures until December 23rd.

In truth, “someone else” purchased the TCS futures from me on December 16, 2014, when I decided to book profits at Rs. 2460. In other words, I sold someone else my purchase position, and even that “someone else” (the counterparty) would have profited from this contract by purchasing it from me for Rs. 2460 and holding it until Dec. 23, 2014. Here are two straightforward questions for you:

  1. What would my profit and loss (P&L) be if I had held the Tata futures from December 15, 2014 (Rs. 2374.9) to December 23, 2015, both per share and overall? (Rs.2519.25)
  2. I closed out my position on December 16th, 2014, for Rs. 2460. This was done because the contract’s square had definitely been assigned to a counterparty. What would the counterparty’s total and per-share profit and loss (P&L) be if he kept the TCS futures contract open until December 23rd, 2014?

If you are unable to respond to either of the two questions above, please leave a question in the comment section below, and I will be pleased to explain the solution. But I genuinely hope you discover the solutions to the aforementioned queries on your own.

In the next chapter, we will discuss margins, an essential aspect of futures trading.

CONCLUSION

  • By entering into a futures agreement, you can profit financially from having a directional opinion on the price of an asset.
  • A token advance known as the margin must be deposited in order to transact in a futures contract.
  • We digitally sign the contract with the counterparty when we trade in a futures transaction, obliging us to uphold the terms of the deal.
  • Due to the futures pricing mechanism, there is a difference between an asset’s futures price and spot price (we will discuss this topic later)
  • The bare minimum number of shares that must be traded is one lot.
  • Until the contract’s expiration, we are under no duty to abide by the terms of any futures arrangement we enter into.
  • Every futures deal needs a certain amount of margin, which is blocked when you place the order.
  • The agreement is revocable at any time, so you have a little window of time after entering it to withdraw your consent.
  • We essentially transfer the risk to another party when we square off an agreement.
  • Margin unblocking occurs once the futures position has been squared off.
  • Your trading account is immediately credited or debited with any profits or losses you incur during a futures transaction.
  • In a futures transaction, the gain of the buyer is the loss of the seller, and vice versa.

Introducing Future contract

by

Forward market

• Forwards market
• Futures contract
• Future trades
• Leverage & payoff
• Margin & M2M
• Margin calculator
• Open interest

• How to short
• Nifty futures
• Nifty futures
• Futures pricing
• Hedging with futures
• Notes

learning sharks stock market institute: what is Future-Contract

Introducing Future contract

Establishing the context

The simple Forwards Contract example from the previous chapter involved two parties agreeing to trade cash for items at a later date. We looked at the transaction’s structure to see how the price variation would affect the various participants. By the end of the chapter, we had identified four major concerns (or hazards) relating to forward contracts, and we came to the conclusion that a futures contract is  to address these concerns.

  1. Liquidity risk
  2. Default Risk
  3. Regulatory Risk
  4. The rigidity of the transitional structure

In this chapter, we will also make reference to the same example. Therefore, it could be a good idea to review your grasp of the example from the previous chapter.

One thing is quite evident from the last chapter: If you observe the price of an asset, you can gain a lot by engaging into a forward arrangement. Finding a counterparty prepared to adopt the opposing position is all that . A forward agreement is obviously constrained by the associated risks, which are entirely eliminated by a futures agreement.

A modification of the forwards agreement is the futures contract or futures agreement. The fundamental transactional structure of a forwards market  by the way the futures contract is constructed. It also does away with the dangers related to the forward contract. If you have a precise understanding of the direction in which an asset’s price is moving, a forward agreement could be profitable for you; this is what I mean by the phrase “basic transactional structure.”

This may seem a little ludicrous, but consider that the “transaction structure” of an automobile from a previous generation was to get you from point “A” to point “B.” Airbags, seat belts, ABS, power steering, etc. are among the safety elements that have been improved in the new generation of cars.

An overview of the Futures Agreement

              Since we now understand that the fundamental transactional structure of futures and forwards is the same, it seems reasonable to consider the elements that set futures apart from forwards. In this chapter, we’ll give you a brief overview of these aspects; later on, we’ll delve deeper into each one.

Remember that in the example from the previous chapter, ABC Jeweller and XYZ agree to buy a specific amount of gold at a specific time in the future. Imagine that ABC had a difficult time locating XYZ to serve as a counterparty to the transaction. Even though ABC has a particular opinion on gold and is eager to enter into a financial arrangement, it would be helpless in such a situation since there would be no counterparty to take the other side of the agreement.

Consider this further. What if ABC decides to stroll into a financial supermarket where numerous counterparties are eager to take the opposing stance instead of investing the time and effort to look for a counterparty? The willing counterparties would line up to take the opposing position as soon as ABC announced its plan in the presence of such a financial supermarket. Furthermore, a real financial supermarket of this nature would not just feature individuals with opinions on gold but also on silver, copper, crude oil, and pretty much every other asset class, including stocks!

The Futures Contracts are actually made available in this manner. They are accessible and open to all of us, not just corporations like ABC Jewelers. We have access to futures contracts through the financial (super) market, also known as the “Exchange.” The exchange could be a commodity or stock exchange.

We are aware that a futures contract and a forwards contract are structured somewhat differently. The major goal of this is to reduce the risks associated with the forward market. Let’s examine each of these features that set futures apart from forward contracts.

Be aware that you can still be unclear about the future; it’s okay; just keep the following things in mind. You should understand how a futures agreement operates before we analyze a futures example.

The underlying is  by futures contracts

The forward’s agreement between ABC Jewelers and XYZ Gold Dealers was  on gold (as an asset) and its price. A futures contract, on the other hand, is  on the asset’s anticipated price in the future. The asset, also known as the underlying, by the futures price. One such asset is gold, which has a “Gold Futures” contract. Consider the underlying and its futures contract as being somewhat sibling twins. The futures contract mirrors the actions of the underlying asset. As a result, the price of the futures contract would increase if the price of the underlying rose. Likewise, if the cost of the underlying decreases, the cost of the futures contract does as well.

 Contracts –

Using the ABC jewelers and XYZ Gold Dealers example once more, the agreement called for dealing with 15 kg of gold of a specific purity. If both parties had agreed, the agreement may have been for 14.5 kg, 15.25 kg, or any other weight they deemed appropriate. The specifications, however, in a futures contract are standardized. They cannot be.

Futures contracts can be –

Trading futures contracts is simple. Contrary to a forward contract, I am not to honor a contract until it expires if I enter into one with a counterparty (also called the expiry day). If my opinion changes at any time, I can assign the contract to another party and terminate the agreement.

Futures markets are subject to strict regulation by a regulatory body (or, for that matter, the entire financial derivatives market). “Securities and Exchange Board of India (SEBI)” is the regulating body in India. This implies that someone is continually keeping an eye on market activity and ensuring everything goes according to plan. This also indicates that it is extremely unlikely that a futures contract will default.

Futures contracts are time-bound.

We will discuss this issue in more detail later, but for the time being, keep in mind that each of the futures contracts you have access to has a unique time frame. In the previous chapter’s example, ABC Jewellers had a particular perspective on gold while keeping a 3-month time frame in mind. ABC would have access to contracts in the 1-month, 2-month, and 3-month time frames if they entered into a comparable agreement on the futures market. The term “contract expiry” refers to the end of the contract’s duration.

Cash  –

The majority of futures contracts are  in cash. This indicates that simply the cash difference is  out. Moving the physical asset from one location to another is not a concern. The regulatory authority oversees the cash settlement, ensuring complete openness in the cash settlement procedure.

Here is a table that briefly compares the “Forwards Contract” and “Futures Contract” differences.

I believe it is necessary to emphasize the difference between the spot price and the futures price at this time. The price at which the asset trades in the “regular” market, also known as the “spot market,” is known as the spot price. If we are discussing gold as an underlying, for instance, there are two prices we are referring to: gold on the spot market, also known as the normal market, and gold on the futures market, also known as the Gold Futures. Prices in the spot market and prices on the futures market move together, so if one increases, both do as well.

With these historical contexts in mind, let’s concentrate on a few additional futures contract quirks.

Ahead of your initial futures trade

We must first comprehend a few other facets of futures trading before delving further and understanding how a futures contract functions. Please keep in mind that we will return to these topics later and go into more detail about them. But for the time being, solid practical understanding of the following topics is need.

Lot size – Future is a standardized contract where everything related to the agreement is pre-determined. The lot size is one such parameter. Lot size specifies the minimum quantity that you will have to transact in a futures contract. Lot size varies from one asset to another.

Contract Value – In our example of ABC jeweller and XYZ Gold Dealers, ABC agreed to buy 15 kgs of Gold at the rate of Rs.2450/- per gram or Rs.24,50,000/- per kilogram. Since the deal was to buy 15 kgs, the whole deal was valued at Rs.24,50,000 x 15 = Rs.3.675 Crs. In this case, it is  that the contract Value’ is Rs.3.675 Crs. Simply put, the contract value is the quantity of the price of the asset. We know the futures agreement has a standard pre-determined minimum quantity (lot size). The contract value of a futures agreement can be  to “Lot size x Price”.

Margin – Again, referring back to the example of ABC jeweller and XYZ Gold Dealers at the time of the agreement, i.e. on 9th Dec 2014, both the parties would have had a gentleman’s word and nothing beyond that. Meaning both the parties would have just agreed to honour the contract on the agreement’s expiry day, i.e. 9th March 2015. Do notice there is no exchange of money on 9th Dec 2014.

However, in a futures agreement, the moment a transaction occurs, both the parties involved will have to deposit some money. Consider this as the token advance required for agreeing. The money has to be  with the broker. Usually, the money that needs to be  is  as a % of the contract value. This is  the margin amount’. Margins play a pivotal role in futures trading; we will understand this in greater detail later. For now, remember that to enter into a futures agreement, a margin amount is required, which is a certain percentage of the contract value.

Expiry – As we know, all futures contracts are time-bound. The expiry or the expiry date of the futures contract is the date upto which the agreement is valid. Beyond the valid date, the contract ceases to exist. Also, be aware that the day a contract expires, the exchanges introduce new contracts.

With these few points that we have discussed so far, I guess we can now understand a simple example of futures trading.

CONCLUSION

  1. The forwards and futures markets give you a financial benefit if you have an accurate directional view of an asset’s price.
  2. The Futures contract is an improvisation over the Forwards contract.
  3. The Futures price generally mimics the underlying price in the spot market.
  4. Unlike a forwards contract, the futures contract is tradable.
  5. The futures contract is a standardized contract wherein all the variables of the agreement is predetermined.
  6. Futures contracts are time-bound, and the contracts are available over different timeframes.
  7. Most of the futures contracts are cash-settled
  8. SEBI in India regulates the futures market.
  9. The lot size is the minimum quantity specified in the futures contract.
  10. Contract value = Lot size times the Futures price.
  11. To enter into a futures agreement, one has to deposit a margin amount, a certain % of the contract value.

Introduction to forward market

by

Forward market

• Forwards market
• Futures contract
• Future trades
• Leverage & payoff
• Margin & M2M
• Margin calculator
• Open interest

• How to short
• Nifty futures
• Nifty futures
• Futures pricing
• Hedging with futures
• Notes

 

learning sharks stock market institute: what is Forward-Market

Introduction to forward market

Firstly, Because the forwards and futures markets are comparable, I believe that understanding the “Forwards market” is the best method to introduce the futures market. Comprehending the forwards market well would lay a strong foundation for understanding the futures market.

Secondly, The universe of financial derivatives includes the futures market in its entirety. When the value of a security is  from another sort of financial asset known as an “Underlying Asset,” it is  to as a “Derivative.” 

Any kind of stock, bond, commodity, or money can serve as the underlying asset. 

Financial derivatives have been in use for quite some time. Around “Kautilya’s Arthashastra,” which was  in 320 BC, the use of derivatives is first discussed in relation to India. According to popular belief, Kautilya wrote about the pricing structure of the standing crops that were awaiting harvest in the ancient Arthashastra (study of Economics) script. He reportedly utilized this technique to pay the farmers well in advance, creating a true “forwards contract.” 

Thirdly, Because the forwards and futures markets are comparable, I believe that understanding the “Forwards market” is the best method to introduce the futures market. Understanding the forwards market well would lay a solid foundation for understanding the futures market.

Forward contracts are the most straightforward type of derivative.Think of the forwards’ contract as the futures contract’s more ancient incarnation. Both futures and forward contracts have a similar transactional structure, but over time, traders have tended to favor futures contracts by default. The forward contracts are still in use, but only by a select group of parties, including businesses and financial institutions. 

This chapter’s main goal is to explain the structure of a typical forward transaction, following which we will dissect it into its component parts and examine its benefits and drawbacks.

A Simple EXAMPLE OF FORWARD MARKET

Importantly, The Forward market was primarily established to safeguard farmers’ interests from unfavorable price changes. Forward market, the parties agree to trade products for money. Besides, The trade takes place on a given future date at a particular price. Both sides agree on a day to establish the price of the items. 

Similar manner, the day and time of delivery of the items are also determined. Without a doubt, the agreement is  in person with the help of a third party. Also known as “Over the Counter” or “OTC,” this agreement. Only the OTC (Over Counter) market, where individuals and institutions transact through one-on-one discussions, allows for the trading of forwarding contracts.

Take into account that there are two parties in this scenario.

For example, One works as a jeweler, designing and creating jewelry. Call him “ABC Jewelers,” please. The other is a gold importer, whose responsibility it is to offer gold to jewelers at a discount. Let’s refer to him as “XYZ Gold Dealers.”

Another, On December 19th, 2014, ABC and XYZ made a deal for ABC to purchase 15 kg of gold at 999 purity from XYZ within three months (19th March 2015). 

They set For gold, a price of Rs. was chosen. per gram or Rs. 3000,000 per kilogram, which is the going rate on the market. Therefore, by this contract, on March 19, 2015, ABC is required to give XYZ a total of Rs. 4.000 Cr. (30,00,000/Kg*15) in exchange for the 15 kg of gold.

Surely, This is a pretty straightforward and typical business agreement that is often used in the sector. A “Forwards Contract” or “Forwards Agreement” is the term used to describe such an agreement.

Furthermore, Keep in mind that due to the fact that the contract was  on December 19, 2014, regardless of the price of gold on March 19, 2015, both ABC and XYZ must comply with its terms. Before proceeding, let’s first review the reasons that each party chose to enter into this Agreement.

Indeed, Why do you think ABC  this contract, in your opinion? Because ABC believes that the price of gold will rise during the following three months, they wish to lock in the present market price. ABC intends to safeguard itself against a downward trend in gold prices.

Obviously, In a forwards contract, the party agreeing to buy the asset at a later time is referred to as the “Buyer of the Forwards Contract”; in this case, that party is ABC Jewelers.

Similar spirit, XYZ wants to benefit from the high price of gold that is now being sold on the market. Also, They predict that the price of gold will decline over the next three months. Forwards contract, the party promising to sell the product at a later date is referred to as the “Seller of the Forwards Contract”; in this case, that party is XYZ Gold Dealers.

Last but not least, Due to their divergent perspectives on gold, both sides consider this agreement to be in keeping with their expectations for the future

3 possible scenarios

Even though each of these parties has a different perspective on gold, there are only three outcomes that could occur after three months. Let’s examine these scenarios and how they might affect each party.
In case 1, the cost of gold rises.

Suppose that on March 19, 2015, the cost of 999-percent pure gold is Rs. 2700 per gramme. It’s obvious that ABC Jeweler’s assessment of the gold price was accurate. The arrangement was worth Rs 4.00 crores at the time of the agreement, but due to the rise in gold prices, it is now worth Rs. 4.38 crores. According to the contract, ABC Jewelers has the right to purchase Gold (999 pure) from XYZ Gold Dealers at the previously agreed-upon price of Rs. 3000 per gramme.

As a result, XYZ Gold Dealers will have to purchase gold at a cost of Rs. 2700 per gramme on the open market and sell it to ABC Jewelers at a cost of Rs. 3000 per gramme, incurring a loss in this transaction.

 

Scenario 2: The cost of gold decreases.

Take into account that on March 19, 2015, the price of 999-percent pure gold is Rs. 2050 per gramme. In these circumstances, the gold price prediction made by XYZ Gold Dealers has come to pass. The arrangement was worth Rs 3.67 Cr at the time of the agreement, but now that gold prices have dropped, it is only worth Rs. 3.075 Cr. 

However, according to the terms of the agreement, ABC Jewelers must buy Gold (999 pure) from XYZ Gold Dealers for Rs. 2450 per gramme.

Despite the fact that gold may be bought on the open market for much less money, ABC Jewelers is compelled to pay more through XYZ Gold Dealers, incurring a loss.

 

Scenario 3: The cost of gold remains unchanged.

If the price is the same on 19 March 2015 as it was on 19 December 2014, neither ABC nor XYZ will profit from the agreement.

A quick note on settlement

On March 19, 2015, let’s assume that the price of gold is Rs. 3000 per gramme. At Rs. 3000 per gramme, it is obvious that ABC Jewelers stands to gain from the agreement, as we have just learned. 15 kg of gold was worth Rs. 4.00 crores on the agreement date (19th December 2014), but as of 19th March 2015, it is worth Rs. 4.38 crores. If both parties uphold the agreement at the end of the three-month period, on March 19, 2015, they have two choices for resolving the dispute:

  1. Physical Settlement: In this scenario, the seller delivers the actual asset after receiving complete payment from the forward contract buyer. XYZ purchases 15 kg of gold on the open market for Rs.4.38 crore and agrees to deliver it to ABC in exchange for Rs.4.00 crore. It’s referred to as a physical settlement.

  2. Cash Settlement: No real delivery or receipt of security occurs in a cash settlement. The buyer and the seller will swap the cash difference in a cash settlement. According to the contract, XYZ must sell Gold to ABC for Rs. 3000 per gramme. To put it another way, ABC pays Rs. 4.00 Crs in exchange for 15 kg of gold, which is worth Rs. 4.38 Cr on the open market. Instead of carrying out this transaction, in which ABC would pay Rs. 4.00 Cr. for gold valued at Rs. 4.38 Cr., the two parties could agree to simply exchange the cash difference. It would be Rs.4.38Cr – Rs.4.00 Cr = Rs.38 Lakhs in this instance. Therefore, in order to close the agreement, XYZ would pay Rs. 38 lakhs to ABC. Known as a cash settlement.

            At a much later time, we shall know a lot more about the colony. However, you still need to be aware that a forwards contract has two fundamental types of  settlement alternatives available: physical and monetary.

What about the risk?

While we are clear on the agreement’s structure (terms and conditions) and how a price variation will affect each party, what about the risk? Keep in mind that there are other significant disadvantages to a forward contract as well, including the following:

  1. Liquidity Risk: For the purposes of our scenario, we have naively assumed that ABC discovers a party XYZ that holds the exact opposite opinion with respect to gold. So they quickly come to an agreement. This is not as simple in reality. In the real world, the parties would go to an investment bank and explain what they wanted. The investment bank would research the market to identify a party with a different viewpoint. Naturally, the investment bank charges a fee for this service.

  2. Counterparty risk and default risk– Think about it. Assume that after three months, gold would cost Rs. 2700. With the financial decision they had taken three months earlier, ABC would be happy. They are anticipating payment from XYZ. But what if XYZ makes a default?

  3. Regulatory Risk: No regulatory body is in charge of overseeing the Forwards contract structure, which is carried out with the agreement of the parties concerned. Without a supervisory body, a perception of anarchy sets in, which in turn makes defaulting more appealing.

  4. Rigidity: On December 19, 2014, both ABC and XZY entered into this agreement with a specific gold view. What would happen, though, if their viewpoint were to drastically alter midway through the agreement? They cannot close the agreement in the middle because of how tight the forward agreement is.

            Future contracts were  to lessen the risks associated with advance agreements because the forward contracts had some drawbacks.

India’s Financial Derivatives Market, which is incredibly active, includes the futures market. We will study more about futures and effective trading strategies during the course of this module!

So let’s get going!

CONCLUSION

  1. A futures contract’s fundamental foundation is by the forwards contract.

  2. A forward is an exchanged off-exchange (OTC) derivative.

  3. Since forwarding contracts are private agreements, each one has a different set of criteria.

  4. A forward contract has a straightforward structure.

  5. The person who commits to buying something in a forward contract is known as the “Buyer of the Forwards Contract.”