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.
- By contributing just 10% of the transaction value, my friend was able to take part in a significant deal.
- My acquaintance had to pay 10% of the total amount to participate in the transaction (call it the contract value)
- 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.
- A slight change in asset value has a significant influence on return.
- It should be clear that a 25% rise in asset value led to a 250% return on investment.
- 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:
- 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.
- 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.
- 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:
- 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
- The use of leverage is crucial when trading futures.
- By using margins, we can take a tiny initial investment and participate in a high-value transaction.
- Typically, margins are levied as a percentage of the contract value.
- We can only deal with the amount of our capital on the spot market because it is not leveraged.
- A modest change in the underlying has a significant impact on the P&L when there is leverage.
- The buyer’s earnings are comparable to the seller’s losses, and vice versa.
- Leverage increases risk and, as a result, increases the likelihood of financial success.
- Futures instruments merely enable money transfers between pockets. As a result, it is known as a “Zero Sum Game.”
- A futures instrument’s payout structure is linear.
512 remarks.
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