Strategies of Futures Contracts

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.

Futures Trading Strategies

We look here at some strategies of futures contracts. We refer to single stock futures. However since the index is nothing but a security whose price or level is a weighted average of securities constituting an index, all strategies that can be implemented using stock futures can also be implemented using index futures.

  • Hedging: Long security, sell futures
  • Speculation: Bullish security, buy futures
  • Speculation: Bearish security, sell futures
  • Arbitrage: Overpriced futures: buy spot, sell futures
  • Arbitrage: Under-priced futures: buy futures, sell spot

1. Hedging: Long security, sell futures

Futures can be used as an effective risk—management tool. Take the case of an investor who holds the shares of a company and gets uncomfortable with market movements in the short run. He sees the value of his security falling from Rs.450 to Rs.390. In the absence of stock futures, he would either suffer the discomfort of a price fall or sell the security in anticipation of a market upheaval. With security futures he can minimize his price risk. All he need do is enter into an offsetting stock futures position, in this case, take on a short futures position. Assume that the spot price of the security he holds is Rs.390. Two—month futures cost him Rs.402. For this he pays an initial margin. Now if the price of the security falls any further, he will suffer losses on the security he holds. However, the losses he suffers on the security will be offset by the profits he makes on his short futures position. Take for instance that the price of his security falls to Rs.350. The fall in the price of the security will result in a fall in the price of futures. Futures will now trade at a price lower than the price at which he entered into a short futures position. Hence his short futures position will start making profits. The loss of Rs.40 incurred on the security he holds, will be made up by the profits made on his short futures position.

Index futures in particular can be very effectively used to get rid of the market risk of a portfolio. Every portfolio contains a hidden index exposure or a market exposure. This statement is true for all portfolios, whether a portfolio is composed of index securities or not. In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations (unlike individual securities, where only 30—60% of the securities risk is accounted for by index fluctuations). Hence a position LONG PORTFOLIO + SHORT NIFTY can often become one—tenth as risky as the LONG PORTFOLIO position!

Suppose we have a portfolio of Rs. I million which has a beta of 1.25. Then a complete hedge is obtained by selling Rs. 1.25 million of Nifty futures.

Warning: Hedging does not always make money. The best that can be achieved using hedging is the removal of unwanted exposure, i.e. unnecessary risk. The hedged position will make less profit than the unhedged position, half the time. One should not enter into a hedging strategy hoping to make excess profits for sure; all that can come out of hedging is reduced risk.

2. Speculation: Bullish security, buy futures

Take the case of a speculator who has a view on the direction of the market. He would like to trade based on this view. He believes that a particular security that trades at Rs. 1000 is undervalued and expects its price to go up in the next two—three months. How can he trade based on this belief? In the absence of a deferral product, he would have to buy the security and hold on to it. Assume he buys 100 shares which cost him one lakh rupees. His hunch proves correct and two months later the security closes at Rs.1010. He makes a profit of Rs.l000 on an investment of Rs. 1, 00,000 for a period of two months. This works out to an annual return of 6 percent.

Today a speculator can take exactly the same position on the security by using futures contracts. Let us see how this works. The security trades at Rs. 1000 and the two-month futures trades at 1006. Just for the sake of comparison, assume that the minimum contract value is 1, 00,000. He buys 100 security futures for which he pays a margin of Rs.20, 000. Two months later the security closes at 1010. On the day of expiration, the futures price converges to the spot price and he makes a profit of Rs.400 on an investment of Rs.20, 000. This works out to an annual return of 12 percent. Because of the leverage they provide, security futures form an attractive option for speculators.

3. Speculation: Bearish security, sell futures

Stock futures can be used by a speculator who believes that a particular security is over—valued and is likely to see a fall in price. How can he trade based on his opinion? In the absence of a deferral product, there wasn’t much he could do to profit from his opinion. Today all he needs to do is sell stock futures.

Let us understand how this works. Simple arbitrage ensures that futures on an individual securities move correspondingly with the underlying security, as long as there is sufficient liquidity in the market for the security. If the security price rises, so will the futures price. If the security price falls, so will the futures price. Now take the case of the trader who expects to see a fall in the price of ABC Ltd. He sells one two—month contract of futures on ABC at Rs.240 (each contact for 100 underlying shares). He pays a small margin on the same. Two months later, when the futures contract expires, ABC closes at 220. On the day of expiration, the spot and the futures price converges. He has made a clean profit of Rs.20 per share. For the one contract that he bought, this works out to be Rs.2000.

4. Arbitrage: Overpriced futures: buy spot, sell futures

As we discussed earlier, the cost-of-carry ensures that the futures price stay in tune with the spot price. Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise.

If you notice that futures on a security that you have been observing seem overpriced, how can you cash in on this opportunity to earn risk-less profits Say for instance, ABC Ltd. trades at Rs. 1000. One—month ABC futures trade at Rs. 1025 and seem overpriced. As an arbitrageur, you can make risk-less profit by entering into the following set of transactions.

  1. On day one, borrow funds; buy the security on the cash/spot market at 1000.
  2. Simultaneously, sell the futures on the security at 1025.
  3. Take delivery of the security purchased and hold the security for a month.
  4. On the futures expiration date, the spot and the futures price converge. Now unwind the position.
  5. Say the security closes at Rs.1015. Sell the security.
  6. Futures position expires with profit of Rs.10.
  7. The result is a risk less profit of Rs. 15 on the spot position and Rs. 10 on the futures position.
  8. Return the borrowed fluids.

When does it make sense to enter into this arbitrage? If your cost of borrowing funds to buy the security is less than the arbitrage profit possible, it makes sense for you to arbitrage. These are termed as cash—and—carry arbitrage. Remember however, that exploiting an arbitrage opportunity involves trading in the spot and futures market. In the real world, one has to build in the transactions costs into the arbitrage strategy.

5. Arbitrage: Under-priced futures: buy futures, sell spot

Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. It could be the case that you notice the futures on a security you hold seem under-priced. How can you cash in on this opportunity to earn risk-less profits? Say for instance, ABC Ltd. trades at Rs. 1000. One—month ABC futures trade at Rs. 965 and seem under-priced. As an arbitrageur, you can make risk-less profit by entering into the following set of transactions.

  1. On day one, sell the security in the cash/spot market at 1000.
  2. Make delivery of the security.
  3. Simultaneously, buy the futures on the security at 965.
  4. On the futures expiration date, the spot and the futures price converge. Now unwind the position.
  5. Say the security closes at Rs.975. Buy back the security.
  6. The futures position expires with a profit of Rs. 10.
  7. The result is a risk-less profit of Rs.25 on the spot position and Rs. 10 on the futures position.

If the returns you get by investing in risk-less instruments are more than the return from the arbitrage trades, it makes sense for you to arbitrage. These are termed as reverse—cash—and—carry arbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line with the cost—of—carry. As we can see, exploiting arbitrage involves trading on the spot market. As more and more players in the market develop the knowledge and skills to do cash—and—carry and reverse cash—and—carry, we will see increased volumes and lower spreads in both the cash as well as the derivatives market.

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