Tuesday, 12 January 2016

FAQ on futures trading in Stock Market

1.    What are futures?


Futures are exchange-traded contracts to buy or sell an asset in future at a price agreed upon today. The asset can be share, index, interest rate, bond, rupee-dollar exchange rate, sugar, crude oil, soybean, cotton, coffee etc.

The standard terms in any futures contract are:
·       Quantity of the underlying asset
·       Quality of the underlying asset (not required in case of financial futures)
·       Expiration date
·       The unit of price quotation (not the price)
·       Minimum fluctuation in price (tick size)
·       Settlement style
For example: when you are dealing in Jan 2016 NIFTY futures contract, you know that the market lot, ie the minimum quantity you can buy or sell, is 75 quantity of NIFTY 50, the contract would expiry on Jan 28, 2016, the price is quoted per share, the tick size is 5 paise per share or (75*0.05) = Rs3.75 per contract/market lot, the contract would be settled in cash and the closing price in the cash market on expiry day would be the settlement price.

1.1           Theoretical way of pricing futures


The theoretical price of a futures contract is spot price of the underlying plus the cost of carry. Please note that futures are not about predicting future prices of the underlying assets.
In general, Futures Price = Spot Price + Cost of Carry. The Cost of Carry is the sum of all costs incurred if a similar position is taken in cash market and carried to expiry of the futures contract less any revenue that may arise out of holding the asset. The cost typically includes interest cost in case of financial futures (insurance and storage costs are also considered in case of commodity
futures). Revenue may be in the form of dividend. Though one can calculate the theoretical price, the actual price may vary depending upon the demand and supply of the underlying asset

3.2    An example of theoretical pricing
Suppose Reliance shares are quoting at Rs1000 in the cash market.
The interest rate is about 12% per annum. The cost of carry for one month would be about Rs15. As such a Reliance future contract with one-month maturity should quote at nearly Rs1015. Similarly Nifty level in the cash market is about 8000. One month Nifty future should quote at about 8040. However it has been observed on several occasions that futures quote at a discount or premium to their theoretical price, meaning below or above the theoretical price. This is due to demand-supply pressures. Everytime a Stock Future trades over and above its cost of carry i.e. above Rs. the arbitragers would step in and reduce the extra premium commanded by the future due to demand. eg: woud buy in the cash market and sell the equal amount in the future. Hence creating a risk free arbitrage, vice-versa for the discount.
It is also observed that index futures generally don't command a huge premium as stocks, due to many reasons such as dividends in index stocks, hedging and speculation etc which keeps the index premium under check.

1.2           What happens to Futures price as a contract approaches expiry ?


As the futures contract approaches expiry, the difference between cash and futures prices (called Basis) reduces as time to expiry reduces; thus futures and cash prices start converging. On expiry day, the futures price should equal cash market price.

1.3           How Does Settlement Takes Place in Futures ?


Presently both stock and index futures are settled in cash on T+1 Day. The closing price in the cash segment is considered as the settlement price. The difference between the trade price and the settlement price is ultimately your profit/loss.

1.4           Is there a delivery based settlement for futures?

Stock-based derivatives are expected to be settled in delivery. On expiry of the futures contract, the buyer/seller of the future would receive a long/short position at the closing price in the cash segment on the next trading day. This position in the cash segment would merge with any other position the buyer/seller has. In case the buyer/seller wants he can square up this position by selling/buying the shares. Or else he would be required to deliver/receive the underlying shares on the settlement day (eg T+2) in the cash segment.
The aforesaid methodology is not final yet. Sebi guidelines in this regard are awaited.
You can call post your comment below to know the exact methodology once the regulator and exchanges announce the same.

1.5           How can I use futures contracts?


You can do directional trading using futures. In case you are bullish on the underlying stock or Index, you can simply buy futures on stock/index. Similarly if you are bearish on the underlying, you can sell futures on stock/index.

1.6           Square off of position in Futures?


It is not necessary to wait for the expiry day once you have initiated the position. You can square up your position at any time during the trading session, booking profit or cutting losses.

1.7           Advantages and risks of trading futures over cash?


The biggest advantage of futures is that you can short sell without having stock and you can carry your position for a long time, which is not possible in the cash segment because of rolling settlement. Conversely you can buy futures and carry the position for a long time without taking delivery, unlike in the cash segment where you have to take delivery because of rolling settlement.
Further futures positions are leveraged positions, meaning you can take a Rs100 position by paying Rs25 margin and daily mark-to-market loss, if any. This can enhance the return on capital deployed. For example, you expect a Rs100 stock to go up by Rs10. One way is to buy the stock in the cash segment by paying Rs100.
You make Rs10 on investment of Rs100, giving about 10% returns. Alternatively you take futures position in the stock by paying about Rs30 toward initial and mark-to-market margin. You make Rs10 on investment of Rs30, ie about 33% returns. Please note that taking leveraged position is very risky, you can even lose your full capital in case the price moves against your position.

1.8           Advantages of Index Futures?


After listening to the news and other happenings in the economy, you take a view that the market would go up. You substantiate your view after talking to your near and dear ones. When the market opens, you express your view by buying ABC stock. The whole market goes up as you expected but the price of ABC stock falls due to some bad news related to the company. This means that while your view was correct, its expression was wrong.

Using Nifty/Sensex futures you can express your view on the market as a whole. In this case you take only market risk without exposing yourself to any company specific risk. Though trading on Nifty or Sensex might not give you a very high return as trading in stock can, yet at the same time your risk is also limited as index movements are smooth, less volatile without unwarranted swings

1.9           Volume and open interest to predict market movement?


The total outstanding position in the market is called open interest. In case volumes are rising and the open interest is also increasing, it suggests that more and more market participants are keeping their positions outstanding. This implies that the market participants are expecting a big move in the price of the underlying. However to find in which direction this move would be, one needs to take help of charts. In case the volumes are sluggish and the open interest is almost constant, it suggests that a lot of day trading is taking place. This implies sideways price movement in the underlying

 

1.10     What happens to your position in the futures contract when corporate announcements like dividend, bonus, stock split, rights etc are made?


In the event of such corporate announcements, the exchanges adjust the position such that economical value of your position on cum-benefit and on ex-benefit day is the same.

An example of dividend effect on futures…


While calculating the theoretical price of a futures contract, the interest rate should be taken as net of dividend yield. So on announcement of the dividend, the futures price should be discounted by the dividend amount. However as per the policy of Sebi and stock exchanges, if the dividend is more than 10% of the market price of the stock on the day of dividend announcement, the futures price is adjusted. The exchanges roll over the positions from last-cumdividend day to the ex-dividend day by reducing the settlement price by dividend.
In such a case, the price of futures does get affected by the announcement of such exceptional dividends.
Suppose Reliance is trading at Rs1500 and a two-month Reliance future which has 45 days to maturity is trading at Rs1520. Reliance declares 250% dividend, ie Rs25. The dividend amount is less than 10% of the market price of Reliance, so the exchange would not adjust the position. As such the market adjusts this dividend in the market price and the futures price goes down by Rs25 to Rs 1495.

An Example of Bonus on your futures position


The lot size of the stock that gives bonus gets adjusted according to the ratio of the bonus. The position is transferred from cum-bonus to ex-bonus day by adjusting the settlement price to neutralize the effect of bonus.
For example: the current lot size of Cipla is 800. Suppose Cipla announces a bonus of 1:1. You are long on 800 shares of Cipla and the settlement price of Cipla on cum-bonus day is Rs 650. On ex-bonus day your position becomes long on 1600 shares at Rs 325. Thereafter the lot size of Cipla would be 1600.
The same way it also works in cash segment

1.11     How can you hedge your position using futures?


Suppose you are holding a stock that has futures on it and for two to three weeks the stock does not look good to you. You do not want to lose the stock but at the same time you want to hedge against the expected adverse price movement of the stock for two to three weeks.
One option is to sell the stock and buy it back after two to three weeks. This involves a heavy transaction cost and issue of capital gain taxes. Alternatively you can sell futures on the stock to hedge your position in the stock. In case the stock price falls, you make profit out of your short position in the futures. Using stock futures you would virtually sell your stock and buy it back without losing it. This transaction is much more economical as it does not involve cost of transferring the stock to and from depository account.
You might say that if the stock had moved up, you would have made profit without hedging. However it is also true that in case of a fall, you might have lost the value too without hedging. Please remember that a hedge is not a device to maximize profits. It is a device to minimize losses. As they say, a hedge does not result in a better outcome but in a predictable outcome.

 

1.12     Is there a way you can hedge for the stocks which you don’t own?


Yes. You can hedge your cash market position in stocks that do not have stock futures by using index futures. Before we go any further, we need to understand the term called beta. Beta of a stock is nothing but the movement of the stock relative to the index. So suppose a stock X moves up by 2% when the Nifty moves up by 1% and it goes down by 2% when the Nifty falls by 1%, the beta of this stock is 2. Beta is crucial in deciding how much position should be taken in index futures to hedge the cash market position.
Suppose you have a long position in ABB worth Rs 5 lakh. The beta of ABB is 1.1. To hedge this position in the cash market you need to take an opposite position in Nifty futures worth 1.1 x 5, ie worth Rs 5.5 lakh.
Suppose Nifty futures are trading at 7500 and the market lot for Nifty futures is 75. Then each market lot of Nifty is worth Rs 5.62 lakh. Therefore to hedge your position in ABB you need to sell one contract of Nifty futures.

3.13  Is this hedging with index futures perfect?


No. Hedging is like marriage and one should not expect it to be perfect. The beta taken in the calculation of the position of Nifty futures is historical and there is no guarantee that it will be the same in future. So any deviation of beta makes the hedge imperfect.
Suppose you want to hedge your position in ABB for 15 days and during those 15 days ABB becomes very volatile and the beta goes up as high as 1.5. In this case your hedging position of one contract is not sufficient and you will be under hedged.
It is very difficult (in fact impossible) to get perfect hedge but one can improve the perfection by adjusting the position in Nifty futures from time to time.

3.14  What does the term basis mean?


The difference between the futures price and cash price is called basis.
Generally futures prices are higher than cash prices (positive basis) as we are positive interest rate economy. However there are times when futures prices are lower than cash prices (negative basis). Basis is also popularly termed spread by the trading community.

3.15  Do you have liquid money with you, can stock futures help you earn risk free interest?


Yes, they can. Using stock futures you can deploy this money to earn risk-free interest. Suppose Reliance is quoting at Rs 1000 in the cash segment and one-month future is quoting at 1010, you can earn risk-free interest by following the steps mentioned below:

·       Buy Reliance Industries in cash market at Rs 1000 and simultaneously sell Reliance Securities future at 1010.
·       Pay Rs 1000 to take delivery of  reliance stock in cash market.
·       On expiry of reliance future contract, the short position would be transferred to your account in the cash segment and a delivery order would be issued against you.
·       Deliver the Reliance stock.
·       Whatever happens to the price of Reliance, you earn Rs 1010 - 1000=10 on Rs 1000 for one month.
·       Need to have mark to mark margins in your account, In case Reliance moves up.


If required the future position can be rolled over to the next month position with a difference of Rs4-5. This roll-over process can continue till you want to get your money back.

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