4.1 - A quick recap

We gained a basic understanding of futures trading through the Tata Consultancy Service (TCS) example from the previous chapter. Because we expected that TCS stock prices would rise in the future, the futures trade required us to be long on TCS futures. We also decided to profitably close the contract the next day. But, as you may recall, at the beginning of this example, we asked a fundamental question. Let me rephrase the question and post it for your reference.

TCS stock was a rational choice. The reason was that the TCS stock price had overreacted against management's announcement. I was confident that the stock price would rise over time. The futures trade was initiated after a directional view was established. It was then asked if the stock price would rise, so why buy futures when one can just purchase the stock in the spot?

To buy futures, one must enter into a digital agreement. A futures agreement is also time-bound. This means that the directional view must be realized within the time frame. It must be completed within the time period specified (expiry), or it will result in a loss. This is different from buying stock and letting it sit in your DEMAT account. There are no obligations to enter into an agreement, nor is there any pressure to do so. Why do we really need futures? Why is it so appealing? It is tempting to just buy the stock, and not pay attention to the stock price or the time.

Financial derivatives include futures and financial leverage is the key to answering all of these questions. According to the saying, leverage is a true financial innovation. If used with care and the right spirit, it can lead to wealth. Let's now look at futures trading.

4.2 - Leverage for perspective

We all use leverage at one time or another in our lives. It isn't always thought of in the right way. We don't see beyond the numbers and so we miss the essence of leverage.

This is a classic example in leverage. Many of you might relate to it.

My friend is a real-estate trader. He likes to purchase buildings, sites, and apartments and hold them for a while before selling them at a later stage. This is his belief, and I disagree. I could debate this all day, but perhaps another time.

Here is a summary from a recent real-estate transaction that he completed. Prestige Builders, a popular builder in Bangalore, identified land in South Bangalore in November 2013. The new project was a luxurious apartment complex featuring state-of-the-art amenities. My friend booked a 2-bedroom, hall and kitchen apartment for Rs.10,000,000/-. It is expected that the project will be completed in mid-2018. The apartment was not yet notified and work has not begun. Potential buyers were required to pay only 10% of the actual purchase price. This is the standard for buying new apartments. As construction progressed, the remaining 90% were to be paid.

My friend had the right to purchase a property worth Rs.10,000,000/o in November 2013 for an initial cash outlay Rs.10,00,000.00 (10% of 10,000,000 /-),). The property was so popular that all 120 apartments sold out in a matter of 2 months after Prestige Builder announced the new project.

My friend was looking for a buyer for his apartment in Dec 2014. My friend is a real estate trader and jumped at the chance. Quick surveys revealed that the property's value had increased by at least 25% in the area (well that's Bangalore's crazy real estate market). My friend's 9th floor apartment was now worth Rs.12,000,000/-. My friend and the buyer reached an agreement and agreed to sell the apartment for Rs.12,000,000/-.

This table summarizes the transaction.

This transaction is filled with many details.

1. My friend was able participate in a large transaction for only 10% of its transaction value.
2. My friend had to pay 10% of actual value (or the contract value) in order to enter into the transaction.
3. The initial value that he pays (10 lakhs) could be considered a token advancement or, in the terms of 'Futures Agreement', it would be the initial Margin Deposit.
4. A small increase in asset value can have a huge impact on the return.
5. This is obvious: a 250% increase in asset value results in a 250% return.
6. This is known as a " Leveraged Transaction."

This example is similar to a futures transaction, and all futures transactions can be leveraged. Keep this in mind as we move on to the TCS trade.

4.3 - The Leverage

We have already looked at the overall structure of futures trades in the previous chapter. Let us now focus on the TCS example and provide some details. The trade details for TCS are as follows: We will assume that the opportunity to purchase TCS is on the 15 th December at Rs.2362/share. We will also assume that the opportunity to sell this position is available on the 23 rd December 2014 at Rs.2519/. We will also assume that there is no difference in the spot and futures prices.

With a bullish view of TCS stock prices and Rs.100,000.0/ in hand we can now decide between Option 1 or Option 2. Buy TCS stock in spot market or Option 3 - Purchase TCS futures in the Derivatives Market. Let's look at each option in detail to see how they work.

Option 1- Purchase TCS Stock on the Spot Market

To buy TCS on the spot market, we must first check the current price of the stock and then calculate how many stocks we can purchase (with our capital). To get the stock credited to your DEMAT account, you must wait at least 2 working days (T+2) after buying it in the spot market. We can sell the stocks once they are in our DEMAT account.

There are a few key features to buying stock in the spot market (delivery-based buying).

1. After we purchase the stock (for delivery at DEMAT), we must wait at least two working days before we decide to sell it. Even if we have a great opportunity to sell, this means that even if it is the next day, we can't really sell the stock.
2. The stock can be bought up to the amount of capital we have. If we have Rs.100,000.00, we can only purchase the stock up to Rs.100,000.
3. There is no time pressure - as long you have the patience and time, you can wait for a long time before selling.

We can purchase - with Rs.100,000.00/- on 15 Dec'14.

= 100,000 / 2362

Shares: 42

We can now square off the position at a profit on 23 rd Dec'14, as TCS trades at Rs.2519/.

= 42 * 2519

= Rs.105.798/-

TCS invested Rs.100,000.00 on 14 th Dec 2014. This has turned into Rs.105.798/ - on 23 rd December 2014, which generated Rs.5,798/ - profit. Let's see how this trade generates returns.

= [5798/100,000.00] * 100

= 5.79%

A 5.79% return over 9 days is quite impressive. A 9-day return of 5.79% is quite impressive when you consider annualized yields of around 235%. This is amazing!

How does this compare to option 2?

Option 2- Purchase TCS Stock on the Futures Market

Futures market variables have predetermined recall. TCS has a minimum lot size (or number of shares) of which 125 is the minimum. Multiples of 125 are also acceptable. The 'contract value is the lot size divided by the futures prices. The futures price is Rs.2362/share; therefore, the contract value is -

= 125 * 2362

= Rs.295,250/ -

That means that to be able to participate in futures markets, I will need total cash of Rs.295,250/=. It's not true. Rs. Not really. Rs. TCS futures requires approximately 14% margin. We only need 14% margin (14%) of Rs.295,250 Rs.413,335/- to enter into futures agreements. You may have the following questions:

1. How about the balance money? I.e. Rs.253,915/( Rs.295,250/ minus R.41,335/)
   • That money is never actually paid.
2. What does it mean to say that a loan was never actually paid for?
   • This will be made clearer when we tackle the chapter "Settlement – mark 2 markets".
3. Are 14% stocks fixed?
   • It varies from stock-to-stock.

These are just a few of the key points. Let's now look at futures trading. Cash available is Rs.100,000. The cash required for margin amounts is Rs. Rs.41.3335/-

We could buy two lots of TCS futures instead of one lot. The number of shares available with 2 lots of TCS Futures would be 250 (125 x 2), at a cost of Rs.82670/- margin requirement. We would still have Rs.17.330/- cash after putting in Rs.82.670/- for the margin amount for 2 lots. This money is not usable and should be left alone.

Here's how the TCS futures equation compares -

Lot Size -125

There are 2 lots.

Futures buy price - Rs. 2362/-

Futures Contract Value = Lot Size *numbers of lots* Futures Purchase Price

= 125 * 2* Rs. = 125 * 2 * Rs.

= Rs. Rs.

Margin Amount – Rs.82,670/?

Futures sell price = Rs.2519/ -

Futures Contract Value at the Time of Selling = 125 * 2* 2519

= Rs.629750/-

This is equivalent to Rs. 39,250/=

Can you see the difference? The profit on a move of 2361 to 2519 was Rs.5,798/$ in spot market. However, the same move made Rs' profit. 39,250/+ Let's see what this means in terms of % return.

Our investment in the futures trade was Rs.82,670/=, so the return must be calculated using this base.

[39,250/82,670]*100

This is a staggering 47% increase in 9 days! Compare that to 5.79% on the spot market. This translates into an annual return of 1925% ..... Hopefully, you should now be convinced why spot market traders prefer to trade in the Futures Market.

Futures are more than just a spot market transaction. You can enter into large transactions with a lower amount of money thanks to 'Margins'. Your profits can be enormous if you have the right directional view.

You can take on positions that are larger than the available capital; this is known as "Leverage". Leverage can be a double-edged sword. Leverage can be a double-edged sword if used with the right mindset and knowledge. If not, it can cause wealth destruction.

Let's first summarize the differences between spot and futures markets in the following table.

We have talked about the benefits of trading in futures. But what about the risks? What happens if the directional view doesn't work out as planned? Understanding both sides of a futures trade is important. We need to know how much money we can make or lose based on the movement. This is  "Futures payoff".

4.4 - Leverage Calculation

When we discuss leverage, one of the most common questions is "How often are you exposed?". ". Higher leverage means that there is more risk.

It is very easy to calculate leverage.

Leverage = [Contract Value/Margin]. TCS trades have leverage.

= [295,250/41.335]

= 7.14, which can be read as 7.14 times, or as a ratio of 1: 7.14.

This means that every Rs.1/- can be used to buy Rs.7.14/- of TCS. This is a manageable ratio. But, the risk increases if leverage is increased. Let me explain.

TCS must fall by 14% at 7.14 times leverage to lose all margin amounts; this can be calculated using -

1 / Leverage

= 1/ 7.14

= 14%

Let's say that the margin requirement was Rs.7000/- and not Rs.413,335/-. This would give you leverage of -

= 295,250/7000

= 42.17 Times

This is clearly a high leverage ratio. If TCS falls below -, one will lose all of his capital.

1/41.17

= 2.3%

The higher the leverage, so the greater the risk. A high leverage level will cause a very small movement in the underlying to wipe out the margin deposit.

Alternativly, for 42x leverage, all you need is a 2.3% move to the underlying to double it.

Personally, I don't like over-leverage. I only trade trades with leverage of about 1:10 to 1:12, and not more.

4.5 - The Futures Payoff

This is what you can imagine: When I purchased TCS futures, my expectation was that TCS stock would rise and I would be financially benefited from the futures transaction. What if TCS stock prices went down instead of rising? It would be a loss. After initiating a futures trading, think about this. I could make a profit at any price point.A futures transaction's payoff structure simply indicates how much I profit at different price points.

Let's create a TCS trade payoff diagram to better understand the structure. It is a long trade that was initiated at Rs.2362/= on 16 th December. By 23 rd Dec the trade has been completed. The price of TCS could go anywhere. As I said, I can make a profit at any price point. I will therefore assume various price points that could be simulated by 23 Dec. I will then analyze the P&L situation for each of these scenarios while I am building the structure's pay. The table below actually does the same thing.

This is how you should read the table. If you were a buyer at Rs.2362/–, what would your P&L be by 23 Dec at Rs.2160/–? The table shows that you would lose Rs.202 per share (2362 - 23160).

What would your P&L be if TCS traded at 2600? As the table suggests, you would make a profit Rs.238/share (2600 - 2362). And so on.

We actually stated in the previous chapter that if the buyer makes Rs. If the buyer is making Rs. X/-. If 23 rd DecTCS is trading at 2600, then the buyer would make a profit of Rs.238/share and the seller would lose Rs.238/share, provided that the seller shorted the share at Rs.2362/+.

Another way to view this is to say that the money has been transferred from the seller to the buyer. It's a transfer of money, not money creation!

There is a distinction between money transfer and money creation. When value is created, money is generated. If you buy TCS shares with a long-term perspective, TCS's profits and margins will improve. As a shareholder, you will be able to benefit from the under-appreciation of the share price. This is either money creation or wealth generation. Contrast this with Futures. Money isn't being created, but simply moving from one pocket into another.

This is precisely why Futures (rather than financial derivatives) are called a " zero sum".

Let's plot the "Payoff Scheme" graph.

(image).

As you can see, a price that is higher than the buy price (2362) will result in a profit while a price that is lower than the buy price (2362) will result in a loss.This trade involved the purchase 2 lots of futures (250-pieces), so Rs.250 can be attributed to a 1 point positive movement (from 2362-23633) A 1 point positive move (from 2362-23633) can result in a loss of Rs.250. This clearly shows the importance of proportionality. This is because the buyer's money is equal to the seller's loss (assuming they have purchased/shorted the same price) and vice versa.

The best part is that the P&L is a straight line. Futures are considered a " Linear Payment Instrument".

To Summarize

1. Futures trading is dominated by leverage.
2. Margins enable us to deposit small amounts of money while being exposed to large-value transactions.
3. The margin charged is typically a percentage of the contract value.
4. Spot market transactions can be done without leverage; however, we are able to transact up to our capital.
5. A small change in the fundamental results in a huge impact on the P&L when leveraged
6. The buyer makes the same amount as the seller, and vice versa.
7. Higher leverage means higher risk, and therefore higher chance of making it.
8. Futures Instrument allows you to transfer money from one account to another. It is also known as a "Zero Sum Game."
9. A futures instrument's payoff structure is linear.