Leverage Futures in Market Trading An Analysis with examples

The Leverage

In the preceding chapter, our focus was on the overall structure of the futures trade. Here we shall use the TCS example and make some concrete details. Considering simplicity, let us assume that TCS could be purchased on 15th of Dec at Rs.2362/- per share and squared off on 23rd Dec 2014 for Rs.2519/- with no difference between spot and futures price.

With Rs.100,000 and a positive outlook on the stock price of TCS, we have two options to consider: buying TCS stock in the spot market or purchasing its futures from the Derivatives market. Let us compare and contrast them to understand better which may be more suitable for us.

Option 1 – Buy TCS Stock in the spot market

Investing in TCS through the spot market requires us to examine its current price and gauge the amount of stocks we can get with our accessible funds. Following this, at least two business days must pass before it is deposited into our DEMAT account. However, once it’s there, the right time to sell can be seized.

Few salient features of buying the stock in the spot market (delivery-based buying) –

1. Once we purchase the stock, it will take a minimum of two business days before deciding to sell. Therefore, if a attractive proposition to sell arises the very next day, we won’t be able to take advantage of it.
2. We can invest in the stock market up to the amount of our disposable capital. For instance, if we have Rs.100,000/- on hand, we must limit our purchase to that sum; not exceeding it.
3. There is no need to hurry; take as much time as one needs, and be patient when it comes to selling.

Specifically, with Rs.100,000/- at our disposal, on 15th Dec 2014, we can buy –

= 100,000 / 2362

~ 42 shares

Now, on 23rd Dec 2014, when TCS is trading at Rs.2519/- we can square off the position for a profit –

= 42 * 2519

= Rs.105,798/-

So Rs.100,000/- invested in TCS on 14th Dec 2014 has now turned into Rs.105,798/- on 23rd Dec 2014, generating Rs.5,798/- in profits. Interesting, let us check the return generated by this trade –

= [5798/100,000] * 100

= 5.79 %

A 5.79% return over 9 days is quite impressive. In fact, a 9-day return of 5.79% when annualized yields about 235%. This is phenomenal!

But how does this contrast with option 2?

Option 2 – Buy TCS Stock in the futures market

We are aware that predetermined variables such as lot size exist in the futures market. Take TCS, for example; the smallest number of shares to be bought is 125 and all subsequent quantities must be multiples of the same. The contract value is determined by multiplying the lot size with the futures price, which currently stands at Rs.2362/- per share.

= 125 * 2362

= Rs.295,250/-

It is not necessary to have Rs.295,250/- in total to take part in the futures market. A margin amount, which is a percentage of the contract value, has to be deposited instead. For TCS futures, roughly 14% is required. Therefore, only Rs.41,335/- has to be given as deposit for entering into a futures agreement. Are there any other queries you would like to make about this?

1. What about the balance money? i.e Rs.253,915/- ( Rs.295,250/ minus Rs.41,335/-)
   • Well, that money is never really paid out.
2. What do I mean by ‘never really paid out’?
   • We will understand this in greater clarity when we take up the chapter on “Settlement – mark 2 markets.”
3. Is 14% fixed for all stocks?
   • No, it varies from stock to stock.

So, keeping these few points in perspective, let us explore the futures trade further. The cash available in hand is Rs.100,000/-. However, the cash requirement in terms of margin amount is just Rs. Rs.41,335/-.

Instead of one lot, let’s purchase two lots of TCS futures. This will give us 250 shares (125 x 2) but at the cost of Rs.82,670/- for margin requirement. After allotting this amount for the two lots, we will still have Rs.17,330/- in cash. It would be best to leave it as is since there are no additional investments available with this amount.

Now here is how the TCS futures equation stacks up –

Lot Size – 125

No of lots – 2

Futures Buy price – Rs. 2362/-

Futures Contract Value at the time of buying = Lot size *number of lots* Futures Buy Price

= 125 * 2 * Rs. 2362/-

= Rs. 590,500/-

Margin Amount – Rs.82,670/-

Futures Sell price = Rs.2519/-

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

= Rs.629,750/-

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

Look at the difference! A shift from 2361 to 2519 brought a profit of Rs. 5,798/- in the spot market, while yielding Rs. 39,250/- in return. Let’s examine how lucrative this looks when we view it as a percentage gain.

We have invested Rs.82,670/- in the futures trade, so we need to ensure that the return is calculated based on this amount.

[39,250 / 82,670] *100

This works out to a substantial 47% in just nine days! A stark comparison to the spot market at 5.79%. When we annualize, this means an incredible return of around 1925 %. So, I’m sure you now understand why short-term traders prefer transactions done through the Futures market.

Futures offer a range of advantages compared to a regular spot market transaction. Thanks to ‘Margins’, you can access much larger transactions with less capital at stake. Your profits can soar if your view is correct.

We can take positions that are significantly bigger than the capital we have; this is referred to as “Leverage”. It’s a double-edged sword that has the potential to create or destroy wealth, depending on whether it is used in an informed and wise manner.

Throughout this discussion, we have considered the potential rewards of trading futures but what about the risk? If our predictions do not turn out how we expected them to, what then? To grasp a full understanding of futures trades, we must comprehend the amount of money we stand to gain (or lose) based on the action of the underlying asset. This is termed as “Futures Payoff”.