Futures Trading Mastering Strategies for Success in the Stock Market

Before the Trade

In the preceding chapter, we studied numerous aspects of futures trading. All traders entering a futures contract have one objective in mind – to make money. To do this effectively, they need an outlook on the value of the asset underlying it. Now might be a good time for us to move away from gold and use stocks as an example to exemplify how this is accomplished through a practical trade.

On 15th Dec 2014, investors of Tata Consultancy Services (TCS) welcomed the management’s announcement at their gathering. However, they reacted negatively to the cautiousness surrounding the potential revenue growth for the December Quarter. Consequently, as reflected in its spot market quote, TCS’ share price fell by over 3.6%. This can be seen from the blue highlight on the snapshot below; we shall discuss the red area shortly.

As a trader, I think the TCS stock price reaction to management’s statement is overblown. This can be attributed to usual trends of the Indian IT sector in December, which is the financial year-end for their biggest market, the US and holiday season, resulting in slower business activity. Such information has been factored in by the market and therefore a 3.6% drop is not justified. From my viewpoint, this presents an attractive opportunity to buy TCS as I expect an uptick in its stock price. Hence, I would suggest investing in TCS at this point.

From my analysis, I have a positive outlook on TCS. My perceptions are that its stock price is highly likely to grow over time. To express it differently, I am cautiously optimistic about the current price of TCS.

Rather than investing in TCS shares via the spot market, I choose to purchase TCS Futures (which will be explained more thoroughly in the next chapter). All that I need to look at is the price which the futures are trading at – this information is easily accessed on NSE’s website. To make things even simpler, a direct link can be found on the spot market quote; it has been highlighted in red on the above image.

It is essential that the futures price follows the spot price, as a decrease in the latter means a drop in the former. This snapshot taken from NSE’s website shows us the TCS Futures price.

Predictably, the TCS Futures has dropped by 3.77%, conforming to the decline in the spot price. Thus, two inquiries may enter your mind –

1. TCS in the spot market has declined by 3.61%, yet TCS futures has dropped by a greater amount, 3.77%. Why is there this discrepancy?
2. The spot price for TCS is Rs.2362.35, but the futures price is slightly higher at Rs.2374.90. What could explain this disparity?

These are both valid inquiries at this time, and the answer will be revealed during our discussion of the Futures Pricing Formula. Most notably, the spot and futures price have both declined for the day. Before delving further, let us review the futures contract and identify a few essential points. To clarify, I am posting the futures contract again, with some salient features noted.

Beginning at the apex, an area shaded in red contains three major facts –

1. Remember the underlying asset is the stock of a company and we are looking at its future contract, making the instrument type ‘stock futures’.
2. This stock’s name is denoted by the symbol “TCS”.
3. The TCS futures contract will come to an end on 24th Dec 2014. It is worth noting that all Indian derivatives reach their conclusion on the last Thursday of each month. We can return to look at what happens when the contract expires at a later point.

We had taken a gander at the blue box earlier; it simply illustrates the future cost.

Lastly, the black box highlights two important parameters – the underlying value and the market lot.

1. The underlying value of TCS shares at the time of this snapshot was Rs.2359.95. This is compared to its spot market price of Rs.2362.35, which had dropped by a few points since then.
2. Remember, a futures contract is fixed and pre-defined. The lot size for TCS futures refers to the minimum number of shares that must be traded if one wishes to agree. Therefore, 125 shares (or multiples thereof) must be bought or sold when trading the TCS futures.

In the prior chapter, recall discussed the “contract value” which is the product of the “lot size” and futures price. To calculate the contract value for TCS futures, we can proceed as follows –

Contract Value = Lot size x Price of futures

= 125 x Rs.2374.90

= Rs. 296,862.5

Let’s examine another futures contract, specifically the State Bank of India (SBI) to further cement our comprehension. Here is a glimpse of the SBI futures trade.

 – The Futures Trade

The TCS Futures trade involves me buying the contract with a price of Rs.2374.9/- per share, with a minimum amount of 125 shares, which is also known as ‘one lot’. It’s based on my anticipation of the TCS stock price increasing.

The ‘Futures Contract’ can be acquired via two routes; by placing a call to our broker, requesting him to buy 1 lot of TCS futures at Rs.2374.9, or by operating through a broker’s trading terminal.

I’m a fan of conducting my trades personally via the trading terminal. If you’re inexperienced in its utilisation, I recommend carefully reading the chapter on it. After loading TCS Futures on my market watch, it’s just a matter of pressing F1 to secure the contract.

When I press the F1 key on my trading terminal, a few changes take place in the background. This expresses my interest in purchasing TCS futures.

1. Entering into a futures agreement requires depositing a percentage of the contract value as margin. This is essentially an advance payment, or token amount. If there isn’t enough money in the trading account to cover this requirement, then we are unable to proceed further. Therefore, the broker’s risk management system runs a check prior to any agreement to ensure that sufficient funds are available.
2. After validating the margins, the system needs to find a fitting counterparty. This match must incorporate me – the buyer of TCS futures – and a seller of the same asset. The stock market is like a ‘Financial supermarket’ which holds many members with different perspectives on the value of certain assets. It appears that whoever is offering to sell TCS futures believes they will decrease in price further. Similarly, to my own motive for why I think TCS stock prices will increase, this seller has their own rationale for wanting to be on the selling side.
3. Once Step 1 and 2 have been completed (the margin validation and finding the counterparty), both buyer and seller digitally sign the futures agreement. This is essentially a ceremonial process, as by consenting to purchase (or sell) the futures agreement, they give each other approval to abide by the contract requirements.
4. Once the signoff is completed, a certain margin will be locked in our trading account. This money is not to be used for any other purpose and will remain so until we hold the futures contract.

After taking these four measures, I now am the proud owner of a TCS Futures Contract. Truly, in the world of trading, this entire process is done in mere seconds!

This critical question can be answered by saying that I own a lot of TCS Future Contracts. By buying TCS futures on 15th Dec 2014, I digitally agreed with an opposing party to buy 125 shares at Rs.2374.9 per share. The contract between me and the counterparty will come to an end on 24th Dec 2014.