Futures Market Understand trading with 3 possible scenarios

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After reaching the agreement, three different outcomes may occur by 24th Dec 2014, as we reviewed in Chapter 1: the price of TCS can increase, decrease, or remain unchanged. Let us examine several potential scenarios and their respective effects on both involved parties.

Scenario 1 – TCS stock price goes up by 24th Dec.

My outlook on TCS shares has been proven correct, so I will reap the benefits.

The spot price of TCS went up on 24th December 2014, from Rs.2374.9/- to Rs.2450/- per share, so the futures price would also rise accordingly. As a result, I am able to purchase 125 shares at Rs.2374.9/- as per the agreement, much lower than the current market rate and consequently will be making a profit of Rs.75.1/- per share (Rs.2450 – Rs.2374.9). My total profit from this deal is Rs.9387.5/- (Rs.75.1 * 125).

The seller clearly suffers a setback by having to offload TCS shares at a rate of Rs.2374.9 per share instead of capitalising on its value in the open market, which stands at Rs.2450/-. It’s clear that the buyer is making a profit due to the seller’s unfortunate situation.

Scenario 2 – TCS stock price goes down by 24th Dec.

My outlook on TCS shares has proved incorrect, which means I will incur a loss.

On 24th Dec 2014, the stock price of TCS went down from Rs.2374.9/- to Rs.2300/- per share, resulting in a decrease of future prices being around the same level. This compelled me to buy the TCS shares at Rs.2374.9/- per share which was higher than the current market rate, thereby resulting in a loss of Rs.75/- per share (Rs.2374.9 – Rs.2300). As I have agreed to purchase 125 shares, my overall loss amounts to Rs.9375/- (Rs.75/- * 125).

I’m at an obvious disadvantage, having to purchase TCS shares at Rs.2374.9/- instead of the open market price of Rs.2300/- per share. It’s clear that what benefits the seller is a detriment to the buyer.

Scenario 3 – TCS stock price remains unchanged.

Under these circumstances, neither the buyer nor the seller gain, therefore neither party experiences a financial effect.

– Exploiting a trading opportunity

I bought TCS futures on 15th Dec 2014 at Rs.2374.9/-, the next day their price shot up and traded at Rs.2460/-. Admittedly that means I stand to benefit a great deal – taking a snapshot of this moment, shows I’m sitting with a per share profit of Rs.85.1/- amounting to an overall gain of Rs.10,637.5/- (125*Rs.85.1).

I’m content with the gains I’ve made overnight. But, if my outlook shifts at Rs.2460 per share, do I have to stick to the deal up until it expires on 24th Dec 2014? If the price dips in the meantime, would I incur a loss?

As I previously stated, futures contracts are transferable. This makes it possible for me to exit the agreement anytime, allowing me to take advantage of the Rs.10,637.5/- profit earned in just one day’s time! Not a bad outcome for minimal effort, if you ask me.

Closing an existing futures position is referred to as “square off”. This process offsets an existing open position; in the case of TCS, if I initially bought 1 lot of TCS futures, I’d have to sell 1 lot of them to cover my initial purchase.

When I decide to close the position, I have on TCS futures, there are two ways to do it: either contact my broker and ask him to cover the open transaction, or take care of it myself through the trading terminal. For example, if I’ve bought 1 lot of TCS futures, the offsetting action would be selling 1 lot of that same futures. As a result, these things will happen:

  1. The broker searches for another party through their trading terminal who would be open to obtaining my futures position. To put it simply, the “risk” of the changing TCS price is being passed onto this other person instead of me, meaning that my current buy position has just been handed off. This is called “Risk Transfer.”
  2. The transfer should take place according to the current trading rate in the market, which is 2460/- per share.
  3. Once the trade has been completed, my position is balanced (or neutralized).
  4. After the trade is done, I can access the money that had been previously blocked for margin. This will enable me to use it for other deals.
  5. The outcome of the transaction will be instantly applied to my trading account that same evening.

The futures trade has been finalized.

If I took a positive view of the future price of TCS at Rs.2460, I would have held on to the stock futures till expiry on 24th December 2014. There is an inherent risk in continuing this, since the price of TCS can fluctuate. The figure on 23rd December 2014 was Rs.2519.25 per share – had I retained my position until then, my profits would have been much greater than if I had sold earlier.

 

On 16th December 2014 I made the decision to take my profit by selling TCS futures at Rs.2460/-. This transfer of buy position to another individual, who might also make a return on the contract by holding it until 23rd December 2014, raises two questions.

  1. Calculating my P&L per share, I would find that if I had held TCS futures from 15th Dec 2014 to 23rd Dec 2015, the total gain would be Rs.144.35. On an overall basis, the profit would be equal to the rise in stock price i.e. Rs.144.35.
  2. On 16th Dec 2014, I closed my position of TCS futures at Rs.2460/-. The opposite party, who took on the square contract, would have incurred Profit & Loss (P&L) on a per-share basis and overall if they would have held their position until 23rd Dec 2014.

We will tackle these queries in forthcoming chapters.

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