Leverage ratio calculation and Payoff Structure in Futures Trading

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When discussing leverage, people often wonder what the level of exposure is. The more a person leverages, the higher their risk and the greater the chance for profit.

Calculating leverage is quite easy –

Leverage = [Contract Value/Margin]. Hence for TCS trade the leverage is

= [295,250/41,335]

= 7.14, which is read as 7.14 times or simply as a ratio – 1: 7.14.

This means for every Rs.1/- in the trading account, you can get as much as Rs.7.14/- of TCS. It is a very reasonable proportion, but if the leverage escalates, then the potential for risk climbs too. Let me explain why.

Investors in TCS need to remember that if their stock goes down 14%, they will lose the entire margin amount. The leverage ratio of 7.14 can be used to work this out.

1 / Leverage

= 1/ 7.14

= 14%

Revising the example, let’s take a look at what would happen if the margin requirement was only Rs.7000/-. The leverage here would be –

= 295,250 / 7000

= 42.17 times

This is clearly is a very high leverage ratio. One will lose all his capital if TCS falls by –

1/41.17

= 2.3%.

As leverage increases, so does risk. With such a high level of borrowing, the slightest shift in the underlying will deplete the margin deposit.

At around 42x leverage, all you need for a double-gain is a 2.3% increase of the underlying asset.

It is recommended to stay within the confines of a 1:10 or 1:12 leverage, not surpassing beyond those limits.

– The Futures payoff

When I bought TCS futures, I was hoping that the stock price would rise, allowing me to make a financial gain. But, if it had gone in the other direction, obviously I would have experienced a loss. Upon initiating a futures trade, the potential for profit or loss is made clear – depending on which way the stock price moves, my return could vary significantly.

To get an idea of the payoff structure for the TCS trade that began at Rs.2362/- on 16th Dec, let us look at different possible price points by 23rd Dec and subsequently analyze the Profit & Loss scenario for each one.

To understand the table as a buyer at Rs.2362/-, work out the potential P&L by the 23rd Dec, supposing TCS is trading at Rs.2160/-. According to the table, each share would result in a deficit of Rs.202/- (2362 – 2160).

Likewise, if TCS was trading at 2600, your P&L would be a gain of Rs.238/- per share (2600 – 2362). Consequently, you stand to make a positive profit.

It was established in the preceding chapter that when someone purchases, their gains equate the losses of the one selling. For example, should TCS be trading at 2600 on 23rd Dec, a buyer would make Rs.238/- per share whereas the seller would suffer from a loss of Rs.238/- having shorted at Rs.2362/- per share.

The exchange of funds is simply moving from the seller to the buyer; it isn’t creating money, it’s just redistributing it.

There is a distinction between the transfer and production of money. When value is created, money is generated, such as when you buy TCS shares with the aim of long-term investment. If TCS performs well by means of increasing profits and margins, then the shareholder will enjoy a hike in their share price; this development translates to money generation or wealth creation. Conversely, Futures does not involve the manufacture of money but its displacement from one wallet to another.

Futures, as well as all financial derivatives, is referred to as a “Zero Sum Game” for this exact reason.

We shall now plot a graph which illustrates the possible price on 23rd December in relation to the buyers P&L, also referred to as the Payoff Structure.

It’s clear that when buying 2 lots of futures (250 shares) at 2362, a price above this resolves in a gain and any price below results in a loss. This is down to the sense of proportionality in the market; for each point that moves positively from the buy price, there is Rs.250 made by the buyer which corresponds to the same figure of loss for the seller. The reverse is true too for any negative movement.

The P&L line being smooth and straight, it can be deduced that futures are a “Linear Payoff Instrument”. This is particularly relevant.

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