leverage in futures trading and Maximising Returns

The previous chapter’s example of Tata Consultancy Services (TCS) helped us become familiar with the concept of futures trading. We invested in TCS futures expecting that the stock price would increase eventually, and closed the contract for a profit the following day. At the start of this illustration, we originally asked a fundamental question – let me rephrase and post it again so it is readily available.

A rationality for investing in TCS was formed – the opinion was that TCS shares had exaggerated the report by management, thus believing that its cost would rise eventually. Thus, a directional view was forged and futures were purchased. But the inquiry stood – why not just buy stocks instead of futures? The prognosis remained the same regardless – expecting an increase in stock prices.

When buying futures, traders are entering a digital agreement with the counterparty that is limited by a specific timeline – if the directional view does not pan out before it expires, losses must be excepted. This contrasts with simply purchasing stocks and leaving them in one’s DEMAT account; there is no need for an agreement or the pressure of time. But what makes futures so attractive? Why risk the added stress when one can buy stock and remain unaffected by stock prices and timelines?

The answers to these questions can be found in the leveraged power of financial derivatives, such as futures. Leverage is an impressive breakthrough when used appropriately; it has the potential to generate substantial wealth. Now, let’s take a look at this aspect of futures trading.

– Leverage in perspective

At one time or another, leveraging is something we all use in our lives. However, we often don’t contemplate it with the necessary depth; overlooking the specifics and therefore not truly realizing the significance of leveraging.

Here is a classic example of leverage – many of you may relate to this one.

My friend is a real estate trader; they prefer to acquire apartments, premises, and buildings, retain them for a period, and then resell later. He believes that it’s better than trading stocks – I could argue my point on this endlessly, but maybe some other time.

Prestige Builders, a well-known name in Bangalore, identified land in the South of the city in November 2013. They made an announcement of a high-end apartment complex with plenty of cutting-edge features. My friend grabbed this opportunity and got himself 2BHK flat on the 9th floor for Rs. 10 million, with completion slated for mid-2018. Since it was still new at that time and building work hadn’t started yet, he had to only pay 10% of the total price as deposit – a fairly standard practice for new apartments. The remaining 90% was due to be paid as construction progressed.

At the start of Nov 2013, my friend was able to purchase a property with an initial cash payment of Rs.10,00,000/- (10% of Rs. 10,000,000/-). This brand-new project from Prestige Builder was highly sought-after; all 120 apartments were snapped up within 2 months.

In December 2014, my friend, a real estate trader, saw an opportunity and seized it. A survey revealed that the property values in the area had risen by 25%, pushing the price of his ninth-floor apartment to Rs.12,500,000/-. There was no hesitation; a deal was struck and the sale finalized at this figure. Real estate is extravagant in Bangalore!

It is obvious that a few elements are prominent in this exchange.

  1. My friend was able to participate in a large transaction by paying only 10% of the transaction value.
  2. To enter into the transaction, my friend had to pay 10% of the actual value (call it the contract value)
  3. The initial value he pays (10 lakhs) can be considered a token advance, or in terms of ‘Futures Agreement,’ it would be the initial margin deposit.
  4. A small change in the asset value impacts the return massively.
  5. This is quite obvious – a 25% increase in asset value resulted in a 250% return on investment.
  6. A transaction of this type is called a “Leveraged Transaction.

Understand this example completely as it is much like a futures trade; remember all futures trades are leveraged. With that in context, let us go back to the TCS trade in the next chapter and understand leveraged transaction in detail.