Before wrapping up this chapter, let us use the futures pricing formula for some practical applications. As mentioned earlier, this formula is especially useful when you’re interested in quantitative trading. Keep in mind that we are merely getting a glimpse of these strategies and will delve into more information concerning them when we get to the “Trading Strategies” module. Let’s look at an example –
Wipro Spot = 653
Rf – 8.35%
x = 30
d = 0
Given this, the futures should be trading at –
Futures Price = 653*(1+8.35 % (30/365)) – 0
Given the market charges, futures ought to be trading near 658. In the event that it’s drastically different and trading at 700 instead; there is undeniably an opportunity for a trade. Generally, the discrepancy between spot and futures should just be 5 points, however because of market irregularities, it’s leapt to 47 points. We can exploit this spread through deploying a trade.
Since the future contract is trading above its fair value, we can call it an expensive market price. Alternatively, we can say the spot is trading at a cheaper rate in comparison to the futures.
The thumb rule in any kind of spread trade is to buy the asset that is cheaper and simultaneously sell the one that is more expensive. Applying this thinking, we can sell Wipro Futures and acquire Wipro in the spot market. Let us use numerical values to understand the implications –
Buy Wipro in Spot @ 653
Sell Wipro in Futures @ 700
We will now assume four different values at which the spot and futures converge; 675, 645, 715. Let’s see what happens to the trade when each of these values are reached.
Once the trade is executed at the predicted price, you have assured the spread. No matter which way the market turns by expiry date, profits are confirmed! It’s sensible to close out the positions just before the contract terminates. This would involve trading Wipro in a spot market and re-buying it in futures market.
This type of trading where one profits from the difference between the futures and spot is known as ‘Cash & Carry Arbitrage’.
– Calendar Spreads
The calendar spread for Wipro can be demonstrated using the cash & carry arbitrage. By trading two futures contracts with different expiries, we can take advantage of the price difference to generate a profit. Let us use the Wipro example to illustrate this concept further.
Wipro Spot is trading at = 653
Current month futures fair value (30 days to expiry) = 658
Actual market value of current month futures = 700
Mid-month futures fair value (65 days to expiry) = 663
Actual market value of mid-month futures = 665
It is evident that the current month futures contract is trading significantly higher than its expected fair value; meanwhile, the mid-month contract is trading near what is predicted as its fair value. By taking this into account, I can assume that the basis of the current month contract will eventually shrink, whilst the mid-month contract should remain close to its fair value.
What do you consider to be the spread in this case? The difference between the two future contracts is 35 points; that being 700 – 665.
What do you think is the spread here? Well, the spread is the difference between the two future contracts i.e. 700 – 665 = 35 points.
The trade set up to capture the spread goes like this –
Sell the current month futures @ 700
Buy the mid-month futures @ 665
Note that when trading the same underlying futures of differing expiries, margins are much lower due to being a hedged position.
Once a trade is initiated, it is sensible to unwind it ahead of its expiry. At that time, we will observe the current month futures and spot reaching the same price.
We assumed that the mid month contract would remain close to its fair value, as my trading experience has shown this occurs frequently.
It is crucial to keep in mind that this chapter only provides a brief overview of trading strategies. A separate module will go into further depth to discuss the optimal ways to deploy these strategies.