Leverage and Profit Dynamics: Contrasting Spot Market and Futures Market Trading

Examining Leverage Mechanics

The preceding chapter concentrated upon futures trade structural frameworks. This discussion employs the TCS example to establish concrete parameters. Assuming simplicity, suppose TCS could be purchased on 15th December at ₹2,362 per share and squared off on 23rd December 2014 at ₹2,519, with negligible divergence between spot and futures pricing.

With ₹1,00,000 available capital and a constructive outlook on TCS share prices, two approaches merit consideration: acquiring TCS shares in the spot market or purchasing futures contracts from the derivatives market. Let us contrast these alternatives to determine optimal suitability.

First Approach: Spot Market Share Acquisition

Investing in TCS through spot markets necessitates examining current pricing and calculating purchasable quantities with accessible funds. Following transaction completion, a minimum two-business-day settlement period precedes deposit into the DEMAT account. However, once credited, shares may be liquidated at opportune moments.

Prominent Features of Spot Market Purchase (Delivery-Based Buying):

Settlement Constraints: Upon purchasing shares, a minimum two-business-day waiting period precedes selling eligibility. Therefore, should an attractive liquidation opportunity emerge the subsequent day, capitalising remains impossible.

Capital Limitation: Investment capacity remains restricted to available capital. For instance, with ₹1,00,000 available, purchases must not exceed this sum.

Temporal Flexibility: No urgency exists; unlimited time allows patient selling decisions at preferred valuations.

Specifically, with ₹1,00,000 disposable capital on 15th December 2014, purchasing capacity equals:

= 1,00,000 ÷ 2,362

≈ 42 shares

Subsequently, on 23rd December 2014, when TCS trades at ₹2,519, position squaring generates profit:

= 42 × 2,519

= ₹1,05,798

Thus, ₹1,00,000 invested in TCS on 15th December 2014 appreciated to ₹1,05,798 by 23rd December 2014, generating ₹5,798 profits. Examining return percentages proves enlightening:

= [5,798 ÷ 1,00,000] × 100

= 5.79%

A 5.79% return across nine days appears quite impressive. Indeed, annualising this nine-day 5.79% return yields approximately 235%—phenomenal performance.

However, how does this contrast with the alternative approach?

Second Approach: Futures Market Participation

Awareness exists that predetermined parameters such as lot sizes characterise futures markets. Consider TCS specifically; the minimum share quantity equals 125, with all subsequent quantities representing multiples thereof. Contract value derives from multiplying lot size by futures price, currently standing at ₹2,362 per share:

= 125 × 2,362

= ₹2,95,250

Participating in futures markets does not necessitate possessing ₹2,95,250 entirely. Instead, a margin amount—representing a percentage of contract value—requires deposit. For TCS futures, approximately 14% proves necessary. Therefore, merely ₹41,335 requires deposit for entering futures agreements. Several queries may arise:

Regarding Balance Funds: What about the remaining ₹2,53,915 (₹2,95,250 minus ₹41,335)?

This amount never actually requires payment.

Clarifying ‘Never Paid Out’: What does this mean precisely?

Greater clarity emerges when examining the chapter on ‘Settlement—Mark to Market’.

Margin Percentage Uniformity: Does 14% apply uniformly across all equities?

No, percentages vary between different securities.

Maintaining these considerations, let us explore futures trading further. Available cash totals ₹1,00,000. However, margin requirements demand merely ₹41,335.

Rather than purchasing one lot, acquiring two TCS futures lots proves viable. This provides 250 shares (125 × 2) at a margin requirement cost of ₹82,670. Following this allocation for two lots, ₹17,330 cash remains. Retaining this amount proves optimal since no additional investments accommodate this sum.

The TCS futures equation now presents as follows:

Position Parameters:

Lot Size: 125

Number of Lots: 2

Futures Purchase Price: ₹2,362

Futures Contract Value at Purchase = Lot size × number of lots × Futures Purchase Price

= 125 × 2 × ₹2,362

= ₹5,90,500

Margin Amount: ₹82,670

Futures Sale Price: ₹2,519

Futures Contract Value at Sale = 125 × 2 × 2,519

= ₹6,29,750

This translates to profits of ₹39,250.

Observe the differential! Price movement from ₹2,362 to ₹2,519 generated ₹5,798 profit in spot markets, whilst yielding ₹39,250 returns in futures trading. Examining this as percentage gains proves illuminating.

With ₹82,670 invested in futures trades, return calculations must reference this amount:

= [39,250 ÷ 82,670] × 100

= 47.47%

This constitutes a substantial 47% across merely nine days! A stark contrast to spot market’s 5.79%. Annualising this figure yields an extraordinary return approximating 1,925%. Understanding now emerges regarding why short-term traders favour transactions executed through futures markets.

Futures offer considerable advantages compared to conventional spot market transactions. Through ‘Margins’, substantially larger transactions become accessible with reduced capital commitment. Profits can escalate dramatically when market assessments prove accurate.

Establishing positions significantly exceeding available capital constitutes ‘Leverage’. This represents a double-edged instrument possessing potential to create or destroy wealth, contingent upon informed and judicious deployment.

Comparative Framework: Spot Versus Futures

Tabulating the contrast between spot and futures markets enhances comprehension:

Capital Efficiency:

Spot Market: Full payment required (₹1,00,000 for 42 shares)

Futures Market: Margin payment only (₹82,670 for 250 shares)

Position Size:

Spot Market: Limited by available capital

Futures Market: Leveraged exposure through margins

Absolute Returns:

Spot Market: ₹5,798 profit

Futures Market: ₹39,250 profit

Percentage Returns (9 days):

Spot Market: 5.79%

Futures Market: 47.47%

Annualised Returns:

Spot Market: ~235%

Futures Market: ~1,925%

Settlement:

Spot Market: T+2 delivery settlement

Futures Market: Daily mark-to-market

Holding Flexibility:

Spot Market: Unlimited holding period

Futures Market: Limited to contract expiry

Acknowledging Risk Dimensions

Throughout this discussion, potential rewards from futures trading received emphasis, but what about associated risks? Should predictions fail to materialise as anticipated, what consequences follow? Comprehending futures trades fully necessitates understanding monetary gains (or losses) based upon underlying asset movements. This concept constitutes ‘Futures Payoff’.

Just as leverage amplifies profits when market assessments prove accurate, it magnifies losses when predictions err. The same 47% profit potential exists inversely as 47% loss potential should TCS prices decline rather than appreciate. This reciprocal nature underscores why disciplined risk management and position sizing prove absolutely essential for sustainable futures market participation.

Understanding payoff structures across various scenarios enables informed decision-making regarding position establishment, sizing, and risk tolerance calibration—topics warranting comprehensive exploration in subsequent discussions.