Practical Applications of Futures Pricing

Practical Application

Before wrapping up this chapter, let us employ the futures pricing formula for some practical applications. As mentioned earlier, this formula proves especially useful when you’re interested in quantitative trading. Keep in mind that we are merely glimpsing these strategies and will delve into more information concerning them when we reach the ‘Trading Strategies’ module. Let’s examine an example:

Given Parameters:

Tech Mahindra Spot = 1,245

Rf = 7.12%

x = 28

d = 0

Given this, the futures should be trading at:

Futures Price = 1,245 × (1+7.12% × (28/365)) – 0

= 1,252

Given market charges, futures ought to be trading near 1,252. In the event that it’s drastically different and trading at 1,295 instead, there undeniably exists an opportunity for a trade. Generally, the discrepancy between spot and futures should just be 7 points; however, because of market irregularities, it’s leapt to 50 points. We can exploit this spread through deploying a trade.

Since the futures 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 Tech Mahindra futures and acquire Tech Mahindra in the spot market. Let us use numerical values to understand the implications:

Trade Setup:

Buy Tech Mahindra in Spot @ 1,245

Sell Tech Mahindra in Futures @ 1,295

We will now assume four different values at which the spot and futures converge: 1,280, 1,225, 1,310, 1,200. Let’s see what happens to the trade when each of these values are reached.

Scenario Analysis:

Convergence Price      Spot P&L         Futures P&L    Net P&L

1,280   +35      -15       +50

1,225   -20       +70      +50

1,310   +65      -15       +50

1,200   -45       +95      +50

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 selling Tech Mahindra in the spot market and re-buying it in the futures market.

This type of trading where one profits from the difference between futures and spot is known as ‘Cash & Carry Arbitrage.

Calendar Spreads

The calendar spread for Tech Mahindra can be demonstrated using the cash & carry arbitrage concept. By trading two futures contracts with different expiries, we can take advantage of the price difference to generate a profit. Let us use the Tech Mahindra example to illustrate this concept further.

Market Parameters:

Tech Mahindra Spot is trading at = 1,245

Current month futures fair value (28 days to expiry) = 1,252

Actual market value of current month futures = 1,295

Mid-month futures fair value (63 days to expiry) = 1,260

Actual market value of mid-month futures = 1,263

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 futures contracts is 32 points; that being 1,295 – 1,263.

The trade setup to capture the spread goes like this:

Calendar Spread Setup:

Sell the current month futures @ 1,295

Buy the mid-month futures @ 1,263

Note that when trading the same underlying futures of differing expiries, margins are much lower due to this 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.

Let us arbitrarily take a few scenarios below and see how the profit and loss pans out:

Calendar Spread Scenarios:

Scenario          Current Month Closes At        Mid-Month Trades At Current Month P&L            Mid-Month P&L          Net P&L

1          1,280   1,285   +15      +22      +37

2          1,225   1,230   +70      -33       +37

3          1,310   1,315   -15       +52      +37

4          1,200   1,205   +95      -58       +37

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.

Key Takeaways

Understanding futures pricing mechanics enables traders to identify mispricing opportunities in the market. Whether through cash and carry arbitrage or calendar spreads, these strategies exploit temporary pricing inefficiencies between spot and futures markets or between different futures contract months.

However, successful execution requires:

• Precise Timing: These opportunities often exist for brief periods as markets quickly correct mispricings.
• Low Transaction Costs: Arbitrage profits can be slim, so minimising brokerage and impact costs proves essential.
• Adequate Capital: Simultaneously holding multiple positions requires sufficient margin availability.
• Risk Management: Even hedged positions carry execution risk and require careful monitoring.

These quantitative strategies represent advanced applications of futures pricing knowledge, demonstrating practical utility beyond simple directional trading. As we progress through subsequent modules, we shall explore these concepts comprehensively, examining optimal entry and exit timing, position sizing methodologies, and risk management frameworks specific to arbitrage and spread trading strategies.