In our Demystifying Derivatives series, we have, through a series of blog posts over the past view months, tried to explain how derivatives (futures and options) work, how much capital (margin) is required to trade in futures & options and one of the most aspects of derivatives trading, how to protect your capital (stop loss). In this post, we will discuss some basic derivative trading techniques.
Please note that, some derivative strategies can be quite exotic, but these strategies will be outside the scope of today’s discussion because they are quite complex to understand and difficult to execute for most retail investors. Let us start with some basic trading techniques in futures because futures behave just like stocks and therefore are easier to understand, as opposed to options which are more complex (we will discuss option strategies in our next post). Before we begin discussing F&O strategies, you should always keep in mind that, unlike stocks derivatives expire on a certain date (in India on the last Thursday of the series month).
Futures Trading Techniques
Long position: If you think that the stock or index (e.g. Nifty) price will rise before the expiry of the futures contract, you may buy the futures of the stock or index (e.g. Nifty). This is also known as taking a long position. You will make a profit or loss on a real time basis, depending on the price movement of the stock / future and the profit / loss will be credited / debited from your margin. At any point of time your margin balance should be higher than the SPAN margin (please refer to our post, Demystifying Derivatives: Margin and risk capital for futures contract), failing which, your broker will ask you to give a cheque to meet the margin shortfall.
You can settle your position at any point of time and book profit / loss before the expiry by squaring off. Squaring off is taking an opposite position in the same derivative contract; for example if you bought December futures of a stock or Nifty (long position), you can square off, simply by selling the December futures of the same stock or Nifty. If you do not square-off before expiry, your position will be automatically squared off on expiry and profit / loss credited / debited to your margin. Taking a long position is no different from buying a stock, the two differences being that, you have to book profit / loss by expiry and that, you can take much bigger position in futures with a smaller amount of capital compared to stocks (spot market).
Short position: If you think that the stock or index (e.g. Nifty) price will rise before the expiry of the futures contract, you may sell the futures of the stock or index (e.g. Nifty). This is also known as taking a short position. This is a major difference between F&O market and the spot (or cash market) in our country. In Indian stock market, you cannot sell shares unless you own the shares. However, you can sell futures, even if you do not own the shares. If the stock / future price falls, you will make a profit and if it rises, you will make a loss. Traders have made a lot of money by taking short positions, especially in bear markets, but traders should always be careful, because in a market there are both buyers and sellers, and the balance of power keeps shifting between the two groups of players.
I would like to think of the market as a soccer (football) game played between the bulls and the bears. Both teams want to score a goal and not concede one. Accordingly both teams attack and defend. When one team goes on the offensive and builds pressure, the other team goes on the back foot. The offensive team seeing the other team going defensive gets emboldened and commits more players upfront, so that they can score goals and finish the game. Committing more players upfront leaves the defence weak; this leaves the offensive team vulnerable to a devastating counter-attack from the defending team, and then the offensive team finds themselves down by a goal instead of leading by three.
Coming back to stock market, in a bull market, bulls go on a buying overdrive, but the bears lie in wait to launch a counter-attack (known in market parlance as bull market correction). Similarly, in a bear market, short-sellers get emboldened and go on a shorting overdrive, but they can get hurt when the bulls counter-attack (known in market parlance as bear market rally). In derivatives, losses can be severe if you are taking a leveraged position. Hence the importance of stop loss whether you are taking a long position or short position in futures.
In derivatives, many traders that I know, use technical analysis and have found it to be very useful. From time to time, we discuss various technical analysis techniques in our blog; if you are interested in derivatives trading, you can benefit by developing technical analysis skill-set.
If you are taking long positions in futures, you can benefit by taking it around strong support levels and book profits at key resistance levels. You can take long positions if important resistance levels are taken out. If you are taking short positions in futures, you can benefit by taking it around strong resistance levels and book profits at key support levels. You can take short positions if important support levels are breached. You should pay attention to key daily moving average (DMA) indicators, because they can act as guidance for stock prices. When taking long or short positions, the momentum oscillators, like MACD and RSI can serve as useful guidance. We have discussed these technical concepts in our blog.
Futures Spread: The previous two techniques discussed above are speculative in nature; in trading parlance, these are known as naked positions and involve considerable risk. A much more conservative technique is “futures spread”. A common form of futures spread, also known as, calendar spread, involves simultaneous buying and selling futures contract of the same underlying asset, with two different expiry dates. For example, Nifty December futures are today (November 29) trading at 8,177. The January Nifty Futures are trading today at 8,210. This is real data; not hypothetical. You will buy December futures at 8,177 and sell January futures at 8,210. The spread between the two is
र 33. Tomorrow, you square off both positions, i.e. sell December futures and buy January futures, and the difference between the two is र 30, that is your profit. As the prices converge, your profit reduces.
Please note that, you cannot make risk free profit, but your risk is substantially in this strategy. There are different spread strategies, involving different exchanges (BSE and NSE) or different assets (Nifty versus Bank Nifty). This is, as discussed earlier, a conservative strategy, with lower returns, but also, considerably lower risks. However, this strategy requires investors to be very involved in the market to get the best returns.
Hedging: Mutual fund managers sometimes use this technique. While we often say that, equity or mutual fund investment should be for the long term, there is no denying volatility is stressful and it can often trigger off panic selling. What does a fund manager do in such volatile markets? He or she has three options. He or she can sell the stocks in the fund portfolios and sit on cash to avoid further losses. However, if the shares were bought at a higher price, then the loss incurred by the investors would be permanent and detrimental to their long term objectives. The fund manager could sit tight and remain invested till the market recovers. But if volatility persists for a long time, NAV will continue to fall causing notional losses to the investors. But in reality, when the value of investments falls very sharply, investors start redemptions. It is normal human behavior. When investors redeem, the fund manager has no option but to sell. When large number of investors redeem, it can hurt investors who decide to remain invested, because in such situations, the fund managers may have to sell their best stocks, because he or she may not find buyer for some stocks.
Derivatives offer a smarter alternative to fund managers in such situations to hedge their portfolio losses. Let us assume, you have invested in a diversified equity fund, which has mostly large cap and some midcap stocks. Suppose, the Nifty falls by 10-15%, causing the NAV to fall by around 10% and the fund manager expects it to fall by another 10–15%. The fund manager can sell Nifty futures. If Nifty falls by another 10%, the value of the underlying stocks of the portfolio can also fall by 10%, but the fund manager will make a 10% profit on the Nifty futures. Therefore the fall in the NAV of the fund will be much less. This will reduce notional losses and stress for investors and at the same time, allow the fund manager to hold on to high conviction stock bets, which in the long will create wealth for the investors. However, you must remember that, hedging is a mechanism to prevent losses only; it cannot be used to make money. Profit or loss of a hedged position is less than, the profit or loss of an un-hedged position.
Arbitrage: Suppose the price of the share of a company today in the spot or cash market is
र 100 and the price of the November futures contract of the company in the F&O market is र 110. If you buy 1000 shares of the company in the cash market and sell 1000 futures, you will lock in a gross profit of र 10,000 today itself. On expiry of the November futures contract on 26/11/2015, the spot and futures price will converge. The expiry price is irrelevant. You will still make a net profit before other expenses. Let us understand how. Suppose the expiry price is र 120. You will make a profit of र 20 per share on the shares that you bought or took delivery in the cash market. On the other hand, you will make a loss of र 10 per share in your futures. The net profit for you, before other expenses, will be र 10 per share or र 10,000 on 1,000 shares. What if, the price of the share falls to र 90 on expiry date? You will make a loss of loss of र 10 per share you bought / took delivery. However, you will make a profit of र 20 per share on the futures. Your net profit per share will again be र 10 or र 10,000 on 1,000 shares. Therefore, we have seen that, using this strategy you can lock in profits and there is virtually no risk, as long as you can spot the arbitrage opportunity.
So if you see a 1 paisa difference between the spot price and futures price, should you go ahead and execute an arbitrage strategy and make a risk free profit? It is not so simple. You need to factor in transactions costs. You need to factor in transaction costs. For each trade, both in cash and F&O market, you need to consider brokerage payment, Securities Transaction Tax (STT), Service Tax etc. Further, your broker will require you to maintain a margin for your futures contract. You need to factor in the opportunity cost of keeping that margin. If the price difference between spot market and futures market is large enough to cover all these costs, only then should execute an arbitrage trade. In my experience, only professional traders are able to execute arbitrage opportunities successfully over a period of time, and therefore, if you want to leverage arbitrage opportunities, you should invest in an arbitrage funds.
About 10 years back, I asked my, then boss, to teach me derivatives trading. He began by teaching me about technical analysis. I wondered at that point of time, why do I need to understand reading charts, daily moving averages, trend lines, oscillators and other technical concepts; what relevance does it have to futures and options? If I was very young I would not have questioned what he was teaching me; but once we have a little knowledge, we start to question the value of learning. Once, I was trading in F&O, making profit and also losing money, I was able to relate to the fundamental concept of derivatives, which was that, derivatives derive their value from the underlying asset; it is not just about technical analysis of asset prices, but also fundamental analysis. Readers should always remember this and therefore, it is extremely important to understand how the underlying asset behaves. In this blog post, we discussed some common trading strategies with futures. In our next post, we will discuss some basic options trading strategies.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.