Trading in Futures

Trading in Futures

Trading in futures is similar to trading in stocks except that you do not take delivery of the stocks. In cash market, you can only hold stocks in the long position for a longer period, whereas in the futures market, you can also hold short positions open for many number of days depending on the contract duration.

You do not have to pay the actual value of the lots while buying futures. Instead you will have to deposit only a percentage of the value of the open position which is called margin money which covers the initial and the exposure margin. This margin amount for each stock futures and index futures is prescribed by the exchange depending on the volatility of the stock or index. In addition to maintaining margin, one has to maintain mark-to-market margins (MTM) which covers the daily difference between the cost of the contract and the closing price of the contract for the day.

Settlement of Futures

In Indian stock market, buying stock futures does not result in delivery of shares. So the futures contract has to be settled on or before the date of expiry of the contract by squaring off the position (i.e., taking position opposite to the existing open position of a futures contract). Based on the profit or loss made by the movement of futures prices, the account of the position holder will either be credited or debited. You can square off your position at any point before the expiry date to book profit or loss. Or you can leave your position open till expiry date on which your profit or loss will be calculated based on the closing price on the expiry date and then your account will be credited or debited accordingly.

Trading Strategies in Futures

Let’s see how speculators, arbitrageurs and hedges take advantage of the futures market.

Speculators

Speculators speculate the market direction and thereby buy or sell futures according to their predictions. Since they have to invest only a percentage of the open position, they take advantage of this to hold a huge position and reap huge profit with lesser investment. The downside of this is they will suffer huge loss if their speculation goes wrong.

Arbitrageurs

Arbitrageurs look out for the large difference in spot and futures price and buy the stock in cash market at the spot price and sell the corresponding futures at the current higher price and wait till the expiry date when both spot prices and futures price converge to book the riskless profit by selling the physical shares and buying back the futures.

Hedgers

If the investor expects the downfall in the market, he can protect his open position in the cash market by selling the futures equal to the value of their open position in the cash market. The downside of this is he will not make profit if the market moves up.

Futures

Futures:

A futures contract is an agreement between two parties to buy or sell a number of shares at a pre-determined price in the future (expiry date).

Contract size:

Every stock futures or index futures consist of a fixed lot of underlying shares as determined by the exchange and it differs between each shares or indices. For eg each lot of reliance futures contract has 600 shares. You can buy or sell only in lots.

Duration of Contracts:

The life of each Futures contract is limited for 3 months only. At any point of time, three types of futures contracts will be traded for any given shares depending on the life or duration of the contract before it gets expired. They are near month contract which expires on the current month, middle month contract which expires the next month or the second month and the far month contract which expires on the third month. All futures expire on the last Thursday of the expiry month. If the last Thursday happens to be a holiday, then they expire on the working day before that. After the expiry of the current month contract, the second month contract will become current month contract and the third month contract will become second month contract and the fresh third month contracts will be issued on the next working day after the expiry of current month futures contracts.

Index Futures:

As stock futures derive their value from the underlying stock, the index futures derive their value from the underlying stock index, which itself is derived from the mathematical formula that is used to measure the changes in stock prices of appropriate sample of stocks that represent a certain segment. Each point in index is converted to certain number of rupees. For example, each point in S&P CNX Nifty is equivalent to Rs 100 as S&P CNX is traded in lots of 100. Duration of index futures contract is similar to that of stock futures.

Price variations between futures and their underlying stock or index:

You can always find that there will be some variations between the actual price of the underlying stock or index  and their future prices. This difference is called the Basis. The basis will usually remain positive in bullish market and turn negative when the market is bearish. The price variations between stock or index and their future prices is due to the cost of carry model that represent all the costs (that one has to bear if he is to hold similar stocks in the cash market which include financing charges at the current rate of interest) and benefits of holding such stocks in cash market and the expectancy model that represent the expected spot price in the future.

Spot price:

 The price of the stock or index in the cash market is called the Spot price.

Strike Price:

The price of the stock future or the index future is called the Strike price.

Both spot price and the strike price converge on the date of expiry of the contract.

Trap for Intra Day Traders

Trap for Intra Day Traders:

Intra Day Traders should be aware of the trap trades that they will have to encounter quite frequently that wipes away their account in no time. Take a look at this graph. Usually intra day traders enter during breakouts. But here in this graph you can see a break out in the long direction at 10.45 and without making any move further enough to make a profit, it reverses and breaks down in the short side at around 11.25. Usually traders who entered long by any method must have suffered loss and squared off their long position and started entering in short side at 11.25 downside breakout.

Click on the image for larger view

Even here, it does not go down enough to make profit by any method and reverse again to break up again in the long direction at around 13.05. Almost all traders would have booked loss in the first two trades and entered the third trade in the long direction at 13.05. The stock again without moving enough to book profit reverses and breaks down at the closing time of the market. So the traders who entered at every breakout in this method would have made a huge loss for the day. These kinds of trades are the biggest traps for any intra day traders.

How to protect ourselves from such traps?

The answer is very simple. Don’t enter into the same stock after suffering two loss trades for the day. If possible don’t enter into the same stock more than once for the day. But during the days market is good, you can actually make profit during your second entry in the opposite direction after having suffered loss in the first direction in one direction. So you can give it another shot after first loss but never more than that. This is where your trading discipline should wake you up before you fall into the trap of excessive trades.

Derivatives Trading

Derivatives:

Derivatives are financial contracts that derive their value from an underlying assets like stocks, stock indices, commodities or currencies. All these underlying assets change in value from time to time. So derivatives are basically introduced to transfer these risks from risk averse investor to the risk appetite investor. Two specific derivatives that form a major role in any stock exchange are

1.       Futures

2.       Options

Three kinds of traders play a major role in derivatives segment. They are Hedgers, Speculators and Arbitrageurs.

Hedgers:

Hedgers are those who hedge the risk of falling or increasing of price of the share that they are willing to sell or purchase in the cash market at some point in the future by taking opposite position in the derivatives segment.

Speculators:

Speculators are those who expect the market to fall when others expect them to raise in future. So speculator enters into agreement with the one who wants to protect his shares that he wants to sell at a future time from fall in prices. So speculator agrees to buy the shares at a pre determined price from the hedger. But if the price moves up, obviously the hedger will not sell it to the speculator, since he can make more money by selling it directly in the market. So Speculator will be given a compensation of some amount instead for entering into this contract.

Arbitrageurs:

Arbitrageurs are those who make use of the difference in prices prevailing between the cash market and the derivatives segment and thus make a riskless profit. For example if a share is traded at Rs 100 in cash segment and Rs 105 in futures segment, he will buy the same at Rs 100 in cash segment and sell the same share at Rs 105 in the futures market. On the Contract expiry day, the prices of the share in cash segment and derivatives segment will converge when he can take the pre-determined profit without any risk.

Common Mistakes of Traders

Common Mistakes of Traders

Huge risk

Traders sometimes make huge money often by favourable market conditions which purely by chance. But they mistake it for their talent and start investing more money in the attempt to make more profit and get rich quick. It is almost more like a rule that you will start losing on the very first day or the second day when you start investing more money without worrying about risks. Many traders experience this quite often, but unfortunately they forget this valuable lesson of market so soon that they  commit the same mistake over and over again.

They can overcome this mistake only if they realise that share market is not an exception to the general rule that it takes more time and effort to start getting rich as in any other field. Always think about risk before increasing the amount of money you are going to trade, no matter how confident you are about your method. Your method may have given you winning streaks for a very long time that it blindens you about the risk. But you should always remember no method will give profit in all markets continuously. And nobody can predict before hand if the market is going to give profit for your method today.

Being positive is good for other parts of your life. But in Share market it is always advisable to be negative in each and every step, because the profit is of very less importance in share market compared to the huge loss , the market incurs on traders quite often.

No Stoploss trades

Traders often get frustrated when they see the market reverse just after hitting their stop loss. So they try to lower the stop loss level considerably and often get more frustrated when they see the market doing the same even with their new stoploss levels. So they eventually start practising trades without stop loss. Sometimes it may work well for few days which increase confidence level of traders about their approach.

But they will be in there for a shock when they see the market reverse very sharply giving them no time to think where to come out of the trade. So they end up taking a huge loss which will damage their account so badly that they will even be wiped out of their account in some cases. Hence, it is always advisable to have stop loss in each trade. Sometimes even good method will fail continuously. But you should not change your stop loss level. If you are in doubt about your current stop loss level, then do paper trade with new stop loss level without risking real money. This gives you more confidence into your new stop loss level before putting the actual money.

Excessive Trades

This mistake is committed often by new traders. The very first trade of all new comers will mostly be a profitable trade. But that is a trap. This first trade gives them over-confidence because of which they turn blind eye to all loss trades that follow. So they end up taking excess trades that will soon wipe up their account.

Excessive or over trading behaviour is due to lack of discipline. To be a profitalbe trader, one must be a disciplined trader. Disciplined traders just accept their loss and move out of trade for the day. This requires a strong discipline. Because human mind tends to go crazy on seeing loss continuously and start taking irrational risks. One should be aware that mind cannot work effectively in such situations. So it is always better to stop trading in that mind set and leave trading for the day if possible for few more days untill you get your mind totally relaxed.

Greediness to make more profit:

More often than not, we come across traders who are hesitant to square off their positions after the stock gives them decent profit. After seeing such profit so soon, their mind start getting greedy to make more money. So they decide to wait some more time only to see the market that is reversing not only to take away their profits but also give them huge loss if they do not have stop  loss in place.