Tuesday, February 26, 2013

Excellent Trading School - 15 - Understanding Futures Contracts

Trading Underlying vs. Trading Single Stock Futures
The single stock futures market in India has been a great success story. One of the reasons for the success has been the ease of trading and settling these contracts.

To trade securities, one must open a security trading account with a securities broker and a demat account with a securities depository. Buying security involves putting up all the money upfront. With the purchase of shares of a company, the holder becomes a part owner of the company. The shareholder typically receives the rights and privileges associated with the security, which may include the receipt of dividends, invitation to the annual shareholders meeting and the power to vote.

Selling securities involves buying the security before selling it. Even in cases where short
selling is permitted, it is assumed that the securities broker owns the security and then “lends” it to the trader so that he can sell it.

To trade in futures, one must open a futures trading account with a derivatives broker. Buying futures simply involves putting in the margin money. They enable the futures traders to take a position in the underlying security without having to open an account with a securities broker. With the purchase of futures on a security, the holder essentially makes a legally binding promise or obligation to buy the underlying security at some point in the future (the expiration date of the contract). Security futures do not represent ownership in a corporation and the holder is therefore not regarded as a shareholder.

Pricing equity index/Stock futures
A futures contract on the stock market index/stock gives its owner the right and obligation to buy or sell the portfolio of stocks characterized by the index. Stock/index futures are cash settled; there is no delivery of the underlying stocks.

The main Advantage of equity index futures are:
• There are no costs of storage involved in holding equity.
• Equity comes with a dividend stream, which is a negative cost if you are long the stock
and a positive cost if you are short the stock.

Therefore, Cost of carry = Financing cost - Dividends.

Application of Futures Contracts

Understanding Beta
Beta measures the sensitivity of stocks responsiveness to market factors. Generally, it is seen that when markets rise, most stock prices rise and vice versa. Beta measures how much a stock would rise or fall if the market rises / falls. The market is indicated by the index, say Nifty 50.
The index has a beta of one. A stock with a beta of 1.5% will rise / fall by 1.5% when the Nifty 50 rises / falls by 1%. Which means for every 1% movement in the Nifty, the stock will move by 1.5% (Beta = 1.5%) in the same direction as the index. A stock with a beta of - 1.5% will rise / fall by 1.5% when the Nifty 50 falls / rises by 1%. Which means for every 1% movement in the Nifty, the stock will move by 1.5% (Beta  = 1.5%) in the opposite direction as the index.

Similarly, Beta of a portfolio, measures the portfolios responsiveness to market movements. In practice given individual stock betas, calculating portfolio beta is simple. It is nothing but the weighted average of the stock betas. If the index moves up by 10 percent, the portfolio value will increase by 10 percent. Similarly if the index drops by 5 percent, the portfolio value will drop by 5 percent. A portfolio with a beta of two, responds more sharply to index movements.

If the index moves up by 10 percent, the value of a portfolio with a beta of two will
move up by 20 percent. If the index drops by 10 percent, the value of a portfolio with a beta of two will fall by 20 percent. Similarly, if a portfolio has a beta of 0.75, a 10 percent movement in the index will cause a 7.5 percent movement in the value of the portfolio.

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