Tuesday, February 26, 2013

Excellent Trading School - 24 - Frequently Asked Questions about Futures Contracts - part 3

Question: What are the advantages of index futures?
Answer: After listening to the news and other happenings in the economy, you take a view that the market would go up. You substantiate your view after talking to your near and dear ones. When the market opens, you express your view by buying ABC stock. The whole market goes up as you expected but the price of ABC stock falls due to some bad news related to the company. This means that while your view was correct, its expression was wrong.

Using Nifty/Sensex futures you can express your view on the market as a whole. In this case you take only market risk without exposing yourself to any company specific risk. Though trading on Nifty or Sensex might not give you a very high return as trading in stock can, yet at the same time your risk is also limited as index movements are smooth, less volatile without unwarranted swings.

Question: How can I use volume and open interest figures to predict the market movement?
Answer: The total outstanding position in the market is called open interest. In case volumes are rising and the open interest is also increasing, it suggests that more and more market participants are keeping their positions outstanding. This implies that the market participants are expecting a big move in the price of the underlying. However to find in which direction this move would be, one needs to take help of charts.

In case the volumes are sluggish and the open interest is almost constant, it suggests that a lot of day trading is taking place. This implies sideways price movement in the underlying.

Question: What happens to my position in the futures contract when corporate announcements like dividend, bonus, stock split, rights etc are made?
Answer: In the event of such corporate announcements, the exchanges adjust the position such that value of your position on cum-benefit and on ex-benefit day itself.

Question: Please explain these adjustments with the help of some examples.What is the effect of dividend on futures?
Answer: While calculating the theoretical price of a futures contract, the interest rate should be taken as net of dividend yield. So on announcement of the dividend, the futures price should be discounted by the dividend amount.

However as per the policy of Sebi and stock exchanges, if the dividend is more than 10% of the market price of the stock on the day of dividend announcement, the futures price is adjusted. The exchanges roll over the positions from last-cum dividend day to the ex-dividend day by reducing the settlement price by dividend.

In such a case, the announcement of such does affect the price of futures with exceptional dividends. Suppose Reliance is trading at Rs300 and a two-month Reliance future, which has 45 days to maturity, is trading at Rs304. Reliance declares 50% dividend, ie Rs.5. The dividend amount is less than 10% of the market price of Reliance, so the exchange would not adjust the position. As such the market adjusts this dividend in the market price and the futures price goes down by Rs5 to Rs 299.

Question: How a bonus would affect my position?
Answer: The lot size of the stock that gives bonus gets adjusted according to the ratio of the bonus. The position is transferred from cum-bonus to ex-bonus day by adjusting the settlement price to neutralise the effect of bonus.
For example: the current lot size of Cipla is 200. Suppose Cipla announces a bonus of 1:1. You are long on 200 shares of Cipla and the settlement price of Cipla on cum-bonus day is Rs1,000. On ex-bonus day your position becomes long on 400 shares at Rs500. Thereafter the lot size of Cipla would be 400.

Question: How can I hedge my stock position using futures?
Answer: Suppose you are holding a stock that has futures on it and for two to three weeks the stock does not look good to you. You do not want to lose the stock but at the same time you want to hedge against the expected adverse price movement of the stock for two to three weeks.

One option is to sell the stock and buy it back after two to three weeks. This involves a heavy transaction cost and issue of capital gain taxes. Alternatively you can sell futures on the stock to hedge your position in the stock. In case the stock price falls, you make profit out of your short position in the futures. Using stock futures you would virtually sell your stock and buy it back without losing it. This transaction is much profitable, as it does not involve cost of transferring the stock to and from depository account.

You might say that if the stock had moved up, you would have made profit without hedging. However it is also true that in case of a fall, you might have lost the value too without hedging. Please remember that a hedge is not a device to maximize profits. It is a device to minimize losses.

Question: I am holding a stock that does not have futures on it; can I still hedge my position using futures?
Answer: You can hedge your cash market position in stocks that do not have stock futures by using index futures. Before we go any further, we need to understand the term called beta. Beta of a stock is nothing but the movement of the stock relative to the index. So suppose a stock X moves up by 2% when the Nifty moves up by 1% and it goes down by 2% when the Nifty falls by 1%, the beta of this stock is 2. Beta is crucial in deciding how much position should be taken in index futures to hedge the cash market position.

Suppose you have a long position in ABB worth Rs2 lakh. The beta of ABB is 1.1. To hedge this position in the cash market you need to take an opposite position in Nifty futures worth 1.1 x 2, ie worth Rs2.2 lakh. Suppose Nifty futures are trading at 1100 and the market lot for Nifty futures is 200. Then each market lot of Nifty is worth Rs2.2 lakh. Therefore to hedge your position in ABB you need to sell one contract of Nifty futures.

Question: Is this hedging with index futures perfect?
Answer: Hedging is like marriage and one should not expect it to be perfect (so always have Plan B ready when trading futures and get ready divorce papers with you in case). The beta taken in the calculation of the position of Nifty futures is historical and there is no guarantee that it will be the same in future. So any deviation of beta makes the hedge imperfect.

Suppose you want to hedge your position in ABB for 15 days and during those 15 days ABB becomes very volatile and the beta goes up as high as 1.5. In this case your hedging position of one contract is not sufficient and you will be under hedged. It is very difficult (in fact impossible) to get perfect hedge but one can improve the perfection by adjusting the position in Nifty futures from time to time.

Question: Can stock futures help me earn risk free interest money?
Answer: Yes, they can. Using stock futures you can deploy this money to earn risk-free interest. Suppose HUL is quoting at Rs300 in the cash segment and one-month future is quoting at 305, you can earn risk-free interest by following the steps mentioned below:

-Buy HUL in cash market at Rs300 and simultaneously sell HUL future at 305.
-Pay Rs300 to take delivery of HUL stock in cash market.
-On expiry of HUL future contract, the short position would be transferred to your account in the cash segment and a delivery order would be issued against you.
-Deliver the HUL stock.
-Whatever happens to the price of HUL, you earn Rs305-300=5 on Rs300 for one month.
-Need to have mark-to-mark margins in your account, incase HUL moves up. If required the future position can be rolled over to the next month position with a difference of Rs4-5. This roll-over process can continue till you want to get your money back.

Question: If futures are quoting below the cash market price, can I gain using futures?
Answer: Yes, of course. But you need to have that stock. Suppose one-month SBI future is quoting at 200 while SBI is quoting at Rs205 in the cash segment. Follow the steps mentioned below to make risk-free money.

-Sell SBI in the cash market at Rs205 and simultaneously buy SBI future at 200.
-Receive Rs205 and make delivery of SBI stock in the cash market.
-On expiry of the SBI future contract, the long position would be transferred to your account in the cash segment and a receive order would be issued to you.
-Get your SBI stock back.
-Whatever happens to the price of SBI, you earn Rs205–200=5 on your stock.

Question: Can I borrow against my shares using stock futures?
Answer: Yes, you can and that is the advantage of futures. Instead of going to the banker and complying with a whole lot of formalities, you can in fact just call me to help you raise money against your shares using futures.

Suppose ACC is quoting at Rs150 in the cash segment and one-month ACC futures are quoting at 152. Follow the steps mentioned below to raise money against your ACC shares.
-Sell ACC in the cash market at Rs150 and simultaneously buy ACC futures at 152.
-Receive Rs150 and make delivery of ACC stock in the cash market.
-On expiry of the ACC futures contract, the long position would be transferred to your account in the cash segment and a receive order would be issued to you.
-Get your ACC stock back.
-Whatever happens to the price of ACC, you lose Rs152-150=2 to raise money against your shares as cost.

Question: I have seen that the difference between the spot and futures prices varies intra-day, can you explain how to do arbitrage to make money in such situations?
Answer: When the futures are quoting at a premium to their theoretical price, one can buy cash and short futures. When the prices come in line, that is when the difference between the futures and cash prices comes down, reverse the positions. Conversely when the futures are quoting at a discount to the theoretical price, one can sell cash and buy futures. When the prices come in line, that is the difference between the futures and cash prices goes up, reverse the positions. Please note that there is the risk of execution of order, you need to decide the arbitration band depending on the transaction cost you bear.

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