Module 4   Futures TradingChapter 4

Leverage & Payoff

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4.1 – A quick recap

With the help of the Tata Consultancy Services (TCS) example in the previous chapter we got a working knowledge on how Futures trading works. The futures trade example required us to go long on TCS futures as the expectation was that the TCS stock price would increase in due course. Further we decided to square off the contract the very next day for a profit. However, if you recall, right at the beginning of the example we posed a very important question, let me rephrase and repost the same for your ready reference.

A rational to go long on TCS was built – the thought was that TCS stock price had over reacted to the management’s statement. I expected the stock price to increase in due course of time. A directional view was established and hence a futures trade was initiated. Now, the question was – anyway the expectation is that the stock price will go higher, why should one bother about buying futures and why not the stock in spot market?

In fact buying futures requires one to enter a digital agreement with the counterparty. Besides, a futures agreement is time bound, meaning the directional view has to pan out within the specified time period. If it does not pan out within the specified time (as in the expiry) then one has to suffer a loss. Contrast this (futures buying) with just buying stock and letting it reside in your DEMAT account. There is no obligation of an agreement or the pressure of time. So why does one really need futures? What makes it so attractive? Why not just buy the stock and stay oblivious to the stock price and the time?

The answers to all these questions lie in the ‘financial leverage’ which is inherent in financial derivatives, including futures. Leverage as they say is a true financial innovation, if used in the right context and spirit leverage can create wealth. Without much ado, let us explore this angle of futures trading.

4.2 – Leverage in perspective

Leverage is something we use at some point or the other in our lives. It is just that we don’t think about it in the way it is supposed to be thought about. We miss seeing through the numbers and therefore never really appreciate the essence of leverage.

Here is a classic example of leverage – many of you may relate to this one.

A friend of mine is a real estate trader, he likes to buy apartments, sites, and buildings holds them for a while and then sells them for a profit at a later stage. He believes this is better than trading in equities, I beg to differ – I could go on and on debating this, but maybe some other time.

Anyway, here is a summary of a recent real estate transaction he carried out. In November 2013, Prestige Builders (popular builders in Bangalore) identified a piece of land in South Bangalore and announced a new project – A luxurious apartment complex with state of the art amenities. My friend jumped in and booked a 2 bedroom, hall, and kitchen apartment, expected to come up on the 9th floor for a sum of Rs.10,000,000/-. The project is expected to be completed by mid 2018. Since the apartment was just notified and no work had started, the potential buyers were only required to pay 10% of the actual buy value. This is pretty much the norm when it comes to buying brand new apartments. The remaining 90% was scheduled to be paid as the construction progressed.

So back in Nov 2013, for an initial cash outlay of Rs.10,00,000/- (10% of 10,000,000/-) my friend was entitled to buy a property worth Rs.10,000,000/-. In fact the property was so hot; all the 120 apartments were sold out like hot cakes just within 2 months of Prestige Builder announcing the brand new project.

Fast forward to Dec 2014, my friend had a potential buyer for his apartment. Being a real estate trader, my friend jumped into the opportunity. A quick survey revealed that the property value in the area had appreciated by at least 25% (well, that’s how crazy real estate is in Bangalore). So my friend’s 9th floor apartment was now valued at Rs.12,500,000/-. My friend and the potential buyer struck a deal and settled on the sale at Rs.12,500,000/-.

Here is a table summarizing the transaction –

Particulars Details
Initial Value of Apartment Rs. 10,000,000/-
Date of Purchase November 2013
Initial Cash outlay @ 10% of apartment value Rs.10,00,000/-
Balance Payment to Builder Rs.90,00,000/-
Appreciation in apartment value 25%
Value of the apartment in Dec 2014 Rs.12,500,000/-
New buyer agrees to pay the balance payment Rs.90,00,000/- to the builder
My friend gets paid 12,500,000 – 9000000 = Rs.35,00,000/-
My friend’s profit on the transaction Rs.35,00,000/- minus Rs.10,00,000/- = Rs.25,00,000/-
Return on investment 25,00,000 / 10,00,000 = 250%

Clearly, few things stand out in this transaction.

  1. My friend was able to participate in a large transaction by paying only 10% of the transaction value
  2. To enter into the transaction, my friend had to pay 10% of the actual value (call it the contract value)
  3. The initial value he pays (10 lakhs) can be considered as a token advance or in terms of ‘Futures Agreement’ it would be the initial margin deposit
  4. A small change in the asset value impacts the return massively
  5. This is quite obvious – a 25% increase in asset value resulted in a 250% return on investment
  6. A transaction of this type is called a “Leveraged Transaction

Do make sure you understand this example thoroughly because this is very similar to a futures trade, as all futures transactions are leveraged. Do keep this example in perspective as we will now move back to the TCS trade.

M4-Ch4-title

4.3 – The Leverage

While we looked at the overall structure of the futures trade in the previous chapter, let us now re-work on the TCS example with some specific details. The trade details are as follows, for the sake of simplicity we will assume the opportunity to buy TCS occurs on 15th of Dec at Rs.2362/- per share. Further we will assume the opportunity to square off this position occurs on 23rd Dec 2014 at Rs.2519/-. Also, we will assume there is no difference between the spot and future price.

Particulars Details
Underlying TCS Limited
Directional View Bullish
Action Buy
Capital available for the trade Rs.100,000/-
Trade Type Short term
Remarks The expectation is that the stock price will increase over the next few days
Buy Date 15th Dec 2014
Approximate buy Price Rs.2362/- per share
Sell Date 23rd Dec 2014
Approximate Sell Price Rs.2519/- per share

So with a bullish view on TCS stock price and Rs.100,000/ in hand we have to decide between the two options at our disposal – Option 1 – Buy TCS stock in the spot market or Option 2 – Buy TCS futures from the Derivatives market. Let us evaluate each option to understand the respective dynamics.

Option 1 – Buy TCS Stock in spot market

Buying TCS in spot market requires us to check for the price at which the stock is trading, calculate the number of stocks we can afford to buy (with the capital at our disposal). After buying the stock in the spot market we have to wait for at least two working days (T+2) for the stock to get credited to our DEMAT account. Once the stocks resides in the DEMAT account we just have to wait for the right opportunity to sell the stocks.

Few salient features of buying the stock in the spot market (delivery based buying) –

  1. Once we buy the stock (for delivery to DEMAT) we have to wait for at least 2 working days before we can decide to sell it. This means even if the very next day if a good opportunity to sell comes up, we cannot really sell the stock
  2. We can buy the stock to the extent of the capital at our disposal. Meaning if our disposable cash is Rs.100,000/- we can only buy to the extent of Rs.100,000/- not beyond this
  3. There is no pressure of time – as long as one has the time and patience one can wait for really long time before deciding to sell

Specifically with Rs.100,000/- at our disposal, on 15th Dec 2014 we can buy –

= 100,000 / 2362

~ 42 shares

Now, on 23rd Dec 2014, when TCS is trading at Rs.2519/- we can square off the position for a profit –

= 42 * 2519

= Rs.105,798/-

So Rs.100,000/- invested in TCS on 14th Dec 2014 has now turned into Rs.105,798/- on 23rd Dec 2014, generating Rs.5,798/- in profits. Interesting, let us check the return generated by this trade –

= [5798/100,000] * 100

= 5.79 %

A 5.79% return over 9 days is quite impressive. In fact a 9 day return of 5.79% when annualized yields about 235%. This is phenomenal!

But how does this contrast with option 2?

Option 2 – Buy TCS Stock in the futures market

Recall in futures market variables are pre determined. For instance the minimum number of shares (lot size) that needs to be bought in TCS is 125 or in multiples of 125. The lot size multiplied by the futures price gives us the ‘contract value’. We know the futures price is Rs.2362/- per share, hence the contract value is –

= 125 * 2362

= Rs.295,250/-

Now, does that mean to participate in the futures market I need Rs.295,250/- in total cash? Not really, Rs.295,250/- is the contract value, however to participate in the futures market one just needs to deposit a margin amount which is a certain % of the contract value. In case of TCS futures, we need about 14% margin. At 14% margin, (14% of Rs.295,250/-)  Rs.41,335/- is all we need to enter into a futures agreement. At this stage, you may get the following questions in your mind –

  1. What about the balance money? i.e Rs.253,915/- ( Rs.295,250/ minus Rs.41,335/-)
    • Well, that money is never really paid out
  2. What do I mean by ‘never really paid out’?
    • We will understand this in greater clarity when we take up the chapter on “Settlement – mark 2 markets”
  3. Is 14% fixed for all stocks?
    • No, it varies from stock to stock

So, keeping these few points in perspective let us explore the futures trade further. The cash available in hand is Rs.100,000/-. However the cash requirement in terms of margin amount is just Rs. Rs.41,335/-.

This means instead of 1 lot, maybe we can buy 2 lots of TCS futures. With 2 lots of TCS futures the number of shares would be 250 (125 * 2) – at the cost of Rs.82,670/- as margin requirement. After committing Rs.82,670/- as margin amount for 2 lots, we would still be left with Rs.17,330/- in cash. But we cannot really do anything with this money hence it is best left untouched.

Now here is how the TCS futures equation stacks up –

Lot Size – 125

No of lots – 2

Futures Buy price – Rs. 2362/-

Futures Contract Value at the time of buying = Lot size *number of lots* Futures Buy Price

= 125 * 2 * Rs. 2362/-

= Rs. 590,500/-

Margin Amount – Rs.82,670/-

Futures Sell price = Rs.2519/-

Futures Contract Value at the time of selling = 125 * 2 * 2519

= Rs.629,750/-

This translates to a profit of Rs. 39,250/- !

Can you see the difference? A move from 2361 to 2519 generated a profit of Rs.5,798/- in spot market, but the same move generated a profit of Rs. 39,250/- . Let us see how juicy this looks in terms of % return.

Remember our investment for the Futures trade is Rs.82,670/-, hence the return has to be calculated keeping this as the base –

[39,250 / 82,670]*100

Well, this translates to a whopping 47% over 9 days! Contrast that with 5.79% in the spot market. For sake of annualizing, this translates to an annual return of 1925 % …and with this; hopefully I should have convinced you why short term traders prefer transactions in Futures market as opposed to spot market transactions.

Futures offer something more than a plain vanilla spot market transaction. Thanks the existence of ‘Margins’ you require a much lesser amount to enter into a relatively large transaction. If you’re directional view is right, your profits can be really large.

By virtue of margins, we can take positions much bigger than the capital available; this is called “Leverage”. Leverage is a double edged sword. If used in the right spirit and knowledge, leverage can create wealth, if not it can destroy wealth.

Before we proceed further, let us just summarize the contrast between the spot and futures market in the following table –

Particular Spot Market Futures Markets
Capital Available Rs.100,000/- Rs.100,000/-
Buy Date 15th Dec 2014 15th Dec 2014
Buy Price Rs.2362 per share Rs.2362 per share
Qty 100,000 / 2362 = 42 shares Depends on Lot size
Lot Size Not Applicable 125
Margin Not Applicable 14%
Contract value per lot Not Applicable 125 * 2362 = 295,250/-
Margin Deposit per lot Not Applicable 14% * 295,250 = 41,335/-
How many lots can be bought Not Applicable 100,000/41,335= 2.4 or 2 Lots
Margin Deposit Not Applicable 41,335 * 2 = 82,670/-
No of shares bought 42 (as calculated above) 125 * 2 = 250
Buy Value (Contract Value) 42 * 2362 = 100,000/- 2 * 125 * 2362 = 590,500/-
Sell Date 23rd Dec 2014 23rd Dec 2014
No of days trade was live 9 days 9 days
Sell Price Rs.2519/- per share Rs.2519/- per share
Sell Value 42 * 2519 = 105,798 250 * 2519 = 629,750/-
Profit earned 105798 – 100000 = Rs.5798/- 629750 – 590500 = Rs.39,250/-
Absolute Return for 9 days 5798 / 100,000 = 5.79 % 39250 / 82670 = 47%
% Return annualized 235% 1925%

All through we have discussed about rewards of transacting in futures, but what about the risk involved? What if the directional view does not pan out as expected? To understand both the sides of futures trade, we need to understand how much money we stand to make (or lose) based on the movement in the underlying. This is called the “Futures Payoff”.

4.4 – Leverage Calculation

Usually when we talk about leverage, the common questions one gets asked is – “How many times leverage are you exposed to?” The higher the leverage, higher is the risk, and the higher is the profit potential.

Calculating leverage is quite easy –

Leverage = [Contract Value/Margin]. Hence for TCS trade the leverage is

= [295,250/41,335]

= 7.14, which is read as 7.14 times or simply as a ratio – 1: 7.14.

This means every Rs.1/- in the trading account can buy upto Rs.7.14/- worth of TCS. This is a very manageable ratio. However if the leverage increases then the risk also increases. Allow me to explain.

At 7.14 times leverage, TCS has to fall by 14% for one to lose all the margin amount, this can be calculated as –

1 / Leverage

= 1/ 7.14

= 14%

Now for a moment assume the margin requirement was just Rs.7000/- instead of Rs.41,335/-. In this case, the leverage would be –

= 295,250 / 7000

= 42.17 times

This is clearly is a very high leverage ratio, one would lose all his capital if TCS falls by –

1/41.17

= 2.3%.

So, the higher the leverage, the higher is the risk. When leverage is high, only a small move in the underlying is required to wipe out the margin deposit.

Alternatively, at roughly 42 times leverage you just need a 2.3% move in the underlying to double your money.☺

I personally don’t like to over leverage, I stick to trades where the leverage is about 1 :10 or about 1:12, not beyond this.

4.5 – The Futures payoff

Imagine this – when I bought TCS futures the expectation was that TCS stock price would go higher and therefore I would financially benefit from the futures transaction. But what if instead of going up, TCS stock price went down? I would obviously make a loss. Think about it after initiating a futures trade, at every price point I would either stand to make a profit or loss. The payoff structure of a futures transaction simply highlights the extent to which I either make a profit or loss at various possible price points.

To understand the payoff structure better, let us build one for the TCS trade. Remember it is a long trade initiated at Rs.2362/- on 16th of Dec. After initiating the trade, by 23rd Dec the price of TCS can go anywhere. Like I mentioned, at every price point I will either make a profit or a loss. Hence while building the pay off structure; I will assume various possible price point situations that can pan out by 23rd Dec, and I will analyze the P&L situation at each of these possibilities. In fact the table below does the same –

Possible Price on 23rd Dec Buyer P&L (Price on 23rd Dec – Buy Price)
2160 (202)
2180 (182)
2200 (162)
2220 (142)
2240 (122)
2260 (102)
2280 (82)
2300 (62)
2320 (42)
2340 (22)
2360 (2)
2380 18
2400 38
2420 58
2440 78
2460 98
2480 118
2500 138
2520 158
2540 178
2560 198
2580 218
2600 238

This is the way you need to read this table, – considering you are a buyer at Rs.2362/- , what would be the P&L by 23rd Dec assuming TCS is trading is Rs.2160/-. As the table suggest, you would make a loss of Rs.202/-per share (2362 – 2160).

Likewise, what would be your P&L if TCS is trading at 2600? Well, as the table suggest you would make a profit of Rs.238/- per share (2600 – 2362). So on and so forth.

In fact if you recollect from the previous chapter we stated that if the buyer is making Rs.X/- as profit then the seller is suffering a loss to the extent of Rs.X/-. So assuming  23rd Dec TCS is Trading at 2600, the buyer makes a profit of Rs.238/- per share and the seller would be making a loss of Rs.238/- per share, provided that the seller has shorted the share at Rs.2362/-.

Another way to look at this is that the money is being transferred from the seller’s pocket to the buyer’s pocket. It is just a transfer of money and not creation of money!

There is a difference between the transfer of money and creation of money. Money is generated when value is created. For example you have bought TCS shares form a long term perspective, TCS as a business does well, profits and margins improve then obviously you as a shareholder will benefit by virtue of appreciation in share price. This is money creation or wealth generation. If you contrast this with Futures, money is not being created but rather moving from one pocket to another.

Precisely for this reasons Futures (rather financial derivatives in general) is called a “Zero Sum Game”.

Further, let us now plot a graph of the possible price on 23rd December versus the buyers P&L. This is also called the “Payoff Structure”.

M4-Ch4-Chart1

As you can see, any price above the buy price (2362) results in a profit and any price below the buy price results in a loss. Since the trade involved purchasing 2 lots of futures (250 shares) a 1 point positive movement (from 2362 to 2363) results in a gain of Rs.250. Likewise a 1 point negative movement (from 2362 to 2361) results in a loss of Rs.250. Clearly there is a sense of proportionality here. The proportionality comes from the fact that the money made by the buyer is the loss suffered by the seller (provided they have bought/short the same price), and vice versa.

Most importantly, because the P&L is a smooth straight line, it is said that the futures is a “Linear Payoff Instrument”.


Key takeaways from this chapter

  1. Leverage plays a key role in futures trading
  2. Margins allow us to deposit a small amount money and take exposure to a large value transaction
  3. Margins charged is usually a % of the contract value
  4. Spot market transactions are not leveraged, we can transact to the extent of the capital that we have
  5. By virtue of leverage a small change in the underlying results in a massive impact on the P&L
  6. The profits made by the buyer is equivalent to the loss made by the seller and vice versa
  7. The higher the leverage, the higher is the risk and therefore the higher the chance of making money.
  8. Futures Instrument simply allows one to transfer money from one pocket to another, hence it is called a “Zero Sum Game”
  9. The payoff structure of a futures instrument is linear.

382 comments

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  1. sushil 12 says:

    Simple and easy. Too Good Sir:)

    • Karthik Rangappa says:

      Thx 🙂

      • pops says:

        You are simply owsum, in a short exp, you just understand us everything which was a question for lifetime , great ,
        ??

      • Shrirang Sarnaik says:

        Sir I am very beginner to future stock market…Till not taken single trade in equity future. I have one query….are future contracts also getting highlighted in Demat or it takes a couple of days…Pls clarify

        • Karthik Rangappa says:

          No, these contracts don’t come to DEMAT like stocks.

          • Shantanu says:

            Hi, If Future contracts dont come to demat how can see what profit or loss we have made from it ? Another query I have is , in Key points you have stated “Spot market transactions are not leveraged, we can transact to the extent of the capital that we have” but we get leverage depending on the volatility of the stock. Can you please explain this stmt.

            Thanks,
            Shantanu

          • Karthik Rangappa says:

            The P&L can be tracked from the position’s tab on Kite. Shantanu, can you please give me more clarity on the line “but we get leverage depending on the volatility of the stock”. Thanks.

    • Nagesh Cavatur says:

      The leverage is the reciprocal of margin percentage x 100. In the TCS example it becomes (1/14)x100 = 7.14.

  2. Santosh says:

    Really nice detailed explanation, though some of us trade futures but do not know the underlying concepts.
    Explanation on Leverage and Risk is beautiful.

    • Karthik Rangappa says:

      Thanks Santosh, glad you liked it. It is in fact quite important to know the nature of beast as it helps us tame it better 🙂

      • Rahul says:

        Absolutely correctly said phrase. Hearty gratitude for the detailed explanation on Futures.

        • Karthik Rangappa says:

          Most welcome 🙂

          • JEGANNATHAN AROCKIAM says:

            Dear Karthik,

            With respect to 4.4, advantage of leveraging you mentioned that more leveraging means ( i.e less margin amount) more risk of loosing capital when the stock price come down marginally. My question is if we loose capital, the amount also will be lesser, instead of 41335 we loose 7000 only. Moreover, why we loose that amount why not wait for increase in stock price? ( I mean within contract period)

            Please elaborate.

            Thanks

          • Karthik Rangappa says:

            The futures work on an M2M basis, so the funds have to be settled on a daily basis. This means the capital has to go out from your account on an at the end of the day (in case of a loss). Yes, you can hold the futures position for recovery but then you need enough money to fund M2M losses (if any).

  3. S.R.Badrish says:

    Hi, It gives a complete explanation about all the points pertaining to futures Trading. Should clear most of the doubts of a layman also.
    Just wanted to mention one point–As far as my knowledge goes, as per the example when TCS is bougt as stock, we can sell the stock even before it comes to our DEMAT Account.
    Anyhow Hats off to the entire team for their effort in putting up a module like this.

  4. amit kumar says:

    Very good explanation kartik, I want to know how much will be profit and loss keeping brokerage and spot and future price different, kindly explain, once again hats off to u nd ur team for doing wonderful job, keep it up.

  5. sushil 12 says:

    sir next chapter plz…? 🙂

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