What can futures ideally be used for?
We know that a future contract is an agreement to buy or sell a stock or the index at a future date. Both the date and the price at the maturity of the agreement are decided well in advance. If you are positive that the price of the underlying will go up, you can go long on futures, and if you are negative on the same, you can go short (sell) futures. There are two basic purposes for which futures can be used.
Using futures for locking in profits or losses
This is one of the most basic forms of hedging. Let us say you purchase 1,000 shares of Reliance Industries at Rs1,150. Two days after you purchase the shares, the price goes up to Rs1,240 on the back of positive announcements by Jio. You can sell Reliance futures (1 lot = 1,000 shares) and the profit of Rs90 (1,240 – 1,150) is locked. You can apply the same strategy if Reliance falls, in which case you can lock the maximum loss.
Using futures for arbitrage opportunities in the market
To understand this, let us see what arbitraging is about. Arbitrage funds typically buy a stock and sell futures at a higher price. Because your future will be, say, 1 month away, there is a premium you have to pay to buy the future, which is somewhat equal to the 1-month interest rate. The gap will be your profit, and you can just keep rolling over the future each month to the next contract while holding your cash market position. Here is how it works.
|Details||Cash Market||Futures Market||Strategy|
|Bought ICICI Bank Sep 01||Rs325|
|Sold Sep ICICI Futures||Rs328|
|Buy in cash / sell in futures||You earn assured spread of Rs3 Yield = 0.91%|
|On Expiry Date||Rs360||Rs360|
|Realized Yield||11.48% (less costs)|
In the above case, you unwind the cash and futures position and take home 0.91% yield for the month. Of course, the final yield will be lower due to brokerage and statutory costs. Often, investors just hold on to their cash position and roll over the short futures, i.e., buy back the current month future and sell the next month future. The roll spread is your monthly earnings.
Why futures should not be used for trading
Having understood that futures can be effectively used for hedging and arbitrage, let us also see in which cases futures must not be used.
Losses can multiply quite rapidly in futures
Futures are leveraged positions. This means that you can take a position worth Rs10 lakh by paying a margin of just Rs2 lakh (the margin varies by stock). Now, if the stock moves against you by 5%, the loss is actually 25% on your margin. If you have taken a futures position like a cash market position, you are surely going to be in trouble.
MTM margins create a cash flow challenge
Futures can work both ways, meaning profits can be unlimited and losses can also be unlimited. To protect the market overall, the exchange charges an initial margin, but that may not sufficient if the price drastically moves against you. In that case, you are required to put in mark-to-market (MTM) margins. If these MTM margins go beyond your point of affordability, you have no choice but to close out your futures position at a huge loss.
Futures are subject to shifts in margin policy
This is a major risk that you face while trading in futures. When you take a futures position, your initial margin comprises of Value at Risk (VAR) margins and Extreme Loss Margins (ELM). The ELM is also referred to as Exposure Margin. In the past, ELM was not mandatory, but now SEBI has made it mandatory to collect ELM from futures clients. In addition, the regulator keeps applying special margins from time-to-time based on valuations and volatility. For example, SEBI has just imposed Additional Special Margin (ASM) on select stock futures. When additional margins are imposed and you do not have liquidity, you could be staring at losses.
Additional restrictions such as MWPL
For every stock future position, SEBI has defined the Market Wide Position Limit (MWPL). If the actual open interest crosses 90% of MWPL, restrictions on fresh positions start applying. This could skew price movement against the stock as fresh positions will not be permitted, and there will be pressure to close out positions.
Risk of compulsory delivery in stock futures
This is a recent risk that has cropped up. Effective July 2018, SEBI has shifted nearly 46 stock futures into the compulsory delivery list. On the day of expiry, these positions will no longer be squared off but result in compulsory delivery. If you are unable to close out your position in advance, the delivery buy or delivery sale will devolve on you. Apart from the higher margin and higher securities transaction tax (STT) liability, you stand the risk of auction if you are short on futures when they devolve into delivery. This is again a risk to be cautious about.
In conclusion, trading in futures may appear to be quick money, but it comes with massive risks that could put you in the grave danger of unlimited losses. It is, therefore, advisable to only use futures for the recommended purposes of hedging and arbitraging to the extent possible.