What are Different Strategies for Futures Contracts?

Is it possible to have strategies in the future? After all, futures are plain vanilla products just like the cash market? The truth is that there are future strategies that are possible in the market. Futures are symmetric in their payoffs to buyers and sellers and hence you do not have as many different permutations as options when it comes to strategies. However, future strategies can still be applied to make the best of situations.

Trading futures strategies can be of 2 types. They can be directional, by using futures as a proxy for the spot market. Alternatively, then can also be protective like in the case of hedges, profit lock-ins, arbitrages, spreads, etc. Trading futures strategies entails a proper understanding of the situation, the expectation, and the costs. Let us look into trading futures strategies in greater detail.

Different Strategies for Futures Contracts

As we stated earlier, futures trading strategies can either be directional or they can be protective. Hence it effectively boils down to your view on the market or the stock. Let us look at how futures trading strategies can be effectively deployed in different situations for enhancing profits.

Using futures leverage to play the pullback

These future trading strategies are largely predicated on price pullbacks. Price pullbacks occur when the up move or the down move has stretched too far in the wrong direction. That includes a stock that has rallied more than warranted or a stock that has corrected more than warranted. Both are ripe for pullback strategies. The most simple and plain-vanilla way to play the futures pullback strategy is to use the traditional supports and resistance lines.

You are aware that resistance levels are price levels at which the price had difficulties breaking above. On the other hand, the support levels are price points where the market had difficulties breaking below. Both can be important pivot points for a pullback strategy. For example, amid an uptrend, if the stock corrects towards the support, there is a high probability that the stock will pull back with a vengeance. That is the time to double your profits by using the power of leverage in the future by adopting a pullback strategy. On the other hand, in a downtrend, if you find the stock rising and facing a tough time at the resistance line, it is time to directionally sell futures.

Playing conviction trades with futures

Why are we talking about conviction in future trading strategies? That is because futures are leveraged. Just as profits can be unlimited, losses can also be unlimited. That is not a very good feeling if you are on the wrong side of a trade. Hence conviction calls are the ones you must play with future.

You can buy futures contracts if you’re expecting the price of an underlying stock or commodity to increase over a certain period. If your forecast of the direction and timing of the price change is accurate, you sell futures contracts later for a higher price. However, the condition is conviction. This is best used only when the conviction is high. Otherwise, leverage in the future could backfire.

Playing breakouts both ways with futures

This is just as the name suggests. Breakout trading is a popular approach in day trading or even in short to medium-term trades. A breakout occurs when an underlying asset’s price moves out of an established trading range. When this happens supported by volumes, it is a signal of a change in direction in a decisive manner. Breakout trading essentially attempts to catch the market volatility when the price is breaking out of support or resistance levels or is getting out of congestion zones. In breakout trading, the timing of the trade, the signals from volumes, and fundamentals are all very important factors.

You would find that the breakout movement of any asset class like equities, currencies, commodities, etc is accompanied by a sharp spurt in volumes. Here, you look for a narrow trading range or channel where volatility has diminished. Normally, the volatility first comes down to more normative levels before the breakout happens. Irrespective of whether you are playing the breakout on the upside or the downside, your focus should be on spurt in volumes, fall in volatility, exit from a congestion zone, etc. These are all preparatory signals to watch out for.

Normally, the experience is that you get to see bouts of great volatility after a breakout occurs since a plethora of pending orders gets executed. You can as well take advantage of this volatility rise by taking a position in the direction of the breakout. The quick trade logic in breakout trades is to go short when prices break below support and go long when prices break above the resistance level.

Get the power of spread trading

Spread trading is, perhaps, the most complex and challenging part of futures trading. All else is generally plain vanilla. What does spread trading involve? The spread trading strategy involves the purchase of 1 futures contract and simultaneous selling of another futures contract of a different asset class, or different maturity. The purpose of this spread strategy is to profit from an unanticipated change in the relationship between the buying price of 1 contract and the selling price of the other futures contract. You get these opportunities often in the market and it is called mispricing.

Spread trading is mathematically complex as it involves correlations, trends, and other statistical measures. However, the good thing about spread trading is that it lowers your risk in trading since it is also a hedged strategy. It may not be a perfect hedge, but it is conceptually a hedge. Trading the difference between 2 futures contracts results in lower risks to a trader. Spread trading is not vulnerable to market volatility and the margins on such spread trading are also much lower.

WHAT IS SPREAD TRADING?

When we talk of future trading strategies, one of the most popular is spread trading strategies. Many large institutions and proprietary desks prefer these spread strategies as they can trade with lower risk and lower margins. Here are some common types of spread trading strategies that you can deploy.

1. Calendar Spread is the most common type of spread trading. It entails buying the futures contract of an asset in one expiry and selling in another expiry. Normally, you sell the overpriced contract and buy the under-priced contract.
2. Relative value spread or Pair Trading entails buying one stock and selling another stock in futures. Now, these are not perfect spreads but you go by past correlations. Such pair trades are common ahead of mergers and acquisitions.
3. Arbitrage spread trading entails the spread between the cash market position and the futures position on a similar stock. This is one of the safest and gives returns close to the risk-free rate of interest in the economy. In India, there are huge sums of money managed under the ambit of arbitrage funds by institutional investors.
4. Spreads across exchanges are also common although such spreads are now down to zero with the advent of algo trading. This entails spreads between NSE and BSE. One of the common such spread tradings is between Nifty on the NSE and Nifty on the SGX.

What is meant by calendar spread?

A calendar spread is a spread between futures of two different expiries of the same stock or index. Here is how you go about a calendar spread.

• Calculate fair value of current month contract
• Calculate fair value of mid-month or far month contract
• Look for relative mispricing based on the cost of carrying approach