Reduction of risk using futures trading

Aim: To reduce risk of the portfolio using futures trading.

Assumptions:
---> The trading system used thrives on diversification to work.
---> The lot sizes traded in cash is equal to that of futures (or the capital invested is big enough to achieve diversification in the "value of futures traded")
---> For each future , LotSize * Price is the same. (For example,stock X is trading at 100 with lot size of 10 and stock Y is trading at Rs200 with a lot size of 5 and so on)

Capital at start:
---> Rs 1crore

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Case 1: (When the capital is used only for cash trading)
Let us take the example of stock "A" the price of which is Rs100 and lot size is 4000.
If a person was to purchase 3000 shares of "A", the amount of capital needed is 400,000Rs (4,000*100).
Investing 100% in stocks, he would be able to purchase a maximum of 25stocks.

Case II: (When he trades futures instead of stocks)
In the futures market, margin trading is allowed,which is usually 20% of the "value" of the contract.
In our above example, if Rs1 crore is traded, the amount needed is Rs20Lakh.

Note: The remaining 80lakhs is left idle. This could be invested in a debt instrument to generate a return of say,8% per annum.

The "traded value" in both cases remains the same as 1crore.
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Now let us take 2 states,

State 1: A profit of 20% of "traded value" is generated.

The profit in Case I: 20lakhs (which is the return on equity)
iProfit from case II : 20lakhs + 6.4lakhs (8% of 80lakhs which is the amount invested in debt) = 26.4 lakhs.

State 2: A loss of 20% has occurred.

The loss in Case I : 20lakhs
Loss in Case II: 20 Lakhs - 6.4 Lakhs (return from debt) = 13.6lakhs.

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Conclusion:
Trading futures makes it a win-win case both ways compared to trading stocks.

Note:
Does this mean you have to quit trading stocks and start trading futures?
NO. Due to the huge capital base, the portfolio is able to be diversified into both stocks AND futures without a problem. If only futures had been traded in case II, without investing in debt, the portfolio could have accomodated 125stocks instead of the traded 25 and the risk return would have increased propotionally with the risk return in stocks.
in state 1: if 100% was invested in futures, a return of 100% could have been generated!!
in state 2: if 100% was invested in futures, the account would have been wiped out!!!

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Experts,please comment on this analysis.

Overall i agree with your point but i have a problem
In state 2 u will receive a margin call when ur margin is below 20% or there could be forced liquidation
In a stock 10 % can be expected as normal price movement in a matter of few days, if that 10% is against us it will take 50% of our margin.
I also dont understand when people talk about hedging using futures
Say u have 300 RIl shares & u sell RIL futures at 1380
Now u say i have hedged myself from any downward movement
I think this can work if ur holding period is till expiration of futures
Otherwise say u intend to hold RIL for a year
But RIL unexpectedly jumps 10% on the expiry week u loose 50% of ur margin assuming20% margin requirement
, then next week RIL comes down again 10%
How has this hedging helped a long term investor
Excuse me if i am being naive
Naveen

Good point.
A drawdown of more than 20% in a year is significant to any portfolio. In the above case, I have assumed a buy and hold strategy but in real life, this needn't be so.
Even if the case is a buy and hold, the margin call can be met by liquidating the debt position instead of closing the position in the futures thus moving slowing into "case 1" but still earning a return on debt.
Even so, a reserve margin of 20% (which is unproductive or idle) or so can be kept and the remaining could be invested in debt (which still earns a return).
If the drawdown is more than 20lakhs in our example, we liquidate 20lakhs worth of debt and use that as margin money.

I believe that had nothing to do with my explanation and at some place,there was a misunderstanding. At no place do I talk of hedging the cash position against futures or vice versa.
The above explanation was purely to point out the advantage of futures trading for a big portfolio "over" cash trading. In futures, the difference between traded value and margin amount can be utilized to earn a return,which otherwise can't be done in trading in the cash market.

[I believe that had nothing to do with my explanation and at some place,there was a misunderstanding. At no place do I talk of hedging the cash position against futures or vice versa.
The above explanation was purely to point out the advantage of futures trading for a big portfolio "over" cash trading. In futures, the difference between traded value and margin amount can be utilized to earn a return,which otherwise can't be done in trading in the cash market.[/quote]

Perfectly right man
But i just wanted to clear myself whether this hedging can be done as we are told.
I totally agree with ur pint that futures are a much better way then simple buy & hold in cash market
Regards

Naveen

Hi Naven its pretty simple.

Say Nifty is @ 3800. I hav been buying into Nifty 50 stocks since last 5 yrs or so(Notice-long term). So my average cost of aqusition comes to 2800. Now at some point markets get over heated and i get a whiff that a correction will take place in which i can loose about 500 pts on my overall portfolio. So i hedge.


some number crunching.
My Avg cost of aquisition say( of 50 stks)=2800*50= Rs 1,40,000
Current Marke value = 3800*50= 1,90,000
Current gain= Rs 50,000

If a corection takes place i loose approx Rs 25000 (50% of my gains or 500 pts on Nifty)

To avoid this i Sell a Nifty futs @ 3800

Two conditions=
1) Market goes Up
2) Market goes down


1) Market goes Up- I loose on the NF but gain on the portfolio. No gain no loss.
2) Market goes down- NF goes into gains and my losses on Portfolio get adjusted.



its a very usefull strategy because if u do so u dont get on the wrong side. Say ur expectations are wrong u can cut ur NF and let ur porfolio run for u.



Hope i could make things clear.


Swagat

It holds good for whatever the strategy you adopt as long as you compare the returns from stocks and the return from (futures + debt)...for aggressive trading as well as buy and hold. It's a case of absolute advantage...(atleast from what I can see)

Dear all

Have factored in the tax liability?????????

1. If u trade shares in cash - u pay 10%-20% on short term profits
long term profits (>1yr) - no tax
2. Trade in futures : its treated as speculation -- tax @ 30%

Please recalculate profits post tax

regards

Ajax

For a trader any gain is taxable @ 30%. So it does not make any difference if one is trading in Cash Market or Derivatives.

Further, if a person is an investor and he is using derivaties only for hedging purpose, any loss or cost of such derivatives should be treated as cost of Capital Asset while gains should be treated as Income from Other sources and hence would be taxed at average rate of taxation for the investor.

Best Regards,
--Ashish