Derivatives Made Easy: PART 1 – Forwards & Futures

We often tend to harbour the notion that the world of finance is full of difficult concepts and theories but, it becomes much simpler if you try to understand them by breaking them into parts and then try to sew them together.

The COVID-19 pandemic has induced huge volatility into the financial markets and in turn put traders in a state of frenzy. Derivatives trading has skyrocketed during this period – sellers fanatically hoping they wouldn’t bear losses and buyers intelligently adjusting their sails with the winds. Stuck at home in the pandemic-forced lockdown (some even with extra disposable income) masses are thronging the Indian stock markets. Running out of options to make quick bucks, retail investors are turning to ‘options’ – the high risk, high return derivatives. Most brokerage agencies have reported a surge in DEMAT accounts, majorly from Tier 2 and Tier 3 cities.

Let us take this opportunity to elucidate the concept of Derivatives for you:

What are “Derivatives” ?

Investopedia says:

“A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset (like a security) or set of assets (like an index). Common underlying instruments include bonds, commodities, currencies, interest rates, market indexes, and stocks.”

What it means is:

1. There is a share of HDFC bank (underlying security)
2. A Derivative is an instrument which, as the name suggests, derives its value from this share i.e. the price of this derivative (and resulting profit and loss) will increase or decrease as the price of share of HDFC Bank changes.

There are four main kinds of derivatives primarily available in the markets:

1. Forwards
2. Futures
3. Options
4. Swaps

Forwards and swaps are not exchange traded; you and I cannot trade these contracts from our trading accounts.

Futures and options are exchange-traded; you and I can trade these contracts from our trading accounts, hence our discussion will majorly focus on Futures and Options. But to understand futures, we’ll have to understand its older brother “Forwards” first.

Forwards:

Forwards contracts were originally started to protect the interest of farmers from adverse price movements. In the forwards market, the buyer and seller of forwards enter into an agreement to exchange the goods at a predetermined price.
Still not clear? Read the example below!

Example –

You own a lemonade stall and buy 100 dozen lemons from your local whole-seller on 1^st of each month. You are expecting that the lockdown due to COVID-19 will end soon and anticipate a rise in the price of lemons due to an increase in demand. On the other hand, the whole seller (your supplier) thinks that things will worsen which will lead to lockdown extension and prices will fall due to the muted demand.

Today is 1^st July and the current price that you are paying for one dozen lemons is say 20 rupees. In such a scenario, you are likely to go to your supplier and say, ”Hey, let’s enter into a contract that I’ll buy 100 dozen lemons from you next month on 1^st August @ 20 Rupees/dozen.” Since seller believes that prices will fall by next month, he thinks that he is better off entering into this agreement to sell you at Rs 20 per dozen.

This agreement happens face to face without intervention of any trusted third party. This is called ‘Over the Counter’ (OTC) agreement.

Let us understand these scenarios on how they affect both you and your supplier:

Scenario 1: The increase in lemon prices will be in line with your prediction and you’ll end up paying less, thus profiting Rs 5 per dozen and the supplier will have to sell you lemons at Rs 20/dozen when he could have sold them to somebody else at Rs 25/dozen.

Scenario 2: Supplier’s view on the lockdown turns out to be correct, lockdown gets extended, nobody comes to buy lemons and the prices fall to Rs 15/Dozen. You’ll have to buy lemons at Rs 20/dozen when you could have got the same at a cheaper price and the supplier ends up making Rs 5/dozen extra (Profit)

Scenario 3: Price somehow stays the same, neither you nor the supplier benefits from the contract.

Now assuming that the contract is honoured, there are 2 ways to settle this:

Let us assume scenario 1 happens,

Physical settlement: Supplier sells you 100 dozen lemons and you pay the supplier (100×20) 2000 rupees.

Cash Settlement: There is no physical exchange of goods. You are interested only in profits and supplier agrees to pay Rs 500 (5 per dozen x 100 dozen) to you to settle the contract.

Now since the structure of this contract is clear, we’ll need to understand what can potentially go wrong with it and why Future contracts were designed.

1. You and the supplier had contrasting views on the COVID-19 lockdown as well as the demand-supply situation, thus entering into contract enforceable after one month. You both had your own view on lockdown.

However, what if your or supplier’s (or both) view change after 14-15 days? The forward contract is rigid and you cannot foreclose the agreement before it’s completed. This is called Rigidity Risk.

• There is no intermediary (middle-man) on which both of you trust who can ensure that none of you default. This is known as Regulatory Risk.

• Your view is correct, you expect the supplier to sell you at the agreed price of Rs 20/dozen instead of the current price of Rs 25/dozen. You feel good about it but the supplier calls local goons, beats you up, and refuses to honour the agreement. This is called the Counterparty / Default risk.

• You have a view that prices will increase, but all your suppliers also have the same view that they will indeed increase and you find nobody in your district to enter into a contract to sell at Rs 20/dozen after a month. So, even if you were the master of macroeconomics, you would not be able to profit from your study since you did not find a counterparty to make this agreement with. This is known as Liquidity risk.

To overcome these drawbacks, futures contracts were designed.

Futures:

Futures retain the core structure of the forward contracts but eliminate the risks associated with forwards. Think of it this way, forwards are like landline telephones while futures are mobile devices. The core structure remains the same (making calls) but mobile phones eliminate various drawbacks of the landline.

Unlike Forwards, Futures trade on the exchange, hence:

1. There is surety of agreement being honoured.
2. There are many participants available on the exchange hence you can easily enter into an agreement.
3. You can exit / re-enter into the contract any time before the expiration.

Some of the other features of futures which are not present in forwards are:

1. They mimic the price of the underlying asset. E.g. If the share price of HDFC bank increases, the price of futures contract of HDFC bank will increase and vice versa.
2. These are standardized contracts, in our example of forwards, we could have entered into a contract for 100 dozen, 104 dozen ,176 dozen, 200 dozen (any quantity). Such negotiations are not possible in futures contacts i.e. quantity parameters are specified.
3. Futures are time bound. There are futures contracts for 1,2,3 months.

The regulator for futures market in India is SEBI (Securities and Exchange Board of India). Think of SEBI as the middleman whom you as well as your supplier of lemons trust and who ensures that both parties honour the contract.

Spot price and futures price:

The current price of a share of HDFC bank is called the “Spot” and price of HDFC bank in futures market is called “futures price”. As mentioned earlier, these two prices move in tandem.

Lot Size: As pointed earlier, the size of futures contracts is specified. E.g. You can buy any number of shares of HDFC Bank but you’ll have to buy HDFC Bank futures in multiples of 550 only. So the number of units that can be purchased or sold for HDFC bank in the futures market is 550, 1100, 1650, and so on.

This is called the “lot size”. Lot size varies from one stock to another.

Contract Value – one lot size for HDFC Bank is 550, hence:

Contract value of 1 HDFC Bank future = 550 x Price of 1 share of HDFC bank.

So one would naturally ask why one should trade futures when:

1. Price of futures move in tandem with price of Equity shares?
2. One can buy / sell these equity shares as well?

Answer – Advantages of trading futures over trading shares:

1. If you think that there is weakness in a certain stock and anticipate a fall in the price, you cannot short equity shares in India (you can but only intra-day). Suppose the price of HDFC bank share is Rs 1100. You expect it to go down in the near future then you can take advantage of this by selling / shorting HDFC Bank futures at Rs 1100 and buying (to close your position) at a reduced price say Rs 1080, thus you sold each at Rs 1100 and bought the shares at Rs 1080 effectively making a profit of Rs 20 per share. You cannot short sell equity shares in India. (you can do it but only intraday, you cannot short and hold your position for the next day)

• Another (and the biggest reason) for trading in futures is leverage (and margin). Sounds alien? Read on, its simple.

Suppose you have Rs 1,50,000 with you and you want to buy shares of HDFC Bank (currently trading at Rs 1100 per share). You would be able to buy (150000/1100) approximately 136 shares. So, total investment is Rs 1,49,600 (136 x 1100)

If the share price moves up, you make a profit and if the prices fall, you make a loss. Assume after a week the prices at which HDFC bank shares go up to Rs. 1150. You are happy with the profit and you sell your 136 shares.

Thus, you have made a profit of Rs [(1150 – 1100) x 136] =Rs 6800.

Now let me introduce to you the concepts of margin and leverage that make futures trading so attractive.

As already stated, the lot size for HDFC Bank Futures is 550. Once we know the lot size, we have to figure out the contract value (lot size x future price) 550 x 1100 = Rs 6,05,000

Note: There is a small difference in the price of futures and spot price (which we shall discuss after completing the basics) but for the sake of simplicity here let’s assume that Futures price is equal to spot price i.e. Rs 1100

To participate in the futures market, one does not need the entire contract value, Rs 6,05,000 in this case. We only need to deposit a certain percentage of the contract value called “Margin Amount”.

Assume we need a margin of 20% in case of HDFC Futures, at this margin we need only (20% of 6,05,000) Rs 1,21,000. Our capital was Rs 1,50,000 so the balance 29,000 can be used for other purposes.

Is the margin equal to 20% for all stocks? NO, it varies from stock to stock.

Now you may wonder, ”What about the balance money Rs 4,84,000 (6,05,000 –  1,21,000) ?”

Well, you don’t need to pay this money. What it effectively means is that using Rs 1,21,000 in your trading account, you can buy Rs 6,05,000 worth of HDFC Bank Futures.

Now, let us simplify this trade for you.

We will divide the transactions in 2 legs viz. Buy Leg and Sell Leg.

Buy Leg:

Lot Size: 550
HDFC Bank Futures Price: Rs 1100
Contract Value: Rs 6,05,000
Margin: 20%

Margin Money required to buy 1 lot of HDFC Bank Futures: Rs 1,21,000

Sell Leg:

Lot size: 550
Assuming HDFC Bank Futures price rise to Rs 1150Profit: (1150 x 550) – (1100 x 550) = Rs 27,500

Compare this with buying equity shares of the same company. With the same capital of Rs 1,50,000, with the same buying price of Rs 1100 and the same selling price of Rs 1150, the profits made are as follows:

In Equity shares: Rs 6800  (on investment of Rs 1,50,000. Returns: approx 4.5%)
In futures: Rs 27,500         (on investment of Rs 1,21,000. Returns: approx 22.7%)

What accounts for this huge disparity in profits?

Answer is “LEVERAGE”

As we have already seen, using margins, we can take positions much bigger that the capital available, this is “Leverage”. If you are directionally correct, then you will earn huge profits in a short span of time but if you are wrong, your losses will also be huge.

Leverage = (100 / % margin), in our case leverage is (100/20) = 5.
It means 1 rupee in our account can buy futures worth 5 rupees.

This leverage amplifies your profits as well as your losses; therefore higher the leverage higher the risks and higher the rewards.

DIY Activity: Calculate the loss in case of equity shares and futures if instead of rising, the price of HDFC Bank had fallen to Rs 1050. You can put your answers in the comments below!

So that’s the basics of futures for you. We’ll go deep into futures trading and then into more lucrative (but highly complex) options trading. Don’t worry, we shall break down those concepts using real-life examples for you. Till then, ciao!!

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