Use futures trading intelligently

A successful self trader – Rule # 2

Warren Buffet may have referred to Futures as weapons of mass destruction. But there is a method in the madness. While you can get away with mistakes in the cash market, your margin for error in futures is limited. But it has some amazing advantages. It combines the best of leverage, economy and efficiency. Futures manage your risk and also spur your investment yield. But Discipline is the key!

FROM THE EDITOR’S DESK

Imagine you have bought futures of Infosys expecting a bumper quarterly result. The profits were on course but the guidance turns out to be an absolute disaster (Oh yes, don’t we remember April 2003?). Most likely you are up against a huge MTM loss and a possible wipe out of your capital. That is where intelligent futures trading and the power of discipline come in handy.

When you trade futures you have some apparent advantages. Firstly you are trading on margin. Effectively, you are carrying a leveraged position without the concomitant worries that borrowing entails. That means you have the potential to increase your ROI. Futures can also be used to create synthetic positions to reduce your risk of equity holdings. But the risks are humungous too!

Being a leveraged position, futures can be dangerous in a volatile market. It is highly vulnerable to macro and overnight risks. Liquidity, being largely institutional in futures, can become unidirectional quite fast. That is dangerous if you are in an opposite position. There is also the spread you need to be careful about and not pay too high a premium on futures in robust markets..

3 SITUATIONS WHERE FUTURES WORK FOR YOU

A bet on stock futures in trending markets

In a trending market, futures permit you to earn returns with minimal risk. Also positions can be carried forward as equity returns in a trending market tend to outweigh the cost of carry forward. To that extent it replicates cash equities!

Locking in your profits with a counter future

Buying in cash and selling in futures is not always a zero sum game. Assume you bought Tata Steel at Rs.220/- and is currently quoting at Rs.350/-. You can sell futures. Your cash holding stays and your profit of Rs.130/- is locked!

Playing macros through the Nifty Index

If US rates are hiked, then Indian markets will go down. Why worry about the stocks to sell? You can take a macro view and sell the Nifty. When heavyweights are hit, the Nifty can hardly be far behind. Also, a hedge against your portfolio!

“The individual investor should always act consistently as an investor and not as a speculator” – Ben Graham

6 STEPS TO DESIGNING A FUTURES TRADING STRATEGY… 

  1. Look at the maximum loss you are willing to take. Design your stop losses and overnight risk management based on that. Any open position should always have a stop loss level set at any point of time so that in the event of sudden movements, you have a grasp of what you are exposed to!
  2. Dealing with premiums and discounts are key. Futures quoting at steep discount could be due to dividends or short build-up. Understand why it is happening. Premiums are normally bullish signals but it could be due to excess selling in cash equities. Be clear about the reasons. 
  3. Check for liquidity and the spreads in the market. Before entering into a futures trade ensure that there is sufficient open interest built up. In stock futures it is a sign of arbitrage interest. That will ensure that there is constant liquidity availability at most price points. Ensure you do not get stuck!
  4. Lot size is critical in a futures trading decision. Eg. Nifty has a lot size of 25 while lower priced stocks have fairly large lot sizes. When a stock like Unitech or J P Infra becomes volatile, the impact on your futures holding tends to get magnified due to the lot size. Be cautious about high lot-size futures!
  5. Keep diligent profit targets and keep taking profit. You are into futures for the short term. You must roll over a position only if the trend of the stock justifies paying the premium and transaction cost to roll over your position. At the end of the day, booked profits always scores over book profits. Touche!
  6. Finally, don’t ever forget that when you trade futures you are effectively borrowing money. When you buy beyond your means, that is borrowing, after all. So all the ills and risks that apply to borrowing also apply to futures trading. Like in borrowing, a futures position needs to be backed by adequate conviction!

HOW DO I REDUCE MY RISK IN FUTURES?

As a futures trader, your primary focus should always be on managing risk. Whatever it takes to preserve your capital in a certain range need to be taken. It could be stop losses, profit booking, hedges etc.. But you can never ever trade futures succesfully if you forget this cardinal rule. Secondly, do an equity mirror trade only when you have absolute conviction. After all, you also need to justify your rollover and transaction costs.

Avoid spreading yourself too thin. Having simultaneous position in 15-20 different stock and index futures is outrageous. You just cannot keep a tab on all these positions and also track their news and numbers. I always recommend that you should limit yourself to 4-5 open positions at any point of time. And lastly, don’t forget transaction costs. Brokerage, STT, stamp duty, exchange fees and rollover costs add up to a tidy sum. Factor them when you set stop losses and profit targets!

TAKEAWAYS FROM THE “FUTURES TRADING” DEBATE…

Warren Buffet once described derivatives trading as “Weapons of mass destruction”. While money has been lost in futures trading, it is more due to lack of discipline and poor surveillance rather than due to a fault in futures trading, per se. In famous derivatives disasters like Barings and UBS, the mid-office and the back office had absolutely no clue about the risk that the trader was exposing their capital to. Now that is a sure shot recipe for trading disaster!

The principal downside of futures trading is that it is leveraged and hence downside risk gets magnified. Futures trading works best when you take a long term view in a trending market and use rolls to mirror a cash equity situation. Short term trading in futures can work if operated within the parameters of strict stop losses and profit targets. Because, where else can you buy a chunk of the entire market with an investment as low as Rs.50,000/- That is surely food for thought!

7 responses

  1. managing risk is not explained properly. Calculation of point of stop losses, appropriate time of profit booking, hedges etc need to be explained for better trades.

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    • Dear Sharad Jain,

      “Managing Risk is very complex and elaborate topic and not in the purview of the subject dealt. However, let us focus on the specific queries raised by you..

      1. Point of Stop loss: There are 2 approaches here. The first is the technical approach. You normally place the stop loss below a support level as per charts. For e.g.If you have bought 100 shares of Reliance at Rs.875 and its chart support is 865, then you can place the stop loss for a long trade at around Rs.863. In case of a short trade, the stop loss can be placed slightly above the resistance level of the stock. Such charts are available on the websites as well as in packages and the broker can guide on that. The second approach is to see how much loss you can afford to take. If in this case you are only willing to take a risk of Rs.500/- then either avoid this position or keep stop loss at Rs.870/-.

      2. Appropriate time of profit booking depends on whether you are getting into a position as a trade or as an investment. We normally advise traders to cut their losses fast and ride their profits long. You can use the concept of trailing stop profits to address this problem. For example you buy Reliance at Rs.875 and the stock has gone up to Rs.925 in 3 days. Suppose the view is that Reliance will touch Rs.1000, then you can hold using trailing stop profits. Currently, you set the stop profit at Rs.915, then as the price goes up further you revise it to Rs.945. That will be the point you will change your long view and close the position in the event of a fall in prices.

      3. Hedging can be done through options or futures. If you are long on Reliance you can either lock in your profits by selling higher futures. Alternatively, you can buy a put option of a lower strike. Eg. if you bought Reliance Stock at Rs.875 and you bought a 870 put option at Rs.8, then your maximum loss is Rs.13 (8+5). Even if Reliance falls to Rs.700, your loss will be limited to Rs.13 only. This is a hedge and used to protect your downside risk of a holding.

      Trust this answers…”

      Regards,

      Team Religare Online

      Like

  2. Very very valuable and important advices for the beginner’s and even for experienced traders too as most of the traders are very particular about their targets but not about the stoplosses.Thanks a lot and be regular in giving such great tips.

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