Financial derivatives come with inbuilt financial leverage, which happens to be the source of force behind the operation of financial derivatives.
In the world of finance, leverage is an innovation which drives investors to invest their money and create wealth out of it.
When used in the right context, financial leverage can provide a medium to expand on your wealth.
Interestingly, futures trading makes extensive use of leverages to create this wealth for investors.
Understanding the Concept of Leverage
At some point or the other in our life, we make use of leverages for different reasons. However, there are only a few who actually realize the importance of leverages.
Appreciation for the concept of leverages comes only when you have completely understood what they are really all about.
Take any example which you like and you will be able to relate it to the essence of leverages. Whether you talk in terms of real estate or equities, the idea of leverages can be applied under all circumstances.
The concept of leverage applies to any situation, where you can enter into a financial transaction with the aim to make a return.
For example, if you agreed to purchase a house property today, by paying 10% of its total value.
This amount of 10% will be regarded as token money for entering into a contract to purchase a house property on a future date.
Now, consider that during the tenure from the time when you pay this token money to the time when you make the complete payment, you locate someone who is willing to purchase the same property from you.
But, this time, the value of the property has appreciated by 25% of the amount of the contract value. By entering into a contract such as this one, you have benefited from a leveraged transaction.
Thus, by paying a partial amount of the total contract value, you can benefit from a manifold increase in the value of such contract.
This is the entire idea behind leveraging and this is how futures trading works to bring a benefit for traders.
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Example on Leverages
Let us take an example from equities to understand the function of leveraging.
Let us assume a stock by the name of ABC. At present, you have a bullish view on ABC stock as an investor.
Thus, you decide to make a purchase of ABC stock to take a position and benefit from its price increase.
Let us suppose that you have at your disposal, an amount of INR 100000 to invest in this stock.
With the expectation that the price of ABC stock will increase over time, you purchase the stock at a price of INR 1362. You expect to sell it on a future date at a rate of INR 1519.
Now, you have two options with you. You can either purchase the stock in the spot market or invest the same money in the derivatives market.
Let us see what would happen under each circumstance.
Buying ABC in the Spot Market
First, you will need to check the price at which ABC is trading at present. With INR 100000 in hand, you will have to calculate the number of stocks which you will be able to buy at the prevailing market rate.
Due to the normal operation of the stock market, you will have to wait for the next two trading days for your broker to credit the stocks in your Demat account.
Once the stock is present in your Demat, you will be at liberty to sell the stock, as and when you deem fit.
This is known as delivery based buying. Here are some unique features of delivery buying which you need to know about:
- As a trader, you will have to wait unless the stocks are really present in your account before you may sell them. Even if a bright opportunity emerges the very next day, you will be unable to trade in the security.
- If the available capital for investment is INR 100000, you will not be able to invest an amount greater than that to purchase the stock.
- There is no fixed date on which you can buy or sell the stock. It is completely up to your discretion to buy and sell the stock as and when you like.
With a sum of INR 100000 and a per share price of INR 1362, you can roughly buy 73 shares of ABC.
Now, suppose that after a week of purchasing, you see the price of the stock rise to INR 1519. You will be able to sell the 73 shares of ABC at this rate for a complete return of INR 110887.
This means that an investment of INR 100000 yields INR 110887 which is a profit of INR 10887. In percentage terms, this would mean 10.887%.
Buying ABC in the Futures Market
In the futures market, there is a fixed lot size for which you can purchase a given stock. Let us assume that the minimum lot size to purchase shares of ABC is 125.
Now, for a price of INR 1362, you will have to spend a total of INR 170250 in the spot market to purchase that many numbers of stocks.
The interesting thing about the futures market is that you will not really need to spend all that money in one go.
In the case of the futures market, you only need to invest the minimum amount of margin money. Thus, you will be able to take a position in the trade.
So, let us say that the margin set by the exchange for ABC is 14%. Then, you will have to pledge a sum of INR 23835 to enter into a futures agreement for ABC.
It is notable that the balance money for the trade is not paid out by the investor. Depending on the mode of settlement, it is possible that at the date of expiry, the investor will have to pay out only the amount of differential to settle the agreement.
The margin requirement varies from one stock to another and the exchange decides the percentage of this margin.
With this margin requirement, you can purchase not 1 but 4 lots of ABC. This would mean 125*4 shares which are equal to 500.
The total cost of these 4 contracts will be INR 95340 which you will need to place as a margin with the exchange.
The remaining balance of INR 4660 will have to remain as it is without utilization anywhere.
Let us summaries the future trades which you have finalized above
Total Lot size – 125
Number of lots taken – 4
The buying price of futures – INR 1362
Value of Futures contract – 125 * 4 * 1362 which is equal to INR 681000
Margin Amount – INR 95340
The selling price of future – INR 1519
The selling price of a futures contract – 125 * 4* 1519 which is equal to INR 759500
The remaining profit will be INR 78500
This example highlights the difference between the profit earning capacity in the spot market and the futures market.
While you were making a profit of INR 10887 in the spot market, the profit in the futures market is INR 78500.
In terms of percentage, this translates to an 82.3% profit in a span of a few days. In the spot market, this return was a bare 10.887%.
Due to the element of margins, a trader can invest a small chunk of his money to make bigger and better returns.
As long as the directional view of the investor is right, these returns can be massive. However, with the futures market, the risk of losing out on the investment cannot be overlooked.
It is indeed possible that the directional view of the trader may not work out as they expect.
Thus, it is vital for a trader to take a view of the money which they can make or lose by entering into the future trade. This element of a future trade is the future’s payoff.
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Calculating the Element of Leverage
Higher the risk, higher is the potential to make a reward. This is the general thesis which every trader follows in the stock market. Thus, it is vital to understand the kind of leverage which they expose themselves to.
Ordinarily, the leverage is a function of the margin divided by the contract value. Thus, in our case, the leverage exposure will be 681000 / 95340 which is equal to 7.14.
Thus, it comes to mean that for every 1 rupee that the investor puts in this futures trade, he stands to enter into a trade of INR 7.14.
If this leverage value increases, the risk which comes with the trade will also increase. This means that if ABC were to fall by a 14% margin, you could stand to lose all your money.
Even though 7.14 appears to be a very small amount at present, it would make a whole lot of difference if this value was above 40 or 50.
Let us say that the leverage ratio is 42.17 for a stock. This means that a mere 2.3% fall in the price of ABC would account to you losing all your money.
How do Futures Pay off?
Every futures trade has a payoff which occurs at every single price point. Due to this, one could either make a profit or incur a loss at each of these price points.
Depending on the price at which you brought the stock, you could incur either a profit or a loss at a later date.
Since you bought the stock at a price of INR 1362, you can say that any price above it will yield a profit for you.
At the same time, any price below that will yield a loss. This creates a proportion which highlights how the profit earned by one accounts for the loss of another.
Thus, when these figures are plotted on a graph, you will see that it comes out to be a straight moving line. Due to this, the futures are known as a Linear payoff instrument.
Leverage & Pay-off in Futures Trading – Conclusion
Leverage has a vital role to play in the futures trade. An investor can make use of a margin to trade in futures with a small amount.
The calculation of margin comes from the value of the contract and is set by an exchange. In contrast, there is no concept of leverage in the stock market.
Due to leverage, even a small change in the price of underlying security can bring a major rise in the value of returns to an investor.
The profit made by one investor is equal to the loss of another trader. Due to high leverage, the level of risk with trade also rises.
Since there is a transfer of funds from pocket to another in the case of a futures trade, it is known as zero sum money.
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