Who Buys/Sells Futures?

Futures contracts are generally traded by three groups of people - namely, the hedgers, the speculators and the arbitrageours.

Hedgers are those who want to hedge their positions against future losses. Let us assume that you are holding 100 shares of Reliance and that it is trading at Rs.2000/- per share today. You have seen that it has become unexpectedly volatile now and it has been giving you jitters. You expect the price to stabilise again after a month and that you would like to hold on to it till that time but at the same time you do not want to get panicky during the volatility. So, the best thing to do would be to sell 100 shares of Reliance Industries in the futures. So, in case of any downmove, the price of Reliance would come down both in the spot market and the futures market. So, any loss that you incur on the spot market will be made up by the profits in the futures markets. Conversely, if the price were to go up, any profits in the spot market would have been set off against the losses in the futures.

The second group of people are the speculators. These are people who like to buy when prices are low and sell when prices are high without any intention of holding their position open for a long period of time. While they can speculate in the spot market too but the advantage in futures is that for the same quantity of shares, they are required to pay only about 20% of the total amount as against the 100% that has to be paid if they were to buy the shares in the spot market.

Arbitrageours are people who take advantage of the high difference between the prices in the spot and the futures market. Let us understand this with the help of an example. Let us assume that Reliance Industries is trading at Rs.2000 per share in the cash market and Rs.2080 per share in the futures. The arbritageours think that this difference is too high and would like to cash in on the opportunity and cover their positions when the difference reduces. So, they buy 100 shares of Reliance at 2000 and incur a transaction cost of Rs.10/- per share and at the same time they sell 100 shares of Reliance at Rs.2080 per share and incur a cost of Rs.1.04 per share. After 20 days Reliance Industries is trading at Rs.1800 in the cash market and Rs.1810/- in the futures. At this time, they reverse their positions, thus selling 100 shares in the cash market at Rs.1800/- with a transaction cost of Rs.9/- per share and buy 100 shares in futures at 1810 with a transaction charge of 91paise per share. Their transactions will have the following effect:

Cash Market

• Bought 100 shares at Rs.2010/- (2000+10) per share at a total amount of Rs.2,01,000/-
• Sold 100 shares at Rs.1791/- (1800-9) per share at a total amount of Rs.1,79,100/-
• Total loss in transaction Rs.21,900/- on an investment of Rs.2,01,000/-

Futures Market

• Sold 100 shares at Rs.2078/96- (2080-1.04) per share for a total amount of Rs.2,07,896/-
• Bought 100 shares at Rs.1810/91- (1810+0.91) per share for an amount of Rs.1,81,091/-
• Total profit of Rs.26,805/- on an investment of Rs.41,600/- (20% margin money)

Net Profit

Net profit on the transactions is Rs.4,905/- (26805-21900) on a total investment of Rs.2,42,600/- (201000+41600) which means a return of 2.02% in just 20 days or 36.9% annualised.

How Are Futures Priced?

The world is full of uncertainty and so are the markets. Anybody who buys or sells a share in the markets is taking a risk. The buyer takes a risk that the stock price will not fall further while the seller takes a risk that the price will not rise further. And when it comes to predicting prices in the future, it is even more risky.

And when the risk is high, the returns should be higher. As discussed in previous examples, you are not entering into a contract with Mr. X but with the stock exchange. If you are required to pay 20% margin to the exchange, so does Mr. X have to. And if Mr. X is willing to take a risk and is investing 20% money, he expects a reasonable return on it. Considering 15% as the reasonable rate of return on stocks, he should be at least expecting a return of 1.25% every month. So, if Reliance is trading at 2000 today and he is expecting a return of 1.25%, he will be willing to sell Reliance at a price above 2025 (Rs.25 being the return he is expecting). This is also known as the cost of carry. Mr. X is charging you a cost of carry because he is locking up a part of his money and is either paying interest on it (if the funds are borrowed) or losing some interest on it if he had invested it elsewhere.

The other important factor while pricing futures is the time value. Uncertainty is directly proportional to the time to expiry. Anything can happen in a month - the inflation (declared weekly) may increase, the economy may show signs of slowing down, the company's main director may resign, the government may impose some restrictions on the company, a neighbouring country may declare war or the government may fall. But as you come closer to the expiry, the same is not likely to happen and the uncertainty considerably decreases. So, the time value is the maximum at the beginning of a contract and least when it is close to expiry. This uncertainty also demands a certain amount of premium. So, most likely, Mr. X would charge you Rs.2000 (the spot price of Reliance today) plus Rs.25/- (the cost of carry) and something more (the time value premium). Which explains why he was willing to sell Reliance at 2040 in the beginning of the month when the spot price was only 2000.