Understanding Leverage & Payoff in Futures Trading

In the previous chapter, with the example of TCS, we learned how futures trading works. In that example, we bought shares of TCS on the expectation that their price would increase going forward. But the very next day after placing the contract, we squared off that position for profit.

There we also asked a question. The question was why did I decide to do that deal in the futures and not buy TCS shares in the spot market?

You are aware that while trading futures, we enter into an agreement for a specific period of time for a share. If your opinion is not correct in that time period and the share price goes in the opposite direction then you may have to suffer loss whereas in spot market you can directly buy shares and keep them in your demat account. There is no time limit and there is no pressure to fulfill any agreement. Then why buy shares in the futures market instead of the spot market?

The answer to these questions is financial leverage which is an important part of financial derivatives. You know that futures are also a part of financial derivatives.

Leverage is a new method of financial trading. A lot of wealth can be created using leverage. Let us see what is leverage.

What is Leverage?

We use leverage in many parts of our life but at that time we don’t know that it is leverage. Especially when it is not seen from the perspective of statistics, it is also a bit difficult to understand.

Let us understand this with an example. A friend of mine does a real estate business. Buys flats, buildings and all such things, keeps them for some time and later sells them at a profit.

In the last days i.e. in November 2013, he bought a flat. He bought this flat from a famous builder in Bangalore – Prestige Builder. Prestige Builder had announced to build a luxury apartment in a part of South Bengaluru. This flat was on the 9th floor in this. The price of this two bedroom flat was Rs 10,000,000. This project was just announced. It was to be completed in 2018. No work had even started on this. Therefore, the buyer had to pay only 10% of the booking amount, the remaining 90% was to be given after the work started.

That is, in November 2013, he had to invest 10% of ₹ 10,000,000 i.e. only ₹ 10,00,000 and he was getting a flat of Rs 10,000,000. That apartment sold out so fast that all the flats were sold out within 2 months.

After 1 year i.e. in December 2014 my friend got buyer for that flat. By that time the price of the flat in that area had increased by 25% i.e. my friend had now got the price of that flat up to 12,500,000. My friend sold that flat for 12,500,000. Take a look at this deal.

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What’s special about this deal

• Despite having only 10% of the amount, my friend could get a great deal.
• He paid only 10% of the total price for this deal.
• The Rs 10,00,000 he paid can be seen as the margin amount or token money to be paid in the futures agreement.
• The slightest change in the price of the asset multiplies the returns.
• In this case a 25% change in the price of the asset increased the return by 250 times.
• Such transactions are called leveraged transactions or leveraged transactions.

You should understand this example very well because this is what happens in futures deals. All futures deals are leveraged. With a look at this example, let us return once again to the example of TCS.

Leveraged Deals

Let’s revisit some of the information in the TCS example of futures trading. For the sake of ease, let us assume that TCS was traded on 15th December at ₹2362 per share and the opportunity to square off came on 23rd December 2014 at ₹2519 per share. Let’s also assume that there is no difference between the futures and the spot price.

So with a bullish outlook in TCS shares and with a capital of ₹ 100000 to invest, we have two options to deal with. Option 1 – Buy TCS shares in the spot market. Option 2 – Buy TCS shares in the futures derivatives market. Now let’s evaluate both these options.

Buy TCS shares in the spot market

To buy TCS shares in the spot market, we need to know its price. It has to be seen how many shares we can buy with our capital. After buying the shares, we have to wait for 2 days (T+2) so that the shares can be credited to our demat account. After the shares come in the demat account, we have to wait for the right opportunity so that we can sell the shares. Let’s take a look at some of the highlights of the spot market delivery deals-

When we buy stocks with delivery in the spot market, we have to wait for 2 days for it to arrive in our demat account. This means that if there is an opportunity on the next day of buying where we can sell it and earn profit, then we cannot take advantage of that opportunity.

We can only buy as many shares as we have the money. Meaning if we have ₹ 100000, then we can not buy shares of more than ₹ 100000.

There is no time pressure, we can keep the stocks for as long as we want and wait for the right opportunity for ourselves.

If we have one lakh rupees on 15th December 2014, then how many shares can we buy?

= 100,000 / 2362

= 42

Now, if we square off on 23rd December, when the share price of TCS is 2519/-, we will get –

= 42× 2519

= 105,798

This means that the shares of TCS purchased on 14th December 2014 for ₹100,000 will reach ₹105,798 on 23rd December i.e. we will make a profit of ₹5798. Let’s see what percentage return we got

= [5798/100,000]×100

= 5.79%

Earning a return of 5.79% in 9 days is a good thing. If you want to look at it as an annual return, then it comes out to 235% per annum, which is a very good return. Now let’s compare it with your other option.

Option 2 – Buy TCS shares in the futures derivatives market

Now you know that the terms of the deal in the futures market are pre-determined. For example, you can buy at least 125 shares of TCS or buy in lots of 125. Multiplying the lot size by the price, we get the contract value. If the share price is 2362 per share then the contract value will be

125×2362

= Rs 295,250

Does it mean that ₹295250 is required to buy one lot of TCS in the futures market? No!!! If the contract value is Rs 295250 then we have to pay only the margin amount. For TCS this margin is 14%. 14% of 295,250 is Rs 41,335. This is the only amount you have to pay for this deal. Now some questions may come

What will happen to the remaining amount after margin (Rs 253,915)? (295,250- 41,335 = 253,915)

In fact this amount is never paid

What does it mean to never get paid?

We will understand this in the chapter Settlement – ​​Mark to Market

Is the margin only 14% per transaction?

No, it is different for each company’s stock.

Now let’s move on to our futures trade. We have ₹100,000 whereas we need margin money ₹41335 that means we can buy not one but two lots of TCS i.e. 250 shares for ₹82670. Even after paying ₹ 82670 as margin money for both the lots, we will still have ₹ 17330 in cash. With this we cannot buy more shares as it is necessary to buy at least one lot. Now let’s see the details of this deal

Lot Size – 125

Total Lots – 2

Purchase Price – ₹2362 per share

Contract value = lot size × total lot × price

= 125 × 2 × ₹ 2362

= ₹590,500

Margin Money – ₹ 82670

Selling Price – ₹2519

Contract Value = 125 × 2 × 2519

= ₹629,750

Thus we got profit of ₹39250 (629750-590500=39250).

Now you must have understood the difference. The share price increased from some ₹2361 to ₹2519. Due to which the profit in the spot market was 5798 while in the future market the profit was ₹ 39250. Remember that we have invested ₹ 82670 here, so we have to see our return on the same amount.

[39250 / 82670 ] × 100 = 47%

The return of 47% in 9 days is very good. Now compare that with the returns received in the spot market which was 5.79%. If we look at the annual return from the futures market, it makes 1925%. Now you must have understood completely why the futures market is a very profitable deal for the short term trader.

In the futures market, you can trade many times bigger than straight deals in the spot market – only on margin basis. You get a chance to do bigger deals with the same capital and you can make a lot of money if your opinion on the price turns out to be right.

Because of margin, we can make big deals with less money, that’s why it is called leverage. Always remember one thing about leverage, it is a double-edged sword. It can make a big profit but it can also cause a big loss.

Before we proceed further, let us see the comparison of this spot and futures deal.

We have talked about the advantages of futures deals, but what are the risks? What if the price didn’t move in the direction we expected? To understand this we need to know how much money we can lose if our opinion doesn’t turn out to be correct. This is called futures pay off.

Leverage Calculation

When it comes to leverage, the first question that is asked is how leveraged are you? The higher the leverage, the higher the risk and the higher the profit potential.

It is quite easy to calculate the leverage-

Leverage = [Contract Value / Margin]

Leverage = [Contract Value/Margin]

Means leveraged for TCS trade

= [295,250 / 41,335]

= 7.14 This is called 7.14 times leverage, in the ratio 1:7.14

This means that for every rupee you can buy TCS shares worth ₹7.14. This ratio is fine. But if this ratio increases, the risk increases. Lets understand with an example. With 7.14x leverage, TCS shares will have to fall by 14% and then your entire margin money will be gone. It is calculated like this –

1/ Leverage

= 1/ 7.14

= 14%

Now suppose the margin would have been ₹7000 instead of ₹41,335. This means that the leverage would have been

= 295,250 / 7000

= 42.17 times

This leverage is very high, so if the TCS stock falls even a little, all your capital will be gone. See:

1 / 42.17

= 2.3%

Meaning the 2.3% fall in TCS share is enough to lose your margin money. The higher the leverage, the higher the risk. When the leverage is high, even a small change in the price of the underlying asset can blow away the entire margin deposit.

But this also means that a gain of 2.3 percent with 42x leverage can double your money.

Personally, I don’t like very high leverage. I only trade where the leverage is 1:10 or as high as 1:12, not above.

Futures Pay-off

When I bought the futures of TCS, we expected the share price of TCS to go up and this would benefit me. But if the share price of TCS goes down instead of going up, then I will lose. In a futures trade, your profit or loss keeps on changing as the price changes. The pay-off structure tells you how much money you are making gains or how much money you are losing at each price level. To understand the pay-off better, let’s look at this TCS deal by creating a pay-off structure. Remember that there is a long trade which is done at Rs.2362. After making this deal, the price of TCS can go either way on 23rd December and I will gain or lose according to that price. For each price level, I have to create and analyze my P&L. see in the table below

If you bought a share at ₹2362 and the price of TCS is ₹2160 on 23rd December, you can see that you are incurring a loss of ₹202 per share as per the table.

Similarly, if the price of TCS reaches ₹2600, you will make a profit of ₹238 per share.

You will remember that we said that if the buyer is making a profit of ₹ x, then the seller will lose only ₹ x. So if the price of TCS is ₹ 2600 per share on December 23, the buyer will make a profit of ₹ 238 per share and the seller will lose ₹ 238 per share.

Another way of looking at this can be that money comes out of the pocket of the seller and goes into the pocket of the buyer. In a way, only money is being transferred here.

Transfer of money and the creation of capital are two different things. Capital is created when you hold the TCS share for a long time, the business is doing well, the profits of the business and its margin are increasing continuously, due to which the shareholder is benefiting. Because this does not happen in futures transactions, money moves from one pocket to another, that is why many times futures are called “Zero Sum Game – Zero Sum Game”.

Now, look at a graph. This is based on the buyer’s P&L based on the TCS price probabilities as of December 23. This is called “Pay Off Structure – Payoff Structure”.

You can see that any price above the buy price makes a profit and any price below the buy price indicates a loss. Since the deal is done in two lots i.e. 250 shares, therefore, an increase of one point leads to a profit of ₹ 250, a fall of 1 point causes a loss of ₹ 250. It moves in very straight proportion and that is why this line is straight and it is called “Linear Pay-off Instrument – ​​Linear Payoff Instrument”. it is said.

Highlights of this chapter

• Leverage plays an important role in futures deals.
• By paying a small margin, we can trade for a large amount.
• Margin is usually a fixed percentage of the contract value.
• Spot market deals are not leveraged. Deals can only be made for the amount that is there.
• Due to leverage, even a small change in the price of the underlying becomes a big gain or loss.
• The buyer’s profit is equal to the seller’s loss and the seller’s loss is equal to the seller’s profit.
• The higher the leverage, the higher the risk and also the potential for making money.
• In futures deals, only money is transferred from one pocket to another, hence it is called zero sum game.
• The pay-off structure of a futures instrument is linear.

Gaurav Heera

Gaurav Heera is a well known name in the field of stock market analysis and education. His distinguished career, which spans more than ten years, has cemented his reputation as an expert with unparalleled knowledge and innovative strategies for navigating the intricate landscape of the financial markets.