Chapter 13: Futures Trading Strategies
Futures are one of the sophisticated financial instruments and quite exciting to trade because of their potential for magnified gains considering the role of leverage coming into play in futures trading.
Since futures trading is a zero sum game, meaning if one trader is making profits, theres always a counterparty that is losing money. Thus, a trader has to understand the risk involved and based on the risk profile develop a trading setup.
In chapter 8, we discussed the Steps to Start Futures Trading and also discussed the trading process elaborately in chapters 10 and 11.
And before we go ahead to discuss futures trading strategies, here’s a quick recap of the process which you can refer to as a trading guide.
Process for Futures Trading:
- Developing a view
- Setting up a trading plan
- Choosing the right financial instrument
- Tools for futures trading
- Selecting the right strategy
- Exiting or Closing a position
- Risk management
Hopefully, you now know the first 4 steps in the process well!
The next stage will empower you to execute your futures trade. Let’s get the party started, starting with how to execute trades with the most popular futures trading strategies.
Step 5: Execution of Trades – Selecting the Right Strategy
Besides discussing strategies lets also quantify the risks involved in these strategies along with some examples so that your learning curve shortens and skyrocket your futures trading journey.
What to Remember When Selecting a Futures Trading Strategy
A few things traders need to ask themselves before choosing futures trading strategies. These questions help traders to take mindful trades and will eliminate chances of panic square ups of trades due to volatility.
What is the strategy?
When to deploy a strategy?
How to deploy the strategy?
Risks involved vs potential profit estimation via payoff graphs
A disclaimer here is that every trader is unique in terms of parameters such as risk taking ability, capital deployed and also, there may be a vast difference in their trading styles while trading futures.
It’s important to understand that simply copying someone’s trading style can do more harm than good. Thus, please DYOR (do your own research) before entering into the futures market.
Popular Futures Trading Strategies
Strategies are a blessing in disguise for any form of trading as they ensure a disciplined and streamlined process for execution of trades.
Strategies enable traders to follow a set pattern for trading and professional traders focus on optimising some of the popular trading strategies according their own preference.
Some tweaking is done in the process of execution but the structure of the underlying defined logic remains the same. Here are some of the most popular futures trading strategies for your reference.
1. Going Long
- Time Period: Intraday or Positional
- Who: A trader having a bullish view on the underlying asset
How to Use This Strategy?
As we saw in the case of Mr Niveshs example in chapter 1, he was bullish on Reliance Industries Ltd in the cash markets and chose to go long in Reliance futures contract.
His assumption was that share prices of Reliance industries in the spot markets may increase and so he decided to go long and bought Reliance futures contract.
The logic is simple, if spot prices of Reliance industries increases, its futures price will also have to increase. Thus, going long would work the best for Mr Nivesh in this case.
Risks Involved in This Strategy
The potential profit of this strategy is unlimited but loss is limited to the extent of the price going to zero from the purchase price.
Again coming back to Mr Nivesh’s example, he understood the risk involved in futures trading and was considering to buy and hold Reliance futures either until expiry or he has the option to close his position before expiry (a detailed chapter #15, is on how to exit a futures trade).
Conclusion
A simple buy and hold strategy – Going long is practically used by traders who want to buy and hold an underlying asset for short term.
Seasoned traders use skills such as fundamental analysis of the underlying asset, price action analysis or using technical indicators on charts, and more to determine entry and exit points.
The above practice, enhances the chance of success in this strategy and help a futures trader to minimise risk and maximise returns on investments with a disciplined approach.
2. Going Short
- Strategy: Going Short
- Time Period: Intraday or Positional
When to Use It?
A trader having a bearish view of the underlying asset and is expecting a decrease in the price of that underlying asset, can use this strategy.
How to Use This Strategy?
Going short is the best way to make money in falling markets. Ideally, when a trader is anticipating a fall in prices of an underlying asset, he can sell the futures contract of the underlying asset and then buy those contracts at lower prices on or before expiry.
Going back to the example of Mr Mandiram , where he was bearish on the aviation sector as fuel prices were increasing.
Mr Mandiram could decide to go short on any of the listed airline stock assuming that rising fuel prices could impact the profitability of the airlines negatively impacting their share prices and causing the prices to fall in the spot markets.
Hence going short by selling futures of that airline stock would be a great way to fulfil Mr Mandiram’s speculation of the bearish bias.
Risks involved?
The potential profit of this strategy is unlimited but loss is limited to the extent of the price going to zero from the purchase price.
Conclusion
Going short involves selling futures contracts with a view that the underlying’s price will fall. It is a bearish strategy that allows you to earn potential gains in falling markets.
However, it’s important to note that while the profit potential is unlimited, the risk is limited to the asset’s price going to zero from the purchase price.
This strategy, as shown by Mr. Mandiram’s bearish stance on the aviation sector, can be a valuable tool for speculators.
3. Bull Calendar Spreads
- Strategy – Going Long and Going Short
- Time Period -Intraday or Positional
Calendar spreads are used by traders to reduce the risk in a position due to volatility the underlying asset.
The goal of this futures trading strategy is to exploit the potential of an arbitrage due to the time decay in the pricing of futures.
Futures pricing involve cost to carry, the further the expiry more would be the cost for carrying the futures contract until expiry.
But when the current month contract is nearing to expiry, futures price tapers towards the spot price and at expiry futures is equal to the spot price.
The cost of carry of the near and the far month contracts also loose some time value but it may continue to trade at the premium as per the logic of cost of carry.
A bull calendar spread is therefore an opportunity for the traders to create a spread by buying a current month contract and selling the near month or the far month contract. Let’s take an example by first looking at a summary of Reliance Future Contracts available for trading.
Let’s Assume Mr Nivesh spots a calendar spread opportunity. The December series has just started and our SuperTrader Mr Nivesh is still bullish on Reliance. But he wants to take less risk this time and is looking to hold is bullish view until January.
Thus, he decides to create a bull calendar spread by going long in December Futures and Going Short in Jan Futures. This is what his payoff graph looks like.
The spread value at the point of entry is currently at 19 points. Here’s how this strategy works.
| Particulars | Day 1 Closing MTM | Day 2 Closing MTM | Day 3 Closing MTM | Expiry Closing MTM | Net P&L at Expiry |
|---|---|---|---|---|---|
|
Long Reliance Dec Futures |
2,721 |
2,740 |
2,720 |
2,750 |
+29 |
|
Short Reliance Jan Futures
|
2,740 |
2,764 |
2,740 |
2,765 |
-25 |
|
Spread |
19 |
+24 |
+20 |
-15 |
+4 |
|
Lot Size
|
250 |
250 |
250 |
250 |
250 |
|
MTM |
=19*250
=4,750
(point of entry)
|
=24*250
=6,000 |
=20*250
=5,000
|
=-15*250
=3,750 |
=4*250
=1,000
|
|
Margin Required |
2,50,000 |
2,50,000 |
2,50,000 |
2,50,000 |
2,50,000 |
|
Profit/Loss (in Rs) |
0 |
+1,250 |
+250 |
-1,000 |
+1,000 |
|
ROI % on Deployed Capital
|
0 |
+0.5% |
+0.1% |
-0.4% |
+0.4% |
And now…
| P&L Days | Net P&L |
|---|---|
|
Day 1 |
+1,250 |
|
Day 2 |
+250 |
|
Day 3
|
-1,000 |
|
Expiry |
+1,000 |
|
Net Gain |
+ 1,500 (0.5%) |
Considering day 1 is the point of entry for the bull calendar spread. On day 2, due to demand and supply anomaly of the spread (the difference between the current month and the next month futures pricing), Mr Nivesh makes a profit of 0.5% which is credited to his margin account.
This goes on until expiry day and since futures settlement happen daily, the difference between the spreads will be either credited or debited to the margin account.
Yes, there are times when this parity between spot and futures changes and the spread might contract. But at expiry there’s a net gain 0.5%.
When to Use It?
A bull calendar spread is used when a trader has a bullish view and is expecting the price of the underlying asset to increase in the short term but wants to hedge his position by creating a spread. An assumption here should be that the spread has to widen or from the point of entry.
Risks Involved?
Although this strategy is almost risk free only if the basic assumption that the demand for stock will increase and therefore , the spread might increase.
However, the risk here is that if the demand for the stock decreases in the future, the spread is most likely to shrink.
What’s more, if the long term contract prices decreases and short term prices remains the same or decreases lesser, spreads may shrink and there may be negative spread which may arise due to demand and supply mismatch, ultimately hampering the ROIs in this strategy.
Conclusion
The bull calendar spread offers a unique approach for traders with a bullish outlook in the short term while seeking to hedge their position.
This strategy relies heavily on the daily fluctuations in the spread between current and next-month futures pricing. As a result, traders can make profits as seen in Mr. Nivesh’s 0.5% gain.
The continuous daily settlement ensures that gains or losses are consistently credited or debited to the margin account until expiry, resulting in a net gain of 0.5%.
While this strategy is relatively low-risk under the assumption of increasing demand for the underlying asset, there is the potential for losses if demand decreases because the spread will begin shrink.
4. Bear Calendar Spreads
- Strategy – Going short and Going Long
- Time Period -Intraday or Positional
And as we know , for any arbitrage opportunity , a trader must buy in the market where the price is cheaper and sell in the markets where the price is higher.
Similar to the bull calendar spread, a bear spread works when the current month future price is trading at a discount to the futures – Lets take the same example of Reliance but this time with a different prices.
| Particulars | Day 1 Closing MTM | Day 2 Closing MTM | Day 3 Closing MTM | Expiry Closing MTM | Net P&L at Expiry |
|---|---|---|---|---|---|
|
Short Reliance Dec Futures |
2,740 |
2,764 |
2,720 |
2,750 |
-20
|
|
Long Reliance Jan Futures
|
2,721 |
2,740 |
2,730 |
2,774 |
+53 |
|
Spread |
19 |
-5 |
-34 |
+14 |
+33 |
|
Lot Size
|
250 |
250 |
250 |
250 |
250 |
|
MTM |
=19*250
=4,750
(point of entry)
|
=-5*250
=-1,000 |
=-34*250
=-8,500
|
=+14*250
=-2,500
|
=33*250
=250
|
|
Margin Required |
2,50,000 |
2,50,000 |
2,50,000 |
2,50,000 |
2,50,000 |
|
Profit/Loss (in Rs) |
0 |
-1,000
|
-8,500
|
+3,500
|
+8,250
|
|
ROI % on Deployed Capital
|
0 |
-0.4%
|
-3.4%
|
+1.4%
|
+3.3%
|
And now…
| P&L Days | Net P&L |
|---|---|
|
Day 1 |
-1,000
|
|
Day 2 |
-8,500
|
|
Day 3
|
+3,500 |
|
Expiry |
+8,250 |
|
Net Gain |
+2,250 (0.9%) |
Notice that the current month futures price is trading at a discount and this discount prevails until expiry Hence a trader has to short December month contract and go long on Jan futures of Reliance to create a bear spread.
When to Use It?
A bear calender spread is used when a trader has a bullish view on the underlying asset in the short term but finds that the current month futures is trading at a discount to the near month futures contract , spotting an arbitrage oppportnity.
An assumption here should be that the spread has to widen or from the point of entry. For the spread to widen , the current month contract prices should decrease in value and the next month contract should increase in value.
Risks Involved?
Although this strategy is almost risk free similar to a bull calender spread, the risk here is that if the demand for the stock increases in the in the current month, the spread is most likely to shrink, ultimately hampering the ROIs in this strategy.
Conclusion
The bear calendar spread strategy is useful for traders who have a short-term bullish view on an underlying asset when the current month’s futures price is trading at a discount compared to the near-month contract.
By shorting the current month contract and going long on the next month’s contract, traders can create this bear spread to take advantage of arbitrage.
While this approach is relatively low-risk, similar to a bull calendar spread, it’s important to note that if demand for the stock rises in the current month, the spread may contract, potentially impacting the overall return on investment.
Spotting Spread Opportunities
To spot spread opportunites, a mathematical model can also be derived wherein one can calculate the mean of the spreads by subtracting the closing prices of near month prices from the current month prices.
This is because if everything remains the same , futures price of Near month contract is always higher than the previous month contract due to the cost of carry factor.
Then derive the Standard deviation and add and subtract it from the mean to define a range .If the spread is above either the defined upper or lower range , there will be a spread opportunity.
A bull calendar spread becomes profitable only when the upper end of the range is breached. SImilarly a bear calendar spread becomes profitable when the lower end of the range is breached.
The logic here is that one has to buy in the cheaper market and sell where the prices are higher based on this logic spreads can be created.