Chapter 10: Going Long & Short in Futures Trading
Picture this, you’re watching a prime-time show on a business channel and there’s a panel of traders who are asked to share their views on stock markets in general and share a few trading ideas.
He believes that the demand for electric vehicles is increasing and has an eye on Tata Motors, a market leader in the domain, he is building a long position on Tata Motors futures contracts in anticipation that prices of the underlying stock would go up. The anchor then asks another trader…
Mr Mandiram says he is extremely bearish on this sector as crude prices are soaring and hence the fuel costs for airlines will increase.
This may impact their profitability in this quarter results and hence, he wants to go short on the airline stocks.
He feels that falling profits would negatively impact the aviation sector and prices of airline stocks may tumble down from current prices.
You may be wondering what Mr Big Bull and Mr Mandiram are talking about.
- What is a long or short position in futures?
- How are they going to profit from a Bullish or Bearish position?
Traders often use these lingos. These terms are used as a reference to the views they are anticipating.
In any marketplace, there is a constant exchange of assets like commodities or any financial asset like stocks between the buyers and the sellers.
Buyers who buy any asset or a commodity from markets at current market prices are anticipating that the prices will go up and they don’t have to pay higher prices for the same underlying at a future date.
Similarly, sellers sell the assets they own assuming that if they don’t sell now , the prices may fall and they might incur losses.
With an intent to making profits speculate on market trends and they refer the phenomenon of prices going up or down trends, as, a Bull market or a Bear Market.
Interestingly traders are naming these market phases with a unique logic.
Just as a bull swings its horn up in the air from the bottom to the top, a trader is expected to have a bullish position meaning the trader would initiate a buy position, buy at the bottom when the price increases and the trader exits.
Hence in a bull market, a trader is said to have a Bullish View of the markets.
Whereas when traders who think prices will fall down consider the markets to be a bearish market and the trader is said to have a bearish view and is expected to have a bearish position in the markets, simply because a bear grabs his prey by pouncing
Hence futures trading is a constant fight between the Bulls vs Bears!
Step 1 – Building Biases to Develop a View in Markets
There is a very common saying that a trader has to first identify when and what to trade.
But if the why is not clear, meaning, why a trader chooses to buy or sell an underlying asset or a commodity is unclear, then there are chances traders might either book profits early or might even have to face losses.
Building biases is the first step for every trader. Knowing Why a trader wants to buy or sell a commodity or asset forms the base for figuring out how to trade futures.
And how to choose stocks or any underlying asset or commodity for futures trading is the counterpart in futures trading.
Before even deciding to start futures trading, a trader must develop a bias towards the underlying asset.
The bias can be a bullish bias in the underlying asset, meaning the trader is expecting that the prices are likely to be in an uptrend or a bearish bias in the underlying asset, meaning that the trader is expecting a downtrend in prices, in the near future.
Traders can develop such biases based on their understanding of how prices move in trends by studying and using tools like Technical Analysis or factors that affect the price of the underlying commodity or asset known as fundamental analysis or a combination of both.
Biases allow traders to sense direction in price trends and help traders to anticipate a trend in the markets and be able to predict price movements.
Once traders identify a trend in the prices of the underlying asset or commodity there are 2 ways to profit on a futures trade:
- Taking a Buy Position (Long Position) if the trader has a bullish bias
- Taking a Sell Position (Short Position) if the trader has a bearish bias
Let’s take an example of both long positions and short positions in futures. Mr Big Bull and Mr Mandiram have established their biases by studying the macroeconomic factors and fundamental analysis along with some sectorial analysis.
Then, they have identified the stocks and taken their positions accordingly. With the help of Pay Off Graphs. Let’s look at how much profit or loss can they make on their positions.
Pay-Off Graphs of Long Positions and Short Positions
As we’ve discussed in Chapter 6, Pay Off graphs are a great representation of an ongoing position and traders can use them to analyse their trades, set risk and reward ratios and help them in better decision-making.
Let’s take our previous examples of Mr Big Bull and Mr Mandiram and analyse their trades on a Pay Off graph.
1. Pay Off graph of Long Position
Since Mr Big Bull is anticipating a good rally in the automobile sector and has chosen to buy Tata Motors Futures , heres how the pay off graph looks like:
Assuming Mr Bull bulls holds a Long Position in Tata Motors November Futures currently trading at INR 435 , his break even cost is at 435 (plus brokerage & taxes).
If the price increases above his breakeven price , Mr Big Bull makes profits and if the price falls below his cost , he starts making losses. His maximum loss is defined but he has an unlimited profit potential.
2. Pay Off Graph of a Short Position
Mr Mandiram on the other hand has a bearish view on the aviation sector and has identified an airline stock Indigo airlines for short selling. Here’s how his payoff graph looks like:
