A guide to Futures & Options Trading Strategies

Here’s a list of a few Futures & Options Trading Strategies that you can use to manage your risks:

Futures & Options are used to manage portfolio risks. Futures Contracts, standalone, are like raging bulls. You cannot predict the size of holes it may dig in your kitty. Hedgers do have a sound basis. They need not worry much. It’s the speculators who may end up losing their shirts in futures trading.

Futures, although a hedging instrument, do have their share of risks. The risks may come up by way of naked positions and highly leveraged positions.

Naked position refers to short selling without owning a position in the underlying stocks. It’s like catching a falling knife. You never know how much it hurts. It’s like you expect to sell high and buy low. And in between, cash in on the price differential. But if the market starts rallying, you end up in soup. It’s a double-edged sword. On the one hand, you have to buy shares at a higher price. On the contrary, you margins keep draining owing to losses. So, you need to address the frequent margin calls.

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In yet another scenario, you bite more than you can chew. I mean you take over-leveraged positions. If the weather is sunny as you expected, then you can make hay. But, if it gets stormy, then the extent of destruction becomes unfathomable.

Immediately a question pops in your mind: “Are futures that devastating?”

I would say a bit.

But is there a way out?

Of course! And a lot many ways than one.

Explore your options!

It’s not a joke.

You may combine the futures contract with options to get a versatile risk management tool.

There exist so many strategies which would not only save your fingers from getting burnt. But also would make trading a lucrative punt.

Futures Trading Strategies

Long Futures, Buy Put

To a large extent, investors take a long position in futures. They look at profiting from rising markets. Historically, the markets have risen more than they have fallen. But, it’s imprudent to assume un-hedged positions. So, under this strategy, the investor provides for the downside risk as well.

Suppose investor purchases May Index Futures contract for Rs 4200 containing 100 shares. The contract value comes to be Rs 420,000 (4200*100). He pays an initial margin of Rs 42000. He is bullish that the index may rise. But at the same time, he is apprehensive about the loss if the market falls.

In this case, both the upside and downside potential are unlimited. Hence, it’s necessary to curb the downside risk of loss.

The investor hedges the downside risk by using options contract.

He buys 100 near month Nifty put options expiring in May at a strike price of Rs 4200. The put premium for the contract comes out to be Rs 42000 (Rs 420 per put for 100 puts).

If the NIFTY rises to say 4800 points, then he makes a profit of Rs 60000 and retains his margin. The maximum loss, in that case, would be the premium on puts.

On the contrary, if the market falls to say 4000, he makes a loss of Rs 20000 (Rs 200*100). However, he recovers it by exercising put option.

While going long on futures, you may, thus, hedge the risk of loss by buying a put option.

Also read: All about Futures & Options: Part 2

Short Futures, Buy Call

There are times when you may get bearish about the markets. Assume that you hold 3-month stock futures contract and go short on the volatility. In the times gone by, markets have always been bullish. The tendencies to go southwards are usually little. Nonetheless, you feel that stock prices of the company would fall. Here, the profit potential is limited to the stock price touching zero level. It cannot go negative.

But what if the reverse happens? The upside risk potential is unlimited. You would be in soup. You can arrest this.

Here again, with the help of options, you may check an un-hedged position. In this case, you may use a call option to bet on the upside potential of the stocks.

The following illustration renders a better understanding.

Imagine an investor goes short on 3-month stock futures of ABC Ltd at Rs 100 containing 100 shares. The contract value is equal to Rs 10000 (Rs 100*100). He pays an initial margin of Rs 1000. In this situation, his profit potential is limited while loss potential is unlimited. He buys 3-month 50 call options of Rs 20 each at an exercise price of Rs 100. He pays a premium of Rs 1000 (50*Rs 20).

If the stock prices fall to say Rs 70, he makes a profit of Rs 3000 (Rs 30*100) on futures. In this case, call expires worthless. He loses the premium of Rs 1000.

To his astonishment, the stock prices of ABC Ltd rise to Rs 110. In the case of un-hedged position, he would have made a loss of Rs 1000 (Rs10*100). But luckily, he has a call backing. He, thus, compensates his loss in futures.

Calendar Spreads

It is a strategy to buy and sell futures contract simultaneously. The contracts would have same strike price but different expiration dates. It aims at betting on the price movement of the underlying within the narrow range i.e. around the strike price. If there’s high volatility, then there would be massive losses.

The investor tries to hedge the short with a long. So that, if the market moves in, either way, he’s not left with no money. He would sell near month contract and buy long-dated futures.

Suppose an investor shorts one November Stock Futures contract of XYZ Co. at Rs 500 containing 100 shares. He deposits Rs 5000 as an initial investment. Simultaneously, he assumes a long position on December Stock Futures of XYZ Co.

If the stock prices rise to Rs 510, he incurs a loss of Rs 1000 on November futures. But this would be a blessing in disguise for the December futures. He may earn even higher profits with a steady rise in stock prices. Hence, loss of one contract is compensated by the gain on another.

Here, the strike price is near the spot price. It would be called as a Neutral Calendar Spread. If the strike price is higher than the spot price, it would be Bullish Calendar Spread. Conversely, if the strike price is lower than the spot price, it’s a Bearish Calendar Spread.

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Final Words

Futures Contracts are incredible risk management instruments indeed. The only caution here is to assume hedged positions. Moreover, choose a suitable hedging instrument to cover the upside and downside risks in futures.