In the previous week, we discussed the mechanics of trading futures, and provided some examples of how to trade them. This week, I'd like to talk about a few trading strategies that can be implemented through the use of futures contracts. These are hedging, directional trading and spread trading.
Let's start with hedging. Large companies are major players in the futures market when it comes to hedging. Commodity producers will often use the futures market to hedge against adverse movements in commodity prices. Multinational corporations that earn and spend in a variety of currencies will use the futures market to hedge against adverse currency movements. What about you, the retail investor? Can the futures market be used as a hedging tool for individual investors? Well, if the answer was no, I would have probably not bothered mentioning it in the first place.
Let's assume an investor owns a portfolio of stocks for which he has invested for the long term. However, recent data suggests the economy might be headed for a slowdown and stocks could fall over the next six months. Now, the investor doesn't want to sell all his stocks and buy them again later because this would be expensive and difficult to implement. Instead, he can go short a stock index future to hedge is portfolio against adverse movements in the stock market. If the stock market ends up falling over the next six months (like the investor expected) the profit from the futures contract should help to offset the losses from his stock portfolio. In this way, he has used the futures market to hedge his portfolio in the near term.
We can extend this strategy further. Let's assume an investor wants to choose stocks that will outperform the market, but doesn't want to be exposed to market movements. He can buy the individual stocks and then sell a stock index future, such that his beta exposure is zero. (Beta is a measure of how much the portfolio will move when the overall market moves) Then his profit or loss will only be a result of whether those particular stocks outperform the market.
Directional trading is fairly straightforward. If you think the rupee is going to rise against the dollar, you can go short a USD/INR futures contract. Similarly, if you believe oil prices will rise, you can go long an oil futures contract. As I mentioned in last week's article, futures offer leverage so an investor only needs to put a small portion of the total value of the contract.
There are few things one needs to keep in mind when using futures for directional trading. First, it is important to decide beforehand how much one is willing to lose on any particular trade. Once that is decided, one should keep aside funds (even if it is more than the required margin) to cover potential losses. The second important point to remember is especially the case for those who wish to hold positions for a longer period. Futures contracts expire and must be periodically rolled. Let's assume an investor believes gold is going to rise over the next six months. A two month future and a six month future are both available, which should he choose? Logically, one might reply the six month future (in which case rolling to the next month won't be necessary if the intended holding period is six months). Unfortunately, near term contracts are a lot more liquid than long term contracts, which will result in a wider bid-ask spread for the six month contract. In this case, the best thing to do is weigh the cost of buying three separate 2 month futures (resulting in overall holding period of six months) versus the cost of buying a single 6 month future, and follow whichever strategy is cheaper.
The final strategy I'd like to discuss is spread trading. Spread trading occurs when an investor simultaneously buys and sells related futures contracts, with the intention of making a profit from the change in the price difference between the two contracts, i.e. the spread. Spreads come in all shapes and sizes, so let's start with a time spread. This is when you buy a contract of a certain month and sell another contract of a different month, both with the same underlying asset. For example, you might find that oil for October delivery is trading at a premium over oil for September delivery. If you believed there was no reason for the oil prices to differ from September and October you could go long the September contract and go short the October contract with the hope that the spread between the two will diminish.
Spreads can also be between different but related assets. For example, you might observe that historically gold has traded at a certain multiple over silver. However, over the last year gold has risen significantly more than silver has, so you conclude that silver is cheap relative to gold A good strategy in this scenario would be to go long a silver futures contract and short a gold futures contract with the hope that they will eventually return to their historical relationship. There are a variety of related contracts that often move together, and trading spreads when historical relationships go out of line can be extremely profitable. Of course, it is important to do one's homework and understand that if a historical relationship goes out of line, there could be a fundamental factor behind it which would prevent it from going back to its old relationship.
Like all forms of investing, trading in futures is risky. It is more risky than stocks because of leverage; but this can amplify your returns. Over the next few weeks, we will discuss options, both pricing and trading strategies.
This column, A Fresh Perspective, is authored by Asad Dossani. Asad is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!