Basics of Derivatives
Dealing in futures contracts requires a large capital; here comes the usefulness of 'Leverage' which is basically the use of borrowed capital to undertake an investment. In this section, we will understand the use of Leverage in futures trading.
The fact that one can take full exposure to the price movement of the underlying asset by just providing a certain percentage of money as margin, if the price movement is in one's favour the return on investment is very high compared to return on investment in case the investor takes the direct exposure in the underlying asset.
Thus, taking exposure to a higher value of asset by just providing margin or a smaller amount of sum is known as Leveraging. "Financial Leverage is a two-sided sword." Let’s understand it with an example.
Let us assume that individual A buys 250 shares of Reliance Industries in cash/spot market @ ₹1000/share. For, this transaction, he has to pay a total ₹250,000 as initial outlay/investment.
On the other hand, an individual B buys 1 lot of Reliance Industries shares in futures market, which is equivalent to 250 shares at the price of ₹1000/share.
However, for this he has to pay only an initial margin of say 30% of the total contract value of ₹250,000, i.e. ₹75,000.
Now, from here, if Reliance goes up by ₹100, then both individual A and individual B makes a profit of ₹(250 x 100) i.e. ₹25,000.
However, the Return on Investment (ROI) for individual A and B are different:
ROI (A) = 25,000/2,50,000 = 10%
ROI (B) = 25,000/75,000 = 33.33%
Thus, we see that since futures allows one to invest a lesser amount of capital for taking an exposure for an asset, the return on investment is comparatively higher.
However, if the price movement is against expectations and Reliance instead of going up by ₹100 falls by the same amount then in that case loss for both the individuals is ₹25000 only but the loss in percentage terms for B (-33%) is much higher compared to A (-10%).
Thus, the way in which futures trading provides higher return if the movement is in favour, similarly, it leads to higher losses when the price movement is unfavourable.
Moreover, if one buys in the spot/cash market, one becomes the shareholder of the company and remains the same even at the fallen price then they do not need to pay any additional amount of money. Thus, if the price recovers in the future, he can still benefit from the transaction.
However, if one buys in the futures market, one does not becomes the shareholder and if the price falls, he/she has to provide additional margin money for the adverse price movement or else the broker cancels his trade and he has to suffer the losses and after this, even if the prices increases in future, one may not realize any gains or benefits. This is the inherent risk of trading in futures.