Aim: To reduce risk of the portfolio using futures trading.
Assumptions:
---> The trading system used thrives on diversification to work.
---> The lot sizes traded in cash is equal to that of futures (or the capital invested is big enough to achieve diversification in the "value of futures traded")
---> For each future , LotSize * Price is the same. (For example,stock X is trading at 100 with lot size of 10 and stock Y is trading at Rs200 with a lot size of 5 and so on)
Capital at start:
---> Rs 1crore
x----------------------------------------------------------------------x
Case 1: (When the capital is used only for cash trading)
Let us take the example of stock "A" the price of which is Rs100 and lot size is 4000.
If a person was to purchase 3000 shares of "A", the amount of capital needed is 400,000Rs (4,000*100).
Investing 100% in stocks, he would be able to purchase a maximum of 25stocks.
Case II: (When he trades futures instead of stocks)
In the futures market, margin trading is allowed,which is usually 20% of the "value" of the contract.
In our above example, if Rs1 crore is traded, the amount needed is Rs20Lakh.
Note: The remaining 80lakhs is left idle. This could be invested in a debt instrument to generate a return of say,8% per annum.
The "traded value" in both cases remains the same as 1crore.
x--------------------------------------------------------------------x
Now let us take 2 states,
State 1: A profit of 20% of "traded value" is generated.
The profit in Case I: 20lakhs (which is the return on equity)
iProfit from case II : 20lakhs + 6.4lakhs (8% of 80lakhs which is the amount invested in debt) = 26.4 lakhs.
State 2: A loss of 20% has occurred.
The loss in Case I : 20lakhs
Loss in Case II: 20 Lakhs - 6.4 Lakhs (return from debt) = 13.6lakhs.
x----------------------------------------------------------------------x
Conclusion:
Trading futures makes it a win-win case both ways compared to trading stocks.
Note:
Does this mean you have to quit trading stocks and start trading futures?
NO. Due to the huge capital base, the portfolio is able to be diversified into both stocks AND futures without a problem. If only futures had been traded in case II, without investing in debt, the portfolio could have accomodated 125stocks instead of the traded 25 and the risk return would have increased propotionally with the risk return in stocks.
in state 1: if 100% was invested in futures, a return of 100% could have been generated!!
in state 2: if 100% was invested in futures, the account would have been wiped out!!!
x----------------------------------------------------------------------x
Experts,please comment on this analysis.
Assumptions:
---> The trading system used thrives on diversification to work.
---> The lot sizes traded in cash is equal to that of futures (or the capital invested is big enough to achieve diversification in the "value of futures traded")
---> For each future , LotSize * Price is the same. (For example,stock X is trading at 100 with lot size of 10 and stock Y is trading at Rs200 with a lot size of 5 and so on)
Capital at start:
---> Rs 1crore
x----------------------------------------------------------------------x
Case 1: (When the capital is used only for cash trading)
Let us take the example of stock "A" the price of which is Rs100 and lot size is 4000.
If a person was to purchase 3000 shares of "A", the amount of capital needed is 400,000Rs (4,000*100).
Investing 100% in stocks, he would be able to purchase a maximum of 25stocks.
Case II: (When he trades futures instead of stocks)
In the futures market, margin trading is allowed,which is usually 20% of the "value" of the contract.
In our above example, if Rs1 crore is traded, the amount needed is Rs20Lakh.
Note: The remaining 80lakhs is left idle. This could be invested in a debt instrument to generate a return of say,8% per annum.
The "traded value" in both cases remains the same as 1crore.
x--------------------------------------------------------------------x
Now let us take 2 states,
State 1: A profit of 20% of "traded value" is generated.
The profit in Case I: 20lakhs (which is the return on equity)
iProfit from case II : 20lakhs + 6.4lakhs (8% of 80lakhs which is the amount invested in debt) = 26.4 lakhs.
State 2: A loss of 20% has occurred.
The loss in Case I : 20lakhs
Loss in Case II: 20 Lakhs - 6.4 Lakhs (return from debt) = 13.6lakhs.
x----------------------------------------------------------------------x
Conclusion:
Trading futures makes it a win-win case both ways compared to trading stocks.
Note:
Does this mean you have to quit trading stocks and start trading futures?
NO. Due to the huge capital base, the portfolio is able to be diversified into both stocks AND futures without a problem. If only futures had been traded in case II, without investing in debt, the portfolio could have accomodated 125stocks instead of the traded 25 and the risk return would have increased propotionally with the risk return in stocks.
in state 1: if 100% was invested in futures, a return of 100% could have been generated!!
in state 2: if 100% was invested in futures, the account would have been wiped out!!!
x----------------------------------------------------------------------x
Experts,please comment on this analysis.