SPECULATION, BEARISH SECURITY,
Stock futures can be used by a speculator who believes that a particular security is over valued and is likely to see a fall in price. How can he trade based on his opinion ? In the absence of a deferral product, there wasn’t much he could do to profit from his opinion. Today all he needs to do is sell stock futures.
Let us understand how this works. Simple arbitrage ensures that futures on an individual securities more correspondingly with the underlying security, as long as there is sufficient liquidity in the market for the security. If the security price rises, so will the futures price. If the security price falls, so will the futures price. Now take the case of the trader who expects to see a fall in the price of ABC Ltd. He sells one two month contract of futures on ABC at Rs.240 (each contact for 100 underlying shares). He pays a small margin on the same. Two months later, when the futures contract expires, ABC closes at Rs.220. On the day of expiration, the spot and the futures price converges. He has made a clean profit of Rs.20 per share. For the one contract that he bought, this works out to be Rs.2000.
ARBITRAGE: OVERPRICED FUTURES.
BUY SPOT, SELL FUTURES
As we discussed earlier, the cost of carry ensures that the futures price stay in tune with the spot price. Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. If you notice that futures on a security that you have been observing seem overpriced, how can you cash in on this opportunity to earn riskless profits ? Say for instance, ABC Ltd., trades at Rs.1000. One month ABC futures trade at Rs. 1025 and seem overpriced. As an arbitrageur and lower spreads in both the cash as well as the derivatives market.
You can make riskless profit by entering into the following set of transactions:
On day one, borrow funds, buy the security on the cash/spot market at 1000.
Simultaneously, sell the futures on the security at Rs. 1025.
Take delivery of the security purchased and hold the security for a month.
On the futures expiration date, the spot and the futures price converge. Now unwind the position.
Say the security closes at Rs. 1015, sell the security.
Futures position expires with profit of Rs. 10.
The result is a risk less profit of Rs.15 on the spot position and Rs. 10 on the futures position.
Return the borrowed funds.
When does it make sense to enter into this arbitrage ? If your cost of borrowing funds to buy the security is less than the arbitrage profit possible, it makes sense for you to arbitrage. This is termed as cash and carry arbitrage. Remember however, that exploiting an arbitrage opportunity involves trading on the spot and futures market. In the real world, one has to build in the transactions costs into the arbitrage strategy.
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