How to use stock futures for long term investing in stocks - Motilal Oswal
How to use stock futures for long term investing in stocks - Motilal Oswal

How to use stock futures for long term investing in stocks

Most traders look at futures as a means of short term trading in the markets or at best as a means of hedging your risk or arbitraging in the equity markets. Interestingly, futures can also be looked at as a means of substituting your investments in stocks. Let us look at the pros and cons of holding futures long term. What are the implications and benefits of long term investment via futures? Above all, for traders looking to take futures positions, what are the best long term investments for beginners? There are actually 3 ways of using futures for long term investments.

 

1.  Substituting cash long position with long futures

Let us take a very simple example here. If you are holding 1000 shares of Reliance Industries in the cash market, you can reduce your funds locked in by purchasing 1 lot of Reliance futures which is worth 1000 shares. When you buy futures, you only pay a margin so the balance money gets freed up. But, you also need to make a provision for MTM margins if the price move goes against you. So the balance freed up can be invested by splitting 20% in liquid funds and 80% in debt funds. We have assumed 6% annualized returns on liquid funds and 10% annualized returns on debt funds. This will ensure that you have liquidity when required. Let us look at how they compare in a bullish market scenario..

 

ParticularsBuy RIL in cash marketBuy RIL in Futures20% balance in liquid fund80% balance in debt fundsBuy DateJan 01st 2018Jan 01st 2018Jan 01st 2018Jan 01st 2018Buy PriceRs.920Rs.920

No. of Shares10001 Lot (1000)

Buy ValueRs.9,20,000Rs.9,20,000

Margin PaidRs.9,20,000Rs.1,20,000

Balance Invest

Rs.1,60,000Rs.6,40,000Sell DateMarch 31st 2018March 31st 2018March 31st 2018March 31st 2018Sell PriceRs.990Rs.990

Sell ValueRs.9,90,000Rs.9,90,000Rs.1,62,400Rs.6,56,000Profit bookedRs.70,000Rs.70,000Rs.2,400Rs.16,000Total ProfitRs.70,000Rs.88,400

3-Month Returns7.61%9.61%
 

 

As can be seen from the above chart, if the trader had adopted the cash buying route, his 3-month returns would have 7.61%. Had he opted for a combination of futures and debt funds he would have earned a return of 9.61% in 3 months. That is the power of leverage that futures provide. Here we are assuming that the holding period is just for 3 months so we can straight away buy a 3-month future. But, what happens if you intend to hold the stock for a period of 1 year. That is when the concept of roll-over cost comes in handy. Let us look at a 1-year holding via futures with roll-over cost imputed into futures cost.

 

2.  Investing for the long term by rolling over futures

If we are looking at an investment period of 1 year, is it possible to use the futures route? The challenge could be that liquid futures are normally available only for the first month and the second month. That means we will have to roll over the futures for 2 month periods. That would imply 6 rollovers in 1 year. How does the cost work out in the above case?

 

ParticularsAmountParticularsAmountReliance May FuturesRs.938.85Roll cost (4.65/938.85)0.495%Reliance July FuturesRs.943.50Annualized Roll Cost3.01%2-month SpreadRs.4.65
 

 

Let us see how this annualized roll cost of 3.01% impacts the profitability of futures versus cash investment..

ParticularsBuy RIL in cash marketBuy RIL in Futures20% balance in liquid fund80% balance in debt fundsBuy DateJan 01st 2018Jan 01st 2018Jan 01st 2018Jan 01st 2018Buy ValueRs.9,20,000Rs.9,20,000

Margin PaidRs.9,20,000Rs.1,20,000

Balance Invest

Rs.1,60,000Rs.6,40,000Sell DateDec 31st 2018Dec 31st 2018Dec 31st 2018Dec 31st 2018Sell PriceRs.1,150Rs.1,150

Sell ValueRs.11,50,000Rs.11,50,000Rs.1,69,600Rs.7,04,000Profit bookedRs.2,30,000Rs.2,30,000Rs.9,600Rs.64,000Total ProfitRs.2,30,000Rs.3,03,600

3-Month Returns25.00%33.00%

Roll Cost
-3.01%

Net Returns25.00%29.99%
 

 

Instead of buying in the cash market, if the trader decides to buy it in the futures market and hold the balance money in a mix of liquid funds and debt funds, then he would still be better off by nearly 500 basis points. That is the advantage of using futures as a long term investment tool.

 

Using futures as a tool of reverse arbitrage

This is an interesting strategy you can apply in times of high volatility. If you are holding on to a stock and the futures is quoting at a deep discount to the cash market price (without dividend effect), then you can capitalize by selling your cash position and buying in futures instead. For example if you create a reverse arbitrage at -1.3% and then close the reverse arbitrage at +0.6%, then you can earn 1.9% returns in a very short period of time. These are market specific opportunities and are only available for a very short period of time.

 

The moral of the story is that futures can be used as an alternative to cash markets for enhanced yields. Of course, you need to be wary of the tax implications of this move!
 

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