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How to trade in futures with minimal leverage risk?

22 Jun 2023

We all know that trading in futures is largely like trading in the cash market. The only difference is that futures are leveraged as they purely entail a margin payment. However, if the price movement is against you then they also entail payment of mark to market (MTM) margins. The big challenge is to minimize the leverage risk in trading futures. What is the risk of investing in futures instead of in cash? More importantly, what is the risk associated with trading in future market? Are there any day trading futures strategies that one can effectively employ? Here are 6 important ways in which one can reduce the risk of leverage in futures trading..

Avoid leverage for the sake of it. What do we really mean by this point? Let us say you have a corpus of Rs.2.50 lakhs with you. You want to deploy the money to buy stocks of SBI. At the current market price of Rs.250, you can buy nearly 1000 shares in the cash market. However, your broker tells you that you can buy more SBI if you buy in the futures and pay a margin. Should you buy futures with a notional value of Rs.2.50 lakh or should you buy futures that entail margin of 2.50 lakh. If you buy SBI with margin of Rs.2.5 lakh, you will be able to by the equivalent of 5000 shares. That means your profits can increase by 5 times but then so can your losses. What is the mid-way approach?

That brings us to the second point, which is about what quantity of futures of SBI to purchase. Since your corpus available is Rs.2.50 lakh, you need to keep some provision for mark-to-market margins too. Let us say that in a worst case scenario you expect the stock of SBI to have a corpus risk of 30%. That means you need to set aside Rs.75,000 purely for MTM margins. Then if you are looking to roll over the futures for a longer period of time then there is a monthly rollover cost of nearly 1% that you need to factor in. So if you want to roll over for 6 months then you need to provide another Rs.15,000 for that. You can provide another Rs.10,000 for special volatility margins. Effectively, you need to keep Rs.1 lakh aside and use only Rs.1.50 lakhs as the allowance for initial margin. That would be a better way to approach your initial margin calculations.

If you are holding futures of volatile stocks or if you are expecting volatility in the market to go up sharply then you can hedge your futures position by attaching a put or a call option as the case may be. This way you can ensure that your MTM risk on futures will be largely compensated by the profits on the options hedge. Remember, buying options has a sunk cost and you need to use this judiciously after weighing the risk and returns of the strategy.

Trade futures with strict stop losses. This is a very basic norm in any trading activity but this will ensure that you are out of losing positions fast. Is it possible that after I trigger the stop loss the stock may eventually hit my target? That is perfectly possible. But, as a futures trader, your primary motive is to protect your capital. When the stop loss is triggered just exit your position. That is because, if you do not put a stop loss you will actually be worse off.

Keep booking profits on your futures position at regular intervals. Why should we do this? It ensures that your liquidity is intact and each time you book profits you are adding on to your corpus. That means your ability to extract leverage from the market increases. Just as it is essential to keep your trading losses short, it is also important to keep your trading profits shorter since you are invested in a leveraged position.

Last, but not the least, avoid the risk of concentrating your exposure. Let us say your futures position are all into rate sensitive industries then any hike in interest rates by the RBI can have a boomerang effect on your trading positions. It is always better to spread out your leveraged positions to ensure that the impact of negative news flows do not become too prohibitive. There is also an averaging angle to it. Normally, when we buy futures and the futures price comes down there is a tendency to average our positions. That is again dangerous because you run the risk of over-exposing yourself to a particular industry or a specific theme.

Leverage is part and parcel of trading futures. It is up to you how best you manage the risk of leverage in futures.

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