Did you know that trading futures is an alternative to borrowing? When we are talking about borrowing we are referring to borrowing money to buy stock and borrowing stocks to sell. But how are stock futures like borrowing. That is because both are leveraged products. By paying a margin you take a position that is much larger than what you can actually afford. Like in any leveraged position the profits in a futures position and a borrowed position can be multiplied and even the losses can be multiplied.
So what do we understand by stock lending and borrowing mechanism? How can we replicate the stock borrowing and the cash borrowing mechanism by trading in futures? Ho to trade futures successfully and what is the best way to trade futures? For that we need to understand the stock lending and borrowing mechanism in detail as also the process of borrowing on margin and investing in shares.
Buying stocks on margin versus buying futures
Let us do a comparative analysis of these two processes with the help of a comparative table..
ParticularsBorrowing money to invest in stocksParticularsBuying stock futures insteadStock to be boughtReliance IndustriesStock to be boughtReliance IndustriesNumber of shares1000 sharesNumber of shares1000 sharesMarket PriceRs.940Market PriceRs.940Value of purchaseRs.940,000Value of purchaseRs.940,000Borrowing marginRs.470,000 (50%)Borrowing MarginN.A.Futures MarginN.A.Futures MarginRs.141,000 (15%)Leverage2:1Leverage6.66:1
When you buy stock futures you are basically replicating borrowing and investing in shares. There are a few differences. You get a much higher leverage in futures buying as opposed to borrowing and buying stocks. As can be seen in the above case, the leverage in stock futures is 6.66 times as against the cash market buying where the leverage is just 2 times. Here is how buying stock futures can be at an advantage over borrowing and buying stocks..
The leverage is much higher in case of futures as the margin required is about 15% of the value of the transaction. That means the profits will be multiplied by a factor of 6.66 times in case of stock futures. A word of caution is that the losses may also be multiplied by that factor.The problem of MTM or mark-to-market margins is more in case of futures than in case of borrowing stocks. In stocks the margin is 50% and hence the lender has a much higher margin of safety with them. However, in case of futures, the margin call is made only when the margin balance falls below the VAR margin.
The only disadvantage in stock futures is that there is no dividend paid on futures and that is a disadvantage in case of high dividend yield stocks. Additionally, there is a rollover cost involved in long futures just as there is an interest cost on funds borrowed. This rollover cost normally tails the interest rates prevailing in the market and ranges between 0.5% and 0.8% monthly based on market volatility.
Selling stocks by borrowing versus selling futures
How does selling stock futures compare with borrowing stocks and selling? Let us understand the difference..
ParticularsSelling Stocks by borrowingParticularsSelling stock futures insteadStock to be SoldReliance IndustriesStock to be SoldReliance IndustriesNumber of shares1000 sharesNumber of shares1000 sharesMarket PriceRs.940Market PriceRs.940Value of SaleRs.940,000Value of SaleRs.940,000Interest on borrowed stock9-11%Interest on Futures saleN.A.Futures MarginN.A.Futures MarginRs.141,000 (15%)
When you sell futures, you pay initial margins and MTM margins in the same way as you would pay when you buy futures. But when you borrow stock there is an interest element that the lender of the stock will charge you. Investors who are holding on to stocks in their demat account can use the Stock Lending mechanism in the exchange platform to earn interest on their idle stocks. But why would somebody want to borrow stocks? There could be a variety of reasons..
Traders borrow stocks when they have a negative view on a stock but do not have it in their portfolios. If the stock is in your portfolio then the simplest thing is to sell the stock and repurchase it when the price comes down. But when you do not own the stock and still have a negative view then you can borrow and sell the stock.
When you borrow stocks there is an interest cost that is implicit in the transaction and hence your downside view on the stock has to cover the interest cost too. Additionally, shorting in the cash market is only possible on an intraday basis as Indian markets operate on a rolling settlement system.
When you short futures, you do not have to worry about borrowing stocks or covering intraday but you can carry till expiry. Additionally, when you roll over your short futures position, you actually earn interest which is an added advantage.