Derivatives: Futures Trading Techniques

Let us start with some basic trading techniques in futures because futures behave just like stocks and therefore are easier to understand. 

Futures Trading Technique

• Hedging:

 Mutual fund managers sometimes use this technique. While we often say that, equity or mutual fund investment should be for the long term, there is no denying volatility is stressful and it can often trigger off panic selling. What does a fund manager do in such volatile markets? He or she has three options. He or she can sell the stocks in the fund portfolios and sit on cash to avoid further losses. However, if the shares were bought at a higher price, then the loss incurred by the investors would be permanent and detrimental to their long term objectives. The fund manager could sit tight and remain invested till the market recovers. But if volatility persists for a long time, NAV will continue to fall causing notional losses to the investors. But in reality, when the value of investments falls very sharply, investors start redemptions. It is normal human behavior. When investors redeem, the fund manager has no option but to sell. When large number of investors redeem, it can hurt investors who decide to remain invested, because in such situations, the fund managers may have to sell their best stocks, because he or she may not find buyer for some stocks.

Derivatives offer a smarter alternative to fund managers in such situations to hedge their portfolio losses. Let us assume, you have invested in a diversified equity fund, which has mostly large cap and some midcap stocks. Suppose, the Nifty falls by 10-15%, causing the NAV to fall by around 10% and the fund manager expects it to fall by another 10–15%. The fund manager can sell Nifty futures. If Nifty falls by another 10%, the value of the underlying stocks of the portfolio can also fall by 10%, but the fund manager will make a 10% profit on the Nifty futures. Therefore the fall in the NAV of the fund will be much less. This will reduce notional losses and stress for investors and at the same time, allow the fund manager to hold on to high conviction stock bets, which in the long will create wealth for the investors. However, you must remember that, hedging is a mechanism to prevent losses only; it cannot be used to make money. Profit or loss of a hedged position is less than, the profit or loss of an un-hedged position.