Understanding Leverage Perspective in Futures Contract

If we put things in a simple manner it always helps us understand things better. Similarly, leverage is simple if we apply common sense. Like, take an example if someone wants to invest in a real estate. Like if someone identifies a real estate scheme at an early stage and invests in that leverage could work at its best.

Like if a builder starts a new project in 2021 and possession is in 2026 and Mr. A the buyer books a 2 BHK apartment in the scheme. The cost is Rs 50,00,000 and as no work is Carried out yet, the buyer needs to pay only Rs 5,00,000 as token amount. The rest of the amount is to be paid in parts at a later stage. Now he is entitled to buy a 2 BHK flat at the time of possession if he makes full payment later. However, within just 6 months there was some announcement of a larger infrastructure project near the scheme. As a result, the price of the apartment increases to Rs 70, 00,000 (up by Rs 20,00,000).

Now as the prices have gone up to Rs 70 lakh, Mr. A gets another buyer Mr. X who wants to buy it at Rs 70 lakh. Here Mr. A and MR.X get into an agreement to purchase the apartment. Mr. A gets the amount of Rs 25,00,000 (Rs 5 lakh paid Earlier to Builder And Rs 20,00, increased price). He takes it and moves out. Now as per the original Agreement, Builder needs to get his remaining Rs 45,00,000. On a stated date Mr.X makes the payment of Rs 45,00,000 to the builder and takes possession.

• Now builder has received his Rs 50,00,000 in full.
• X Also made a payment of Rs 70,00,000 (Rs 25,00,000 to Mr. A + Rs 45,00,000 to Builder).
• Here with an Investment of Rs 5,00,000 Mr. A made a profit of Rs 20,00,000.

Again this was on Rs 5 lakh and not Rs 50 lakh. Hence just because of finding the opportunity at right time, he could make a profit of 400 percent or 4x.  However, this is a best-case scenario and may not be possible every time. This is the best Example of Leverage.

As we mentioned earlier there would be a margin amount required in the Case of Future contract, instead of the total contract value. As we pay only the margin amount we get some Amount of Leverage. Let’s understand the same with a similar example of Reliance Industries.

Leverage Calculation

Usually, when we talk about leverage, the common question one gets asked is – “How many times leverage are you exposed to?” The higher the leverage, the higher is the risk, and the higher is the profit potential.

Calculating leverage is quite easy –

• Leverage = [Contract Value/Margin]. Hence for Reliance trade, the leverage is

= [6,78,000/1,52,000]

= 4.46, which is read as 4.46 times or simply as a ratio – 1: 4.46

Now following formula gives us what percentage margin we are paying for Reliance Industries.

Here Divide 1/ Stock Leverage Ratio

= (1/ 4.46)*100, gives us 22.42 percent margin bracket.

This means every Re.1 in the trading account can buy up to Rs.4.46 worth of Reliance Industries. This is a very manageable ratio. However, if the leverage increases, then the risk also increases.

We can take the example of Reliance to understand the impact of leverage on our payoff and the Returns we have generated.

We had explained how instead of Rs 6.78 lakh to buy in the cash market one had to margin of Rs 1.52 lakh to buy Reliance Futures. Now take a look at the returns generated.

With 250 units purchased at Rs 2715 in Cash, the total Returns, if the stock closed at Rs  2755, would be As follows

• Rs 2755 – Rs 2715 = Rs 40.

We had purchased 250 shares the total returns would be Rs 10,000. Even in case of Future Contracts the total profit would also be Rs 10,000. This means in absolute terms returns are same. However we need to calculate returns on the Capital invested.

In cash transaction the amount invested was Rs 6.78 lakh and in case of Futures contract it was only Rs 1.52 lakhs. So returns in percentage terms are as follows.

• Cash Transaction :  (Rs 10,000 / Rs 6,78,000)*100 = 1.47 percent
• Future Transaction : (Rs 10,000 / Rs 1,52,000)*100 = 6.57 percent

This can also be calculated as follows. If the returns generated 1.47 percent * 4.46x leverage would result in 6.57 percent of returns. IT is generated in one month period. We have not annualised the returns as the things would become more complex. Else on the annualised basis the different Would be much higher.

With the margin requirement at 22 percent, when the stock increases by 22 percent the amount invested would get doubled Futures.

While we are speaking only at the positive aspect, the leverage part works at similar pace on the down side as well. And just with a down side of 22 percent the entire capital invested in the Future Contract would get eroded.

The above example clearly shows, higher the leverage higher the returns. But we opine taking higher leverage is not a great idea. The simple reason is, the Way it Works in favour it also works against as well. The maximum Leverage we opine would be 1:8 to 1:10. Anything higher than that would be excess leverage.

Short Selling Is Possible

The way we have explained the Buying of Reliance Industries, in the case of Futures one can Short first and then recover later. Means One can Sell first and then Buy later as the share price moves down. All the calculations would be similar as above, just that if we have shorted – the profit starts when a stock declines.

Lastly, there is no need to carry the Future Trade till the last Day of Expiry. If your target is achieved ahead of the expiry, one can square off positions time on a trading day. Further, a lot of people trade with something called stop loss. This means in the above example We expected a price of Rs 2755 for Reliance Industries, However on the contrary, the price declined. Here one would exit the futures contract at a loss at a set price earlier. Suppose someone puts a Stop Loss at Rs 2700, if the price declines to Rs 2700 (before touching the target of Rs 2755) one would book loss and exit the trade.  This restricts the further loss if the scrip moves further downwards.

Future is a Zero Sum Game

One must remember that the investment in Futures is like a Zero Sum game. In Cash markets where if the share price increases then even the market cap of the company increases and this results in Wealth generation or money creation. However, in the Derivatives segment, the money flows from one pocket to another – hence it is termed as a Zero-Sum Game. While we have explained how the profit and loss would be calculated in the Futures Trade, in Part 3 of our Series on Futures Contracts we would explain the Margin call and requirement in further detail.