What are the strategies in futures trading?
There are several securities that are traded in the stock market, but among the most popular are shares of companies and derivatives based on them. The market segment where shares are traded is also called the cash market while the segment where derivatives are traded is called the F&O market, or futures and options market.
The derivatives market is substantially larger than the stock market and accounts for a significant portion of the volume on most stock exchanges. Though there are several types of derivatives, futures and options are the two main types that are traded in the market.
What are futures?
Futures are derivative contracts that represent an agreement between two parties to buy or sell a commodity at a particular future price and date. During contract expiry, the buyer is obligated to purchase the underlying asset while the seller is obligated to sell the underlying asset at the predetermined price.
For example, consider that a trader enters into a futures contract to buy 100 shares of Reliance Industries at Rs 2500, to be executed on June 23, 2023. Now, assume that the shares are trading at Rs 3,000 in the open market at this date. The buyer will have to buy these shares at the set price (earning a profit) and the seller will have to sell the shares to the buyer (suffering a loss). The condition holds even if the price drops to Rs 2,000 at that date. In such a case, the buyer will suffer a loss and the seller will profit from the trade.
On the other hand, an options contract is different from futures as it offers the buyer and seller the ‘option’ to buy or sell the underlying asset, but not the obligation to do the same. A buyer or seller of the contract can refuse to exercise their right buy or sell the underlying asset if they decide against it.
Both futures and options are easily tradable in the market. There are different strategies that traders use to increase profits from these contracts.
Strategies for futures trading
Futures trading strategies can be broadly categorised into two sections – directional and protective. A directional trading strategy refers to trading futures as a proxy to the spot market (that is, the movement of price in the cash market). This strategy refers to buying or selling contracts based on the ups and downs of the spot market. Protective strategies refer to measures that protect investors from losses in case of market downturns. These measures include hedges, profit lock-ins, arbitrages, spreads, etc.
Pullback refers to a brief dip or a pause in an asset's overall trend. For example, if a stock is continuously rising, chances of a correction, or pullback, are relatively higher. The Pullback strategy involves identifying signs of such brief dips and making money out of it.
During a downtrend, pullbacks generally occur when prices hit a well-established support level. Conversely, in an uptrend, the price may drop after reaching a well-established resistance zone. As long as a trader can identify these supports and resistances accurately, they can either go long or go short on a stock.
Such resistance or support levels are also good opportunities for traders to enter into a position if they had earlier failed to identify the broader trend.
Trading the range
Through a stock’s candlesticks on the chart, you can identify several support and resistance zones. One strategy that traders employ is trading the range between support and resistance levels that are nearest to each other.
This strategy takes advantage of expected price behaviour at certain support and resistance levels. For instance, a trader employing this strategy will buy when the stock hits its support and will sell when the stock hits its resistance.
Due to excessive demand or supply, there are times when resistance and support levels do not hold up and stock prices break out of these ranges. Typically, there are clues that indicate that prices are about to break out of the range, and understanding such signals is critical. When prices shift away from this range, it is referred to as a breakout.
Breakouts, when supported by healthy volumes, signal that the direction of the price movement has changed and that the market may trend in the direction of the breakout. When breakouts are not supported by strong volumes, they are usually called false breakouts. In this case, the prices normally revert back into the earlier trading range.
In breakout trading, a trader takes a long position if the price breaks above its resistance. On the other hand, a trader takes a short position if the price breaks below its support.
Traditional markets are not perfect. Sometimes, the market may price two contracts with the same underlying asset, differently. Traders on the lookout for such mispricing can earn money from the same. This is called spread trading.
For example, the price of two contracts, say, near-month expiry futures contract of Nifty and mid-month expiry futures contract of Nifty, are related. If one moves at a certain point in one direction, the other will do the same. However, sometimes, the movement is not proportional and there could be a time when then there is a brief ‘lag’ between the two prices.
If traders can spot this lag, they can earn profits without taking too much risk as it involves buying or selling the same asset with different expiry, thus acting like a hedge against each other. When traders notice the mispricing, they will buy 1 lot of futures contracts with a certain expiry date and sell another lot of the same contract with a different expiry date. Spread trading can be done by taking positions in different asset classes as well – for example gold and silver – as long as the relationship in prices is clearly defined.
There are several forms of spread trading. One of them is called the calendar spread. It entails buying and selling two different maturity contracts of the same underlying asset. Meanwhile, pair trading involves betting on the price spread between two similar securities. Finally, arbitrage involves taking advantage of the difference between the spot price and the futures price.
Q. What is future trading?
Future trading is the trading of futures contracts in the secondary market. Traders usually trade such contracts to profit from price fluctuations.
Q. Is future trading risky?
Yes. Trading in futures can be relatively riskier than buying and selling stocks. However, with proper discipline and through the application of strategies, you can earn hefty profits from trading futures.
Preference shares are a type of equity that provides shareholders with preferential rights, such as priority in receiving dividends and assets in the event of liquidation. They offer investors a fixed dividend payout and a higher claim on company assets compared to common shareholders.