Derivatives have built-in financial leverage, the source of power that underlies derivatives trading. Leverage encourages investors to invest money and create wealth in the finance world. Appropriate use of financial leverage can be a means of increasing wealth. Futures trading uses leverage extensively to create wealth for investors.
Published on 17 March 2023
For example, you can associate it with the nature of leverage. Whether we are talking about real estate or stocks, the concept of leverage applies to all situations. The concept of leverage can be applied to any situation where a financial transaction can be made for profit. If you agree to buy a house today, you pay 10% of the total price. This 10% amount is considered a symbolic amount for the conclusion of a future home purchase contract.
Consider that during the tenure, from the time you pay that token money to the time you make the full payment, you will find someone willing to buy the same property from you. However, the property value has increased by 25% of the contract value this time. By entering into such a contract, you can enjoy the benefits of leveraged trading.
Thus, the value of such a contract can be multiplied by several times by paying a fraction of the total cost of the contract. This is the whole idea of leverage or leverage trading.
Let's take an example from equities to know how leverage functions:
Consider a stock called ABC. Currently, as an investor, you have got a whole bullish outlook on ABC. Therefore, you decide to buy ABC stock to benefit and take a position from its rate increase. Let's say you have got an amount of 1 lakh to invest in this stock.
And with your expectation that ABC stock price will increase over time, you buy the stock at a rate of ₹1362 and expect to sell it at a price of ₹1519 in the future. At present, you've two options. Buy the stock on the spot market or layout the same money in the futures market.
Let's take a look at what will happen under each circumstance.
Due to the normal operation of the exchange, you will have to wait for the next two trading days from your broker for the shares to be credited to your Demat account. Once the shares are in your Demat, you are free to sell the shares as and when you see fit. This is commonly called delivery-based buying.
This example illustrates the difference between profitability in the futures and spot markets. While you made a profit of ₹78,500 in the futures market, the profit in the spot market is just ₹10,887. Therefore, traders need to look at the money they can lose or make when entering future trades. This particular element of a futures trade is known as futures payoff.
In general, when we talk about leverage, we are often asked the question, “How much leverage are you exposed to?” Of course, the higher the leverage, the higher the risk and potential benefit.
Leverage calculation is simple.
Leverage = [Contract Value/Margin]
So this means that for every ₹1 invested in this futures trade, the investor can enter a trade of ₹ 7.14. As this leverage increases, so does the risk associated with trading. That means you could lose all your money if ABC fell 14%. While ₹ 7.14 seems like a very small amount right now, it would make a big difference if that were above 40 or 50. Let's say the leverage ratio for a stock is ₹42.17. This means that if ABC's price fell by just 2.3%, you would lose all your money.
The payoff is the profitability of the options and futures under different prices. When buying options, you will have a strike price that will become the reference for assessing your payoff. Simply put, the payoff formula is the simulation of the profitability of options under various price circumstances.
Basically, leverage is a chance for the investors to pump up their trade returns in the stock market. But there are also several risks involved, as discussed above. So, you need to be smart about your moves and balance them accordingly. So, track your position, use the stop-loss order better, and try not to get carried away when trading.