What Do You Mean by Leverage & Payoff in Futures & Options?
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.
Leverage: Understanding the Concept
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.
- Buying ABC in the Spot Market: First, you need to check the price ABC is currently trading at. Then, with ₹100000 in hand, you need to calculate the number of shares you can buy at the prevailing market rate.
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.
- Buying ABC in the Futures Market: There is a fixed lot size in the futures market that you can buy a particular stock for. Let's assume that the minimum lot size to buy ABC stock is 125. For a price of ₹1,362, you now have to spend a total of ₹170,250 in the cash market to buy that many shares. The interesting thing about the futures market is that you don't have to spend all your money at once. You just need to spend a minimum amount on margin money. This allows you to take a position in trading.
- Total Lot size - 125
- Number of lots taken - 4
- The buying price of futures - ₹1362
- Value of Futures contract - 125 * 4 * ₹1362 equal to ₹681000
- Margin Amount - ₹95340
- The selling price of future - ₹1519
- The selling price of a futures contract - 125 * 4* ₹1519 = ₹759500
- The remaining profit - ₹78500
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.
Understanding Leverage Calculation
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.
What is Payoff?
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.
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Frequently Asked Questions
All futures trade has a payoff that takes place at all price points. Because of this, one can either make a profit or suffer a loss at each of these price points. Depending on what price you got the stock at, you can end up with either a profit or a loss at a later date. It is often called a Linear Payoff instrument.
Futures and Options are financial instruments in the equity derivatives market.
A futures contract is generally a legal agreement between the two parties when selling or buying the underlying security at a given price on a future date.
The Option is a contract that conveys, but is not obligatory, the right to sell or buy the underlying asset at a specified date or earlier.