17.6 Key concepts

Spreads

A futures spread is simply the simultaneous trading of one contract against another. Spread refers to the relationship of two different futures prices of an asset. In other words, a spread position is initiated by the simultaneous purchase and sale of futures contracts on the same asset but with different delivery months, or by simultaneous purchase and sale of futures on different commodities for delivery in the same or different months. A profitable spread creates a gain on one side of the spread which is larger than the loss on the other side of the spread.

Following are major types of futures spreads.

1. Intra-commodity futures spread (Time Spread):
   This is the most common type of spread, involving long and short positions between different contract months of the same commodity. It is where a trader takes long and short positions on futures with the same underlying commodity, but different delivery months. Eg: long October crude oil contract and short December crude oil contract. Normally, these types of spreads are usually either "bull spreads" or "bear spreads".
   
   The "bull spread" refers to being long a nearby contract of the commodity and short a deferred contract. It is called a bull spread because these spreads most often perform best in bullish, demand-driven markets. In such cases where a commodity is in short supply, nearby contracts can go to significant premiums over the deferred.
   
   The "bear spread" is just the opposite of the bull spread, being long a deferred contract and short the nearby. These spreads can be very effective near market tops, because when the market starts to decline, the nearby contracts will often decline quicker than the deferred contracts.
2. Intermarket or Inter-commodity futures spread:
   A trader takes long and short positions on different futures contracts with different but related underlying commodities, and the same delivery month. Eg: long September Wheat and short September Soybeans. Inter-commodity spreads can also be calendar spreads, when the contracts have different maturity periods. Spread trading has always been popular in futures markets. Commercial users are frequently trading spreads as a tool of hedging. It is observed that spread positions are usually less volatile than outright position. So spreads are less risky and therefore, the exchange allow less margins on spreads trading.

Open Interest

Let us discuss now about another important concept in both futures and options. Open interest (also known as open contracts or open commitments) means to the total number of derivative contracts, like futures and options, that have not been settled in the immediately previous time period for a specific underlying security. For each buyer of a futures contract there must be a seller. From the time the buyer or seller opens the contract until the counter-party closes it, that contract is considered 'open'.

How to Calculate Open Interest

Each trade completed on the exchange has an impact upon the level of open interest for that day. For example, if both parties to the trade are initiating a new position (one new buyer and one new seller), open interest will increase by one contract. If both traders are closing an existing or old position (one old buyer and one old seller) open interest will decline by one contract. The third and final possibility is one old trader passing off his position to a new trader (one old buyer sells to one new buyer). In this case the open interest will not change.

1. On January 1, A buys an option, which leaves an open interest and also creates trading volume of 1.
2. On January 2, C and D create trading volume of 5 and there are also five more options left open.
3. On January 3, A takes an offsetting position, open interest is reduced by 1 and trading volume is 1.
4. On January 4, E simply replaces C and open interest does not change, trading volume increases by 5.

Implications of change in Open Interest

The relationship between the prevailing price trend and open interest can be summarized by the following table.

By monitoring the changes in the open interest figures at the end of each trading day, some conclusions about the day's activity can be drawn.

Increasing open interest means that new money is flowing into the marketplace. The result will be that the present trend (up OR down) will continue.

Declining open interest means that the market is liquidating and implies that the revailing price trend is coming to an end. A knowledge of open interest can prove useful toward the end of major market moves.

A levelling off of open interest following a sustained price advance is often an early warning of the end to an up trending or bull market.

Futures Margins

In the futures market, margin has a definition distinct from its definition in the stock market, where margin is the use of borrowed money to purchase securities. In the futures market, margin refers to the initial deposit of "good faith" made into an account in order to enter into a futures contract. This margin is referred to as good faith because it is this money that is used to debit any day-to-day losses. Participants in Futures are required to keep a margin with stock exchanges. Futures margin requirements are set by the exchanges and are typically only 2 to 10 percent of the full value of the futures contract and is required of both buyers and sellers of futures contracts to ensure that they fulfill their futures contract obligations.

Initial Margin

Before a futures position can be opened, there must be enough available balance in the futures trader's margin account to meet the initial margin requirement. When you are opening the futures position, an amount equal to the initial margin requirement will be deducted from your margin account and transferred to the exchange's clearing firm. This money is held by the exchange clearinghouse as long as the futures position remains open.

Maintenance Margin

The maintenance margin is the minimum amount a futures trader is required to maintain in his margin account in order to hold a futures position. The maintenance margin level is usually slightly below the initial margin. If the balance in the futures trader's margin account falls below the maintenance margin level, he or she will receive a margin call to top up his margin account so as to meet the initial margin requirement.

How does the mark to market mechanism work?

Mark to market is a mechanism devised by the stock exchange to minimize risk. In case you start making losses in your position, exchange collects money to the extent of the losses up front. For example, if you buy futures at Rs 300 and its price falls to Rs 295 then you have to pay a mark to market margin of Rs 5. This is over and above the margin money that you pay to take a position in the future. The notional loss / profit arising out of mark to market is paid / received on T+1 basis.

Mark to Market Example

Assume that Initial Futures Price = Rs. 5000; Initial Margin requirement = Rs. 25000; Maintenance Margin Requirement = Rs. 15000; Contract size = 50 lot (that is, one index futures contract has 50 times value of index). How the end of day margin balance of the holder of

1. long position of a contract and
2. short position of a contract,

varies with the changes in settlement price from day to day is given below.

Terminology to Ponder

The terminologies used in a futures contract are:

Spot Price: The current market price of the scrip/index.

Future Price: The price at which the futures contract trades in the futures market.

Tenure: The period for which the future is traded.

Expiry date: The date on which the futures contract will be settled. End of which a contract will cease to exist.

Basis: The difference between the spot price and the future price.

Contract cycle: The period over which a contract trades. The index futures contracts on the BSE & NSE have one month, two-months and three-month expiry cycles which expire on pre defined date of the month. For example in NSE, a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three- month expiry is introduced for trading.

Contract size: The amount of asset that has to be delivered under one contract. Also called as lot size.

Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.

Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called marking-to-market.

Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.