For a market to succeed it must have all kinds of participants hedgers, speculators and arbitragers. The confluence of these participants ensures liquidity and efficient price discovery on the market. We, at SSJ Finance can help you choose the right trading strategy that suits your profile and requirement.
The main trading strategies that can be formulated using futures are listed below:
Hedging
Speculation
Arbitrage
Hedging
Hedging is the act of taking a position in the futures market that is exactly opposite to ones position in other segments of the market such as the equity segment, commodity physical market etc., with a view of offsetting losses in one segment (say ,in equities/commodities spot market) with a gain in the other (say ,futures segment). Hedging does not necessarily improve financial outcome or result in increased profit. This strategy helps in reducing or limiting risk associated with unpredictable changes in prices, in other words, it increases the certainty of the outcome. Hedging strategy can be adopted in the following two ways:
Buying Hedge or Long Hedge � In the equities market, if you are short in the cash segment, you can buy futures contracts and hedge your cash position. Based on the rationale that both cash and futures segment move in tandem, in case prices rise, you will make a profit in the futures contract which will offset your loss in the cash segment. If prices fall, you will make a profit in the cash segment and a loss in the futures segment. In case of commodities market, this strategy is quite useful for exporters / traders who have made commitments to deliver the specified amount of raw materials / processed products / manufactured goods at a later date at a price currently agreed upon, but do not have the stock of raw materials to fulfill their commitments for forward deliveries.
Selling Hedge or Short Hedge � This means selling futures contracts to hedge long position in cash market. For example, in the commodities market, manufacturers and dealers who have bought raw materials or are maintaining inventory for future sale, can protect the prices of their future sales by selling futures contracts.
Speculation
Under the hedging strategy, profit is minimal since profit generated in one segment is eaten up by loss in the other segment. If risk minimization is not your motive, and you are interested in making maximum gains from your investment, you can become a speculator. Under the speculation strategy, when an investor thinks that the market is bullish, he buys the Index futures contract. Similarly, if he is bearish about the market, he sells the Index futures contract. The same strategy can be applied to individual stock futures as well.
The advantage of this strategy is that without any existing position in the cash market, and even without having the physical resources to take delivery of the underlying asset or the desire to take delivery of the underlying asset, a speculator can make use of price movements to make a profit, based on his expectations. Another advantage to the market as a whole is that speculators provide liquidity to the market, since they accept the risk which hedgers wish to transfer. Without them, the hedging function would have proved to be a very expensive option.
Note: Futures market provides you with the advantage of leverage, since you can trade large volumes with only a small investment in the form of margin money. While profits can be huge, ones losses can also be large. Hence, you must step into the futures market with great caution, only after understanding the risks involved.
Arbitrage
Arbitrage involves the simultaneous purchase and sale of an asset in order to profit from a temporary price differential, usually taking place on different exchanges or marketplaces. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, �a risk-free profit�. If you want to replace the returns from your idle funds in fixed deposits with higher yielding returns, arbitrage is a good risk free investment option for you.
A person who engages in arbitrage is called an arbitrageur. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies.
