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Last week, we discussed how to decide between futures and options when you are setting up a short position. To recap, short call position generates limited gains compared with short futures position. The capital required in the form of margins are not different for both short call and short futures positions. Therefore, short futures position is preferable to short calls. In response to this article, a reader posed this question: Can we apply the required capital rule to decide between long futures and long underlying? In response to this query, this week we compare long futures and long underlying positions.
Equivalent position
When you setup a long position in futures, you only have to pay an initial margin. Thereafter, you may be obligated to post mark-to-market margins till contract expiry. In contrast, you must pay the entire amount upfront when you setup an underlying position. Clearly then, you must choose futures because you can setup an equivalent position for a lower capital. In fact, this is one of the advantages of trading derivatives instead of the underlying. So, a simple rule would be to choose futures over the underlying when futures contract on the underlying is available. Note that you have to compare the underlying using the equivalent position argument. That is, one futures contract must be compared with the capital required to setup a long position in the underlying with the number of shares equal to the permitted lot size.
That said, calculating the returns on long futures position is somewhat different. To be clear, this calculation is more relevant for institutional investors than for individual traders. Nevertheless, it could be worthy of discussion here. Suppose you buy one contract of the near-month Reliance futures for 2,316. Given the permitted lot size of 250, the notional value of the futures contract is 5.79 lakh. Assume the initial margin is 1.02 lakh. Then, the calculation requires that you consider interest income earned on the remaining amount. Let us suppose you earn 3 per cent per annum for 16 days. So, the total return would be the capital appreciation (decline) from the long futures position plus the income earned divided by the notional value of the futures contract. This is referred to as the notional return.
Optional reading
Your capital is an important factor when you are trading for short-term gains. This makes long futures position more attractive to setup than long underlying. Some individuals are fearful of the risk because of the contract multiplier (permitted lot size) on the futures contracts. Take Reliance futures. If the futures price decreases 10 points, your unrealised loss will be 2,500 (10 times 250 being the permitted lot size). But the loss will be no different for the underlying for an equivalent position argument. The only instance when you must prefer the underlying is when you want to restrict the position size to less than the permitted lot size of the futures contract.
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