Page 107 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes
Figure 7.1: Pay-off profile of ‘Going Long’

Profit

Futures Price
Stock Price

Loss

Example: Let’s say that, with an initial margin of ` 2,000 in June, Ramesh, the speculator
buys one September contract of gold at ` 350 per gram, for a total of 1,000 grams or ` 3,50,000.
By buying in June, Ramesh is ‘going long’; with the expectation that the price of gold will rise by
the time the contract expires in September. By August, the price of gold increased by ` 2 to
` 352 per gram and Ramesh decides to sell the contract in order to gain a profit. The 1,000 gram
contract would now be worth ` 3,52,000 and the profit would be ` 2,000. Given the very high
leverage (remember the initial margin was ` 2,000), by going long, Ramesh made a 100% profit.
Of course, the opposite would be true if the price of gold per gram had fallen by ` 2. The
speculator would have realized a 100% loss. It’s also important to remember that throughout the
time the contract was held by Ramesh, the margin may have dropped below the maintenance
margin level. He would have thus had to respond to several margin calls, resulting in an even
bigger loss or smaller profit.
The salient features of going long strategy are:

1. Situation: Bullish outlook for the market. Price of the underlying expected to increase.
2. Risk: Unlimited as the price of the underlying, and hence of futures, falls, until it reaches
zero.

3. Profit: Unlimited. It depends on the upward price movement.
4. Break-even: The price of the underlying (on maturity) equal to the futures price contracted.

7.1.2 Going Short – Sell Futures

A speculator who goes short — that is, enters into a futures contract by agreeing to sell and
deliver the underlying at a set price — is looking to make a profit from declining price levels. By
selling high now, the contract can be repurchased in the future at a lower price, thus generating
a profit for the speculator.

Example: Suppose June Crude Oil futures are trading at ` 40 and each futures contract
covers 1000 barrels of Crude Oil. A futures trader enters a short futures position by selling 1
contract of June Crude Oil futures at ` 40 a barrel.

Case 1: A June Crude Oil future drops to ` 30: If June Crude Oil futures are trading at ` 30 on
delivery date, then the short futures position will gain ` 10 per barrel. Since the contract size for
Crude Oil futures is 1000 barrels, the trader will net a profit of ` 10 x 1000 = ` 10000.

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