Page 167 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes
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 increases by ` 2 to ` 352
per grams and Ramesh decides to sell the contract in order to realize 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.
Figure 12.1: Pay-off profile of 'Going Long'

Profit

Futures Price
Stock Price

Loss
The salient features of going long strategy are:
(a) Situation: Bullish outlook for the market. Price of the underlying expected to increase.
(b) Risk: Unlimited as the price of the underlying, and hence of futures, falls, until it
reaches zero.
(c) Profit: Unlimited. Depends on the upward price movement.
(d) Break-even: The price of the underlying (on maturity) equal to the futures price
contracted.
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. The pay-off
profile of 'going short' is depicted in Figure 12.2.

Figure 12.2: Pay-off profile of 'Going Short'

Profit

Futures Price
Stock Price

Loss

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