This article was originally published in Postnoon on June 8th, 2012. Co-Author: Amulya Chirala.
Srikanth: Hi professor, sorry I had to leave in the middle of our conversation on futures last week. You told me that futures are contracts that help people hedge their portfolios. Please do tell me how people like me can use futures as a part of our investment portfolio.
Prof. Nikki: Futures are very powerful instruments for an investor to manage his risk. But the importance of learning about them before trading in them cannot be overstated because they can also be pretty complex. And even after reading about them, it is best to start small.
Srikanth: How would you suggest we start using futures?
Prof Nikki: I think the best way would be to start with simple contracts to hedge your position on some stock that is experiencing some volatility.
Srikanth: Whoa… That’s a lot of jargon in one sentence… Hedging? And how would you define volatility?
Prof Nikki: Ah! Once a student, always a student. I did explain hedging to you last week. As usual, you did not pay attention! Let me explain again.
Hedging refers to taking a position (or trade) to offset your initial position. Let me try and make it clearer, if you own a stock (you are long stock) , you stand to gain if the stock price goes up, therefore, by entering a trade where you stand to gain when the stock price goes down, you will offset the initial position. You can do this by entering a futures contract to sell (short position) the stock at a certain time and price in future.
Volatility is a measure of variation of prices. A more volatile instrument is one which has more drastic price movements.
Srikanth: So then we would profit both ways? And what if I do not want to sell my stock?
Prof Nikki: Don’t you wish! Unfortunately no, because whichever way the stock moves, the gains from one position would be offset by losses from the other.
And you don’t really have to sell your stock if you don’t want to, you can either close out your position by entering a contract to buy stock (long position) or if the contract allows it, you can settle by paying the equivalent cash value.
Srikanth: Hmmm… So if the losses and gains keep cancelling and doesn’t give me additional gains, why should I go through the effort of entering into a futures contract?
Prof Nikki: One reason could be that you really like a stock that you own, something that has been a good solid company, pays good dividends etc, but is presently experiencing some trouble. In this case, you do not want to sell yet, but want to protect yourself from a very sharp decline in price…so you lock in a price and wait.
Srikanth: That makes sense, I do have a few stocks like that. With the economy in doldrums, the stocks are indeed showing signs of what you call ‘volatility’.
Prof Nikki: Yes. But do remember that futures are financial instruments and not magic wands that eliminate risk. Be sure to read up on them in detail, especially about margins before you put your money in them.
Srikanth: Sure Prof!