– By Ajay Krishnan,?Knowledge Partner & Educator, EZWealth?
For those who have trading experience in the equity market, the concept of futures would be easy to understand. But if you are true beginner, then let me make it simpler for you. In a futures contract, either of the parties agree to buy/sell an underlying in the future at a price that is decided in the present day.
For e.g., if you buy USDINR futures for December at 70 and the spot price of USDINR in December at expiry is 72, then you make a profit of Rs. 2/- on that contract. This happens when you have a bullish view on the USDINR. If your view was incorrect, USDINR might depreciate in the future and your long position will be in a loss.
This works very similar to buying and shorting of equities and is easy to understand. And since spot trading is not allowed on exchanges in India, currency futures are the closest instrument you have for straightforward trading in FX.
Types of Participants in the Futures Market
Before jumping into the intricacies of futures trading, let us take a moment to understand the various players in the FX futures market. This is necessary because you need to know who you will be playing against!
1. Hedgers:?These types of participants have a real exposure to foreign currency risk on account of their underlying business and their objective is to remove the FX risk using currency futures. They are usually exporters/importers who try to lock in the future currency rates in the face of uncertainty. They are also the big boys at the table.
2.Speculators: This set of market participants does not have a real exposure to foreign currency risk. These participants assume FX risk by taking a view on the market direction and hope to make returns by taking the price risk. Most FX traders come under this category. In fact, it is estimated that almost 80% of the global FX transactions are speculative.
3.Arbitrageurs: They check for any opportunities of arbitrage in the market and try to make a profit out of it. For e.g., if they see USDINR is trading in the forward market (OTC market) at 72.085 and the future market (exchanges) at 72.285, arbitrageurs will buy forwards and sell futures thereby making a profit of 20 paise per dollar (200/- per lot). They also influence FX prices by buying dollars in the Indian markets and selling them at a higher price in the off-shore markets or vice-versa (NDF markets especially, we will come to this later).
Spreads Trading
As we discussed in the previous article, the spot currency market in India is inaccessible to the retail traders. In global markets, spread trading is a very common and winnable strategy. In classic spread trading, you buy the spot and short the future of the same underlying. This is because in FX, the futures price is almost always higher than the spot (due to interest rate parity which will be covered subsequently).
For e.g., take the case of the USDINR ? the future price of the pair has been higher than the spot 90% of the time. There are times when the spread (difference between the buy and sell prices) is higher than it normally is. If you are able to figure this out, then this provides the trader with an ?arbitrage? opportunity. If he thinks the future price is higher/lower than it should be, then he can go long/short on the spot and short/go long on the futures thereby taking the spread as profit. Wonder what kind of market player does this? You?re right, arbitrageurs!
However, since the currency spot market is inaccessible to the retail traders in India, we cannot really do this.
So, we do the next best thing ? spread trading the futures! This is easy to understand ? instead of buying the spot and shorting the futures at 3 months (for e.g.), we buy the 1-month futures and short the 4-month futures. This essentially gives us the same calendar period ? 3 months in this case ? and hence, are called Calendar spreads.
In calendar spreads, the trader has to decide if the spread between two future contracts (same underlying but different maturities) is ideal or otherwise. The farther month futures contract will always be at a premium to the nearer month futures contract, if all other variables are equal. For example,
USDINR OCT FUT – 73.085
USDINR NOV FUT – 74.110
When you look at the prices above, you can see the spread is 1.025. But from your observations in the past, the spread between two consecutive months should be around 0.800. So here, you have an arbitrage opportunity of 0.225. In that case, would it not be profitable to buy October futures and sell November futures? Yes sir! If you square off your trades before expiry (at which time spot becomes equal to future price), you get to keep this spread profit! Just like how you would trade premiums and not wait for an option to expire ? is it getting clearer now?
The difficult part is, to recognise whether a spread trading opportunity exists or not. Due to this, only experienced traders and arbitrageurs are able to make consistent profits through this method.
Regardless, let us explore the two major futures strategies in FX:
Intra currency spreads (or Calendar spreads) and Inter currency spreads (buying and selling different currencies with same maturities).
Before we dive in to them, let us understand the rationale behind the changing spreads between currency pairs. Spreads are influenced by mainly three factors:
i) Interest rate differential between the two countries (currencies)
ii) Liquidity in the FX market and the banking system
iii) Monetary policy decisions (Repo rates, Reverse repo rates, Cash Reserve Ratio etc)
Due to the various fundamental factors involved in FX futures, it is prudent to keep abreast of the latest news and developments around the world as all these contribute to the strength or weakness of the US Dollar. And since we will be focusing on USDINR pair for the most part in this series, the same becomes mandatory to make consistently profitable trades. In the next article, we will cover the Intra currency spreads, also popularly called the Calendar spread.