??By Ajay Krishnan,?Knowledge Partner & Educator, EZWealth?
In the previous article, we explored the basics of currency futures. In this one, we will take a closer look at various futures trading strategies and how to employ them.
Futures strategies in FX are also called ?spreads?. The reason is because we are employing two or more different contracts by utilizing the difference (or spread) of one of the aspects of the contract. This can be a function of time, price or location.
Why Use Spreads?
Using spreads is the most common method of reducing your margin requirement and to hedge the outright positional futures position that you might have entered into. As a risk management system, future spreads are used and recommended by professional FX traders worldwide. Let us see why using spread strategies are beneficial for you:
1.Increasing avenues of profit
2. Risk Management
Imagine you have bought the USDINR DEC futures at 73. You have done this because your view on the USD is bearish. But what if something unexpected (an announcement by Mr. Trump maybe) happens and the USD shoots up the roof? You stand to make a huge loss. So as to hedge this risk of the market turning against your view, you can employ a future spread. Let us see how we can do that.
Spreads can be broadly classified into three: Intracurrency spreads, Intercurrency spreads and Interexchange spreads.
Intracurrency Spreads
This kind of spreads make use of the same currency futures contract with different expiry dates. Hence as explained above, this is a function of time. This is mainly used to capture a narrowing or widening spread between two contracts with different maturities. Since the spread you are trying to capture is based on contracts expiring in different calendar months, these popularly called calendar spreads. This is based on the fact that nearer term contracts tend to be cheaper than farther term contracts, mainly due to interest rate differences and cost of carry. There are two ways you can employ calendar spreads: Future Bull Spread and Future Bear Spread.
Future Bull Spread?????????
When you are bullish on an asset over time, you would go long on the futures of that asset, so you tend to gain when the underlying appreciates. A future bull spread is created when you are long on the nearer term contract of that asset and short on the farther term contract of the same asset.
Example: Your view on the USDINR is bullish so you buy the USDINR NOV FUT at 73.85 and simultaneously short the USDINR DEC FUT at 74.10.
Why do we do this? Unlike taking an outright long position in the USDINR NOV FUT which can only make you money if the USD appreciates, now you have a back up option that will make you money even if the trade goes the other way! As there are two ?legs? to this trade, let us see how our pay off will be:
1. USDINR NOV FUT appreciates; USDINR DEC FUT appreciates by the same amount ? Slight loss (as DEC FUT are priced higher).
2. USDINR NOV FUT appreciates; USDINR DEC FUT appreciates but lower ? Slight profit
3. USDINR NOV FUT appreciates; USDINR DEC FUT depreciates ? Maximum profit
4. USDINR NOV FUT depreciates; USDINR DEC FUT depreciates by the same amount ? Slight profit (as DEC FUT are priced higher)
5. USDINR NOV FUT depreciates but not as much as DEC FUT; USDINR DEC FUT depreciates ? Slight profit
6. USDINR NOV FUT depreciates; USDINR DEC FUT appreciates ? Maximum loss.
As you can see above, there are 4 times you will end up making profit out of 6 times giving you a risk-reward ratio (RRR) of 2:3 (66.6%) which is much better than the RRR of an outright long futures position which is 1:2 (50%).
The second reason we do this is due to the way it helps us manage risk. I cannot say this enough, but as an investor your aim should always be to ?manage risk? first before ?making profits?. You will see that, amazingly, when your risk is minimised the profits start to come automatically. Bull spreads are just really trading the price difference (spread) between the two contracts, and you can see that such spreads do not move abruptly and are predictable to a large extent. Due to this in the global FX markets, a spread is usually considered as a ?single position? by the brokers and require much lower margin requirements. Of course, this is because of better risk management.
When to Use the Future Bull Spread
We can use this strategy when you expect the spreads to narrow down between two different months. If you are planning to use an arbitrage opportunity, then you would want the spreads to widen.
The main opportunity to use the spread is when you think the near-term contract is going to appreciate in value much more than the farther month contract. This can be when you think an important announcement will boost the USDINR for a short while and then cool it down again in the medium to long term (like a temporary price hike on crude, which happened in the first week of October).
Conclusion
From the above discussion, it is clear that entering into a futures spread is much more logical and efficient than a single outright position due to the avenues of profit, management of risk and the capability to remain profitable even if the underlying remains stagnant ? even if the USDINR remains at 73 till December you still make a profit as you shorted the DEC FUT at 74.10 ? and the lower margin requirements due to the lower risk position.
In the next article, we will discuss Future Bear Spread and Intercurrency Spreads.
Next: Currency Future Strategies – II