What is trading?
A short position
Futures contracts
are Derivatives
Stocks
Bonds
Derivatives
are all different
types of securities
Stocks
Bonds
Till, now we have
mostly spoken
about
stocks
Derivatives
Derivatives
Derivatives are
contracts whose value
depends on the value of
some other entity
A stock, bond, currency,
commodity etc
Derivatives
A stock, bond, currency,
commodity etc
Derivatives allow folks to
bet on the value of the
underlying asset without
actually owning it
Derivatives
Futures
Options
For wards
Swaps
are all different
kinds of
derivatives
Derivatives
Futures
Options
Derivatives are a
very vast area by
For wards
themselves
Swaps
Derivatives
Futures
Options
For wards
Swaps
Understanding a little bit
about how they work, will
help us understand some of
the mechanics of trading
Derivatives
Futures
Lets spend a little
Options
bit of time on
For wards futures contracts
Swaps
Futures
A Futures contract is a contract
bet ween 2 parties
to buy/sell an asset
at a fixed future date
at an agreed price
Futures
A Futures contract is a contract
bet ween 2 parties
Vitthal will sell Swetha
to buy/sell an asset
10 tons of wheat
at a fixed future date
at an agreed price
on Jan 31, 2017
at INR 15/kg
Futures
A Futures contract is a contract
bet ween 2 parties
to buy/sell an asset
Vitthal will sell Swetha
10 tons of wheat
at a fixedThis
future
date
on
Jan
31,
2017
could be anything - stock,
at an agreed
price
bond, currency or a at
commodity
INR 15/kg
like oil, gold, wheat etc
Futures
A Futures contract is a contract
bet ween 2 parties
Vitthal will sell Swetha
Expiry
date
of
the
contract
10
tons
of
wheat
to buy/sell an asset
at a fixed future date
at an agreed price
on Jan 31, 2017
at INR 15/kg
Futures
A Futures contract is a contract
bet ween 2 parties
Vitthal will sell Swetha
Expiry
date
of
the
contract
10
tons
of
wheat
to buy/sell an asset
at a fixed future date
at an agreed price
on Jan 31, 2017
at INR 15/kg
Futures
A Futures
contract price
is a contract
The market
of the
asset
is
Vitthal
will
sell
Swetha
betcalled
ween 2 parties
the spot price
10
tons
of
wheat
to buy/sell an asset
at a fixed future date
at an agreed price
on Janprice
31, 2017
For ward
at INR 15/kg
Futures
A Futures contract is a contract
bet ween 2 parties
Vitthal will sell Swetha
to buy/sell an asset
10 tons of wheat
at a fixed future date
at an agreed price
on Jan 31, 2017
at INR 15/kg
Futures
Vitthal will sell Swetha
on Jan 31, 2017
10 tons of wheat
at INR 15/kg
In this contract
Vitthal benefits if the spot price
of wheat on Jan 31 < INR 15
Futures
Vitthal will sell Swetha 10
tons of wheat
on Jan 31, 2017 at INR 15/kg
Spot price of wheat on
Jan 31 , 2017
< INR 15/kg
Vitthal will benefit
> INR 15/kg
Swetha will benefit
Futures
Vitthal will sell Swetha 10
tons of wheat
on Jan 31, 2017 at INR 15/kg
Vitthal will benefit if wheat
price falls below INR 15
Short Position
Swetha will benefit if wheat
price rises above INR 15
Long Position
Futures
The price of the futures contract
is directly dependent on the spot
price of the underlying asset
Futures
If the spot price increases ,
futures price increases and
vice versa
Futures
Futures contracts allow traders
to bet on the value of something
without directly investing in it
Futures
For example, a futures contract on a
stock market index, allows the trader
to go long or short on the index
Futures
In addition to this, there are 4
important differences bet ween trading
futures and trading stocks directly
Futures
4 important differences
1. It is far easier to express a short view on a
stock or a commodity via futures than via the
underlying stock or commodity itself - no need to
borrow
Futures
4 important differences
2. Futures have an expiry date
You can hold on to a
stock forever
Futures
4 important differences
2. Futures have an expiry date
On the expiry date, the
futures contract will s ettle
Futures
4 important differences
2. Futures have an expiry date
The settlement could be a cash
settlement or a physical settlement
Futures
4 important differences
2. Futures have an expiry date
In a cash settlement, when the futures
contract expires, the cash value of the
underlying asset will change hands
Futures
4 important differences
2. Futures have an expiry date
In a physical settlement, the actual
stock or commodity is transferred this can be a pain, and is not the norm
Futures
4 important differences
3. Futures have a margin requirement
To minimize the risk of default on the
contract, traders need to maintain a cash
margin at a brokerage/clearing house
Futures
4 important differences
3. Futures have a margin requirement
A cash balance of 5-15% of the
futures contract value needs to
be maintained by the trader
Futures
4 important differences
3. Futures have a margin requirement
As the spot price of the underlying asset changes,
futures value changes,
cash balance requirement changes
Futures
4 important differences
3. Futures have a margin requirement
If the trader does not maintain the
required cash balance, then the broker
can close out the position
Futures
4 important differences
4. Futures are marked-to-market on a daily
basis
Each day, the gains or losses on the
contract will be reflected in your account
Futures
4 important differences
4. Futures are marked-to-market on a daily
basis
This means that cash will flow into,
or out of, your account each day
Futures
4 important differences
4. Futures are marked-to-market on a daily
basis
This means that you could run into cash
flow issues if you trade on margin and
your position loses money
Futures
4 important differences
4. Futures are marked-to-market on a daily
basis
This daily mark-to-market is what leads to the
phenomenon of the dreaded margin call, where your
broker asks you to deposit cash or quit trading
Futures
What are futures
contracts used for?
Futures
What are futures contracts used for?
Hedgers
Speculators
Arbitrageurs
are the different
kinds of folks based
on why they invest in
futures/derivatives
Futures
What are futures contracts used for?
Hedgers
Speculators
Arbitrageurs
Hedging is the
process of
protecting against
exposure to risk
Futures
What are futures contracts used for?
Hedgers
A farmer who produces
wheat might buy a
Speculators futures contract to
hedge
against
the
risk
Arbitrageurs of wheat prices falling
Futures
What are futures contracts used for?
Hedgers
Speculators
Arbitrageurs
Speculators have a
point of view on which
direction the price of
the asset will go
Futures
What are futures contracts used for?
Hedgers
Speculators
Arbitrageurs
They use futures
contracts to go long or
short on an asset based
on that point of view
Futures
What are futures contracts used for?
Hedgers
are folks who
Speculators look for market
inefficiencies
Arbitrageurs
Futures
What are futures contracts used for?
Hedgers
Speculators
Arbitrageurs
For example, there is a
mathematical
relationship bet ween
the spot price and the
futures price
Futures
What are futures contracts used for?
Hedgers
Speculators
Arbitrageurs
If that relationship is
violated, for instance if
the futures contract is
too expensive relative
to the spot price
Futures
What are futures contracts used for?
Hedgers
Speculators
Arbitrageurs
Then buying in the spot
market and selling in
the futures market
can guarantee a profit
Futures
What are futures contracts used for?
Hedgers
Speculators
Arbitrageurs
This is called
an arbitrage
opportunity
Futures
What are futures contracts used for?
Hedgers
Speculators
Arbitrageurs
Arbitrageurs will rush
to exploit this, and the
spot price will rise, and
the futures price will
fall
Futures
What are futures contracts used for?
Hedgers
Speculators
Arbitrageurs
This will continue until that
mathematical relationship
is satisfied again, i.e. until
the arbitrage opportunity
closes
Futures
What are futures contracts used for?
Hedgers
Speculators
Arbitrageurs
In a perfect market ,
arbitrage opportunities
are rare and disappear
in a very short time
Quant itative Trading
with the help of
Financial Markets
Trading Strategies
developed using
Mathematical Models
involves trading in
Quant itative Trading
with the help of
Financial Markets
Trading Strategies
developed using
Mathematical Models
involves trading in
What is a trading
strategy?
What is a trading strategy?
A trader needs to make a
set of decisions each day
Which securities to trade?
Whether to go long or short?
How long should the position be held?
What is a trading strategy?
A Trading Strategy is a
set of rules that decides
Which securities to trade?
Whether to go long or short?
How long should the position be held?
What is a trading strategy?
An example:
Whenever the closing price >
opening price of a stock, go long
on the stock the next day
What is a trading strategy?
A Trading Strategy is a set of rules
These rules could be based on
experience, judgment, or instinct
What is a trading strategy?
A Trading Strategy is a set of rules
These rules could be developed
using quantitative models
What is a trading strategy?
A Trading Strategy is a set of rules
How do we figure out whether
a trading strategy is good?
What is a trading strategy?
A Trading Strategy is a set of rules
There are different measures to
help evaluate a trading strategy
Performance Measures
Return
The average upside/downside
Risk
The variability in the Return
Risk adjusted Return
Accounts for both
of the above
Return
Here is the price trend of Apple Stock over the last 5 years
Return
Lets say you bought some Apple shares in 2012
Return
As the price of the shares increases, you make a profit
Return
As the price of the shares decreases, you make a loss
Return
The net gain/loss you make
over the period that you
hold the stock is called the
Return
Pbuy
Psell
Return
Return
P
P
buy
sell
=
Return is usually
expressed as a %
Return
P
P
buy
sell
=
Return %
aka Return Rate
Pbuy
Return
How does Return
help in evaluating a
trading strategy?
Return
Compute the daily returns on your
trading strategy
Pyest
P
Daily Return % = today
Pyest
Return
P
Pyest
Daily Return % = today
Pyest
The Average Daily Return tells us
how the strategy has performed
Average Return
can be calculated based on
the frequency of trading,
daily/weekly/monthly
Average Return
This measure doesnt
account for the fact that
the returns might vary a lot
Average Return
This is exactly where
Risk comes in
Performance Measures
Return
The average upside/downside
Risk
The variability in the Return
Risk adjusted Return
Accounts for both
of the above
Risk
Risk is a measure of
variability in the Return
Risk
Risk is often measured as
The standard
deviation of returns
Risk
Standard deviation measures
of risk have some flaws
They do not perfectly capture some
forms of risk, such as tail risk
Risk
Even so, standard deviation
measures of risk are
Very common, and quite
robust - if used with caution
Risk
For now, lets use keep
things simple we will use the terms risk and
standard-deviation synonymously
Risk
Lets consider the Monthly return series of 2 stocks
Stock B
Stock A
2.5
1.875
1.25
0.625
April
May
June
July
April
May
June
July
Stock A
2.5
Risk
4
1.875
1.25
0.625
April
Stock B
May
June
July
April
May
Average monthly return
1.8% for both stocks
June
July
Stock A
2.5
Risk
4
1.875
1.25
0.625
April
Stock B
May
June
July
April
May
June
However, Stock B has much
more variability in the return
July
Stock A
2.5
Risk
4
1.875
1.25
0.625
April
Stock B
May
June
July
April
May
June
This variability makes it riskier
to invest in Stock B vs Stock A
July
Risk
In general, the higher the
average return of a security
The higher the risk as
well
Risk
The lower the risk of
an investment
the safer the
investment is
Risk
Theoretically, it is possible to
have a security with Zero Risk
The return from such a security is
called the Risk-Free Rate of Return
Risk
Zero Risk
In reality, all securities carry
some amount of risk
Risk
Zero Risk
Risk-Free Rate
of Return
Some government issued bonds can be
used as a proxy for a risk-free security
Its considered highly unlikely that the
government would default on its obligation
Risk
Zero Risk
Risk-Free Rate
of Return
Its considered highly unlikely that the
government would default on its obligation
But governments default quite often, and even
the US has flirted with defaulting on its debt, for
instance in 2011
Risk
Zero Risk
Risk-Free Rate
of Return
In general, an investor would not use
a trading strategy unless the return
is higher than the Risk Free rate of
return
