Trading Futures

To understand futures trading and profit/loss that can occur while trading, knowledge of pay-off

diagrams is necessary. Pay-off refers to profit or loss in a trade. A pay-off is positive if the

investor makes a profit and negative if he makes a loss. A pay-off diagram represents

profit/loss in the form of a graph which has the stock price on the X axis and the profit/ loss on

the Y axis. Thus, from the graph an investor can calculate the profit or loss that his position can

make for different stock price values. Forwards and futures have same pay-offs. In other

words, their profit/loss values behave in a similar fashion for different values of stock price. In

this chapter, we shall focus on pay-offs of futures contracts.

Pay-off of Futures

The Pay-off of a futures contract on maturity depends on the spot price of the underlying asset

at the time of maturity and the price at which the contract was initially traded. There are two

positions that could be taken in a futures contract:

a. Long position: one who buys the asset at the futures price (F) takes the long position

and

b. Short position: one who sells the asset at the futures price (F) takes the short position

In general, the pay-off for a long position in a futures contract on one unit of an asset is:

Long Pay-off = S T – F

Where F is the traded futures price and ST

is the spot price of the asset at expiry of the contract

(that is, closing price on the expiry date). This is because the holder of the contract is

obligated to buy the asset worth ST for F.

Similarly, the pay-off from a short position in a futures contract on one unit of asset is:

Short Pay-off = F – ST

    Pay-off diagram for a long futures position