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Applications of Futures/Options

Trading Method
(1) Directional Trading

Futures trading means to enter into a Futures contract either to purchase or sell the Heng Seng Index at a future time. When an investor entered the market at certain price level of the index (either buy or sell at certain index level), the investor could take 3 types of action over different point of time in the course of the event:

i) The investor could wait for the contract to become expired and calculate the difference between the final closing price and the initial price of the future in order to determine the result of the investment.
ii) After the purchase and before the contract become expired, the investor could choose to close the contract during any trading days – if a future was sold then one must buy another back in order to close the deal, and vice versa.
iii) The investor could complete the whole trading process (i.e. a buy and a sale) on any given trading day.

The following example demonstrates how an investor trades at different times (trading fees not shown

  April Hang Seng Index Futures Price Difference Gain / Loss
April 2nd Morning Buy at 11,000    
April 2nd Afternoon Sold at 11,050 + 50 + $2,500
April 15 Sold at 111,00 + 100 + $5,000
April 29 (Last Day of trading) Closing Price 11,200 + 200 + $10,000

  April Hang Seng Index Futures Price Difference Gain / Loss
May 6th Morning Buy at 11,000    
May 6th Afternoon Sold at 11,050 + 50 + $2,500
May 16 Sold at 111,00 + 100 + $5,000
May 30 (Last Day of Trading) Closing Price 11,200 + 200 + $10,000
(2) Arbitrage


When price difference between 2 related products appears or is expected to occur, investor can take the opportunity and perform reverse trading to gain profit. When buying certain product and at the same time perform a sell on a related product is reverse trading. When the price of the two products changes profits exist. The most common example is the calendar spread. Calendar spread takes advantage of the price difference of the months on the Index Futures and executes reverse trading.

For example, an investor is expecting the decrease of the Index points difference and set up a strategy as follow:

On April 15th the investor buys a April contract and sells a May contract. The difference between the two contracts is 100 points. On April 28th the difference between the two reduces to 20 points. The investor sells the April and buys the May contract at the same time. The trading of the two contracts brings in 80 points of profit, i.e. $4,000.
 

  April Heng Seng Index Futures May Heng Seng Index Futures Difference
April 15th Buy at 11,000 Sells at 11,100 + 100
April 28th Sells at 11,200 Buys at 11,220 - 20
Total + 200 -120 + 80


  May Heng Seng Index Futures June Heng Seng Index Futures Difference
May 4th Sells at 11,400 Buys at 11,410 -10
May 21th Buys at 11,500 Sells at 11,560 +60
Total - 100 + 150 + 50

On May 4th the investor sells a May contract and buys a June contract. The difference between the two contracts is 10 points On May 21st the difference between the two increases to 50 points. The investor buys the May and sells the June contract at the same time. The trading of the two contracts brings in 50 points of profit, i.e. $2,500.
(3) Hedging

When an investor holds a stock or plans to purchase stock, the investor use future contracts to offset potential loss incurred by fluctuation of stock market.

Example: An investor holds a stock combination worth HK$10,000,000. The investor is expecting the market trading will be slow and is not ready to sell his combination in the short term. The investor sells Heng Seng Index Future contracts to reduce his loss over a falling market.

  Stock Market Future Market
April 1st Stocks combination worth $10,000,000 Future market priced at 10,000. sells 20 May Future contracts and total: 10000 * $50 * 20 = 10,000,000
May 15th Stock price falls. Stock combination falls to 9,500,000 Buys 20 May contracts at 9,500 points. Recover loss from future contracts trading(10000 – 9500) * $50 * 20 = $500,000
Using future contracts hedging, the investor recovers the loss incurred by the falling stock market from gain taken from the future market. However, if the expected market falls does not occur or the market rises, the loss incurred from the future market would then be offset by gain taken from the stock market.