Saturday, February 03, 2007

Tutorial on trading futures

This is a small tutorial on how to make arbitrage profits from trading futures.

What are futures?
The futures contract calls for delivery of a commodity at a specified delivery or maturity date, for an agreed-upon price called the futures price, to be paid at contract maturity.

How to get the price information?
Let us take Gold for example. We can get the spot price (current trading price of the commodity) and the futures price from various sources. We also need the risk-free rate or Treasury Bill rate. Let us use Wall Street Journal market place.

Here is the information after th bell today, 2/2/2007.

Gold spot price - $647.45 (So)
6-month T-bill rate - 5.152% (Rf)

You will also find the list of all Gold futures prices here.
(From there, I got
Gold August-07 price (6 months from now) - $663.9 (Fo)
We will not need this information now, it is for comparison)

How to make arbitrage profits by trading Gold futures?
If the markets were efficient, the Spot-Future parity must hold good.
Fo = So (1 + Rf)^T

where T in our case = 0.5 years, as I'm estimating the 6-month futures price of Gold.
Plugging in the data we got from WSJ,

Fo = 647.45 * (1+.05152)^0.5
= $663.91

Now if we check what the 6-month Gold future contracts are trading in the market at, we see that it is $663.9 too ! If it were selling for less than $663.9, people could make arbitrage profits. Since the market is efficient, in that case, there will be buying and selling of such contracts till the market corrects itself to sell 6-month futures at $663.9, and that is what has happened here.

Now for argument sake, let us suppose, Gold is trading at $663.0 instead of $663.91. I'll show you how to make profits

1. Today
(a) Long the Gold futures. So there is no cash flow now. You have just entered an agreement to buy at a future date for $663.0
(b) Go short on Gold. ie. sell Gold at its current spot price. You get $647.45.
(c) Invest this money in T-bills maturing at the end of 6 months from today

2. After 6 months
(a) You will get 647.45(1.05152)^0.5=$663.91 from the T-bills
(b) Use $663.0 out of that to pay for the futures contract and get the Gold
(c) Use this Gold to cover your short position
(c) $0.91 is your profit left on the table! Enjoy!



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