Derivatives

How to manage losses on short futures

Venkatesh Bangaruswamy | Updated on May 23, 2021

The strategy involves judicious use of ratio put spread

Last week, we discussed how moving from a long stock to a long call can moderate a behavioural attitude called disposition effect. This week, we discuss how to manage losses on short futures or short stock position.

Adding spread to futures

Suppose you have a view that the underlying will decline to 14,620. You short the near-month futures contract on the underlying at 14,955. Three days later, futures price climbs to 15,150. What should do you? You have a 195-point loss on your position. But what if you believe that the underlying can decline subsequently to 15,040?

You should add a ratio put spread to your short futures position. That is, you should go long on one contract of a higher strike put and short on two contracts of a lower strike put. It is important to maintain this ratio of 1:2 on the spread.

In the above example, given the view that the futures will decline to 15,048, you should buy one contract of the 15,100 put and short two contracts of the 15,000 put. You should be able to buy the 15,100 put for 106 points and short the 15,000 put for 69 points. You can, therefore, set up a ratio put spread for a net credit of 32 points (106 less 138).

Now, suppose the near-month futures trades at 15,040 at contract expiry (note that futures price converges with the spot price at expiry). Your futures position would suffer a 85-point loss. Your ratio put spread would gain 60 points (15,100 less 15,040), the intrinsic value of the 15,100 put. The 15,000 put will expire worthless, leaving you with an inflow of 92 points and a loss of 85 points for a net inflow of seven points.

The maximum profit on the position will be the difference between the future price at contract initiation less futures price at expiry plus the net credit from the spread plus the difference between the option strikes. Suppose the futures price at contract expiry is 15,000, then the maximum profit will be 87 points (14,955 less 15,000 plus 32 plus 100).

What if the underlying moves below 15,000, the lower strike put? Note that one short position on the 15,000 put is covered by the long position on the 15,100 put. But the other short put will accumulate losses. If the spot price is between 15,000 (the lower strike put) and 14,955 (the price at which the short futures position was initiated), then the short put will gather losses. Suppose the spot price is 14,955, the short put will carry a 45-point loss, the difference between the lower strike put and the spot price. There will no-gain no-loss on the short futures position, as the futures price at initiation is equal to the spot price at expiry. So, the total loss on the position will be 13 points i.e., 45 points on the short put less the net credit of 32 points on the ratio spread.

Optional reading

The choice of strikes on the ratio spread is based on several factors. One, the long strike should be close to the futures price at the time you are setting up the spread. Two, the short strike should be preferably one strike below the level at which you believe futures price (spot price) will take support.

The strategy of attaching a ratio spread to the short futures would be meaningful if two conditions are fulfilled. First, you gain a sizeable net credit on the put spread. Second, the lower strike put is closer to the price at which you initiated your short futures position.

Note that the put spread can also be added to a short underlying position. But you may have to incur borrowing cost, as you have to borrow the stock to meet delivery requirements in the spot market.

The author offers training programmes for individuals to manage their personal investments

Published on May 23, 2021

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