Index futures explained
A stock market index is made up of a basket of stocks that indicate the general movement of stock prices. Stocks that make up an index have to satisfy certain conditions like high market capitalisation, good liquidity, and so on. Index futures allow traders to cash in on the general movements in stock prices.
What are index futures
These futures are a kind of stock futures. But, before we get to that, let’s look at a quick definition of what a futures contract is. A futures contract allows a buyer or seller to buy or sell a particular commodity at a predetermined price (`strike price’) in the future. Stock futures will enable you to purchase a certain quantity of a specific stock at a predetermined price in the future.
Stock index futures work similarly. Let’s say, you think that the Nasdaq index will move up by 500 points shortly. So you purchase 100 Nasdaq index futures at USD 8,000 each. In the meantime, Nasdaq moves up to 8,500. You can then exercise the futures at USD 8,000 and make a neat profit of USD 2,50,000! Of course, if the index moves in the opposite direction and hits 7,500, you will have no choice but to buy at the strike price of USD 8,000 and lose USD 2,50,000!
In India, the first stock futures contracts were index-based, which were introduced in the year 2000. These futures are traded on stock exchanges like the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). They’re available for the BSE Sensex and the NSE Nifty 100. There are also many other indices – sectoral and otherwise – that are available for trading.
Types of index futures
- S&P BSE Sensex:30 underlying securities make up the BSE’s Sensitive Index or Sensex.
- Nifty 50: 50 underlying securities make up the NSE’s Nifty index.
- Nifty IT: Here, shares of information technology make up the underlying securities. Fortunes of these futures will depend on the performance of the overall sector.
- Nifty Bank: Bank shares make up this index. So, how the Nifty Bank futures will perform will depend on how well the banks are doing.
- S&P BSE Bankex: These futures consist of banking stocks listed on the Sensex.
- S&P BSE Sensex 50: This index includes 50 stocks instead of the 30 that make up the Sensex.
- S&P BSE Bharat 22 Index: This index is made up of 22 central public sector enterprises (CPSE).
- Others:You can also trade in these futures from foreign stock exchanges, for example, Standard & Poor’s 500 and FTSE 100 futures, on Indian exchanges like the NSE.
Who trades in index futures?
There are two broad types of traders in these futures. One section comprises those who are interested in hedging against share price movements. A portfolio manager may trade in these to hedge against any potential losses. If the prices in a portfolio decline, he or she can choose to sell these futures contract at a higher rate to offset the losses. However, such hedging will reduce overall profits.
Another kind of participant in this market is the speculator. For many speculators, futures are much better than single stocks since risks are spread out over a general basket of shares. In growing economies, indices will generally be on an upward path.
What is margin in index futures trading?
Before you start trading, you will have to deposit an initial margin with your broker. This is a percentage of the value of your transactions. It should also be enough to cover the most significant possible loss in one day, and both buyers and sellers have to deposit it.
Here’s how it works. If you want to trade in Rs 10 lakh worth of these futures and the margin is 5 percent, you will have to deposit Rs 50,000 with your broker. So, by depositing this small amount, you will be able to trade large volumes. This will increase the prospect of making a profit. However, this kind of `leverage’ can lead to considerable losses if the indices don’t move in the way you expect. Margins are relatively lower in futures of stock indices than other futures contracts.
What is the maturity period of an index futures contract?
These futures are available for maturity periods of one, two, and three months on a rolling basis.
How are index futures contracts settled?
At the end of the expiry period, the contract is settled in cash; that is, there is no delivery of shares. If the index is higher than the strike price at the end of the expiry period, the buyer would have made a profit, and the seller a loss. If the index is lower, then the seller or future writer incurs a loss.
However, you don’t have to wait until the expiry date to sell your futures. You can sell your position at any time before the end of the expiry date if you feel that these are not moving to your advantage.
What are the advantages and disadvantages of stock index futures?
| Advantages | Disadvantages |
| You can use leverage to take large positions, which will increase your chances of profit
|
The high leverage means that your losses will also be high if these futures don’t move in the way you expect |
| Investing in these futures is better than investing in individual stocks because the risks are spread out over several stocks
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Individual stocks do outperform the index on many occasions. So, you will lose out on that possibility of profit |
| Hedging is possible with these future contracts for portfolio managers. Any losses in the portfolio can be offset by selling their positions | Hedging increases costs for portfolio managers and may hence lower their overall profit |
| You need to pay only a fraction of the transaction as margin to trade large amounts | If you make losses on your position, the broker will demand an additional margin and may sell your position to recover it |
| Allows for making profits from market indices movements | There’s no guarantee that indices will always move upward, leading to losses |
What is index option?
First, let us understand what options are before we get to index options. Options are rights to buy or sell an underlying asset at a fixed price, also called the strike price, on a preset date in future, which is the date of contract expiration. In India, options expire on last Thursday of every month. The underlying securities could be anything from stocks, bonds, commodities, interest rate futures, or stock index. Options are named after the underlying assets like stock options, index options, currency options and commodity options.
Index Option Definition
In index options, the underlying asset is an index. It could be a stock index like the S&P 500, for example. Index options allow traders to take hedged exposure to all the company stocks or an entire market segment that are part of the index instead of taking bets on individual company shares.
Index option gives the owner the right to buy or sell exposure to indices as an underlying asset at a predetermined price on a fixed future date (last Thursday of every month).
Types of Index Options in India
There are two types of index options – call option and put option. Let us examine them in detail.
What is an index call option?
A call option gives the owner a right to buy a given quantity of an underlying asset, a stock index in this case, at a fixed price on the date of the expiry of the contract. The buyer of an option is said to go long on an option.
For example, if trader M is bullish and expects the current prices of say Nifty50 index to settle at a higher price band of say Rs.13,000-Rs.14,000, but the spot price is Rs. 12,000 per lot, he could buy a one-month call option on Nifty50 at a strike price of Rs.12,500. This includes payment of a premium to the underwriter which will be pocketed by the seller or underwriter.
Scenario 1
Now on the day the contract expires, M finds the spot price of Nifty50 trading at Rs. 13,200. Trader M will be said to be in the money, as the strike price of his index option contract would be lower than the spot price of the index. This difference of Rs.700 between the strike price and the current price is the profit.
Scenario 2
But what if the current price of Nifty50 on the day of contract expiry trails at Rs. 12,200? In that case, when the strike price is higher than the spot price of the index, the buyer of the option will decline to exercise his right of purchasing the underlying index at the strike price. In that case, the real loss would be limited to the premium amount he paid for the contract; and the option contract would be rendered worthless.
What is an index put option?
A put option on an underlying index is the right to sell the underlier at a set price on a specific date, or the expiration date. The seller or writer of an option contract is said to be short on an option.
Let us consider an example of a European put index option.
Suppose trader N is bearish and expects spot prices of Nifty 50 index to fall dramatically in a month, he would like to hedge his price risks by getting into a put option contract. If the spot price of Nifty50 index is at Rs.12,000 and trader N expects this price to go down, he would enter a put options contract at a mutually decided price of say Rs. 11,500 per lot.
On the day the contract expires, if the spot price of Nifty50 is anywhere less than the strike price of Rs.11,500, let’s assume at Rs.10,500, trader N can execute his right to sell the underlying stock at the pre-decided price of Rs. 11,500, making a decent profit of Rs.1000, which is the intrinsic value or the difference between the strike price and spot price of the underlying index.
But if on the day the option contract expires, the spot price of Nifty50 is higher than the strike price of Rs.11,500, at say Rs.12,500, then trader N will choose not to execute his right to sell at the strike price lower than the spot market price of the index. In that case, the trader would be said to be out of the money by Rs.1000. He will let the contract expire worthless by limiting his loss to the amount of premium paid by him.
Conclusion
Trading in stock index futures can be very fruitful if you do it properly. You don’t have to invest large amounts of capital and since you are investing in a basket of shares, risks are lower too. However, leverage can be risky if you are not careful. It certainly increases your chances of profits, but the risks are more substantial too.
