Investors guide to index futures

STOCK index futures have arrived in India, but for the layman remains an unknown area.

Some frequently asked questions on futures and their mechanism.

What are stock index futures and options?

A futures or options contract based on a set of underlying securities is called a `Stock Index Futures or Options Contract'. When trading takes place in stock index futures, it means that the participants are taking a view on the way the index will move. By trading in index-based futures and options, you buy or sell the 'entire stock market' as a single entity.

S&P CNX Nifty is a scientifically developed index of which top 50 bluechip companies form a part. The index covers more than 25 industry sectors and is professionally managed by India Index and Services Ltd. IISL has a licensing and co-branding arrangement with Standard & Poor's (S&P), the world's leading provider of investible equity indices, for co-branding IISL's equity indices. Daily derivatives trading based on S&P 500 index is over $50 billions. S&P CNX Nifty can be used for the purpose of speculation, hedging as well as an arbitrage tool.

Have you bought a share hoping it will go up? Have you ever felt that a stock was intrinsically undervalued? That the profits and the quality of the company made it worth a lot more as compared with what the market thinks? Have you ever been a `stockpicker' and carefully purchased a stock based on a sense that it was worth more than the market price?

When doing this, you face two kinds of risks:

Your understanding can be wrong, and the company is really not worth more than the market price, or

The entire market moves against you and generates losses even though the underlying idea was correct.

The second outcome happens all the time. A person may buy Infosys thinking that it will announce good results and the stock price would rise. A few days later, S&P CNX Nifty drops, so he makes losses, even if his intrinsic understanding of Infosys was correct. There is a peculiar problem here.

Every buy position on a stock is simultaneously a buy position on S&P CNX Nifty. This is because a buy Infosys position generally gains if S&P CNX Nifty rises and generally loses if S&P CNX Nifty drops. It is useful to ask: does the person feel bullish about Infosys or about the index?

Those who are bullish about the index should just buy S&P CNX Nifty futures; they need not trade individual stocks.

Those who are bullish about the Infosys do wrong by carrying along a long position on S&P CNX Nifty as well.

There is a simple way out. Every time you adopt a long position on a stock, you should sell some amount of S&P CNX Nifty futures. When this is done, the stockpicker has `hedged away' his index exposure. How do you do this?

Size of counter position

We need to know the `beta' of the stock, that is, the average impact of a one per cent move in S&P CNX Nifty, upon the stock. If betas are not known, it is generally safe to assume the beta is 1. Suppose we take Lupin Labs, where the beta is 1.2, and suppose we have a long Lupin Lab position of Rs. 200,000.

The size of the position that we need on the index futures market, to completely remove the hidden S&P CNX Nifty exposure, is 1.2 * 200,000, that is, Rs. 240,000.

Suppose S&P CNX Nifty is at 1200, and the market lot on the futures market is 100. Hence, each market lot of S&P CNX Nifty is Rs. 120,000. To sell Rs. 240,000 of S&P CNX Nifty we need to sell two market lots.

We sell two market lots of S&P CNX Nifty (200 Nifties) to get the position:

Long Lupin Lab Rs. 200,000

Short S&P CNX Nifty Rs. 240,000

Long Infy, short Nifty example

October 1, 1999: You buy Infosys for Rs. 10 lakhs.

The expiry date of Nifty June futures is October 29, 1999.

Nifty spot is at Rs. 1,403.20 and Nifty futures is at Rs. 1,420.

The beta of Infosys is 1.2.

You need to sell 1.2*10 lakhs = 12 lakhs on the index futures, that is, 12 market lots.

October 29, 1999: Nifty fell 5.5 per cent.

October 29, 1999: Nifty spot at Rs. 1.325.45 and settlement price of Nifty October futures is also Rs. 1,325.45.

You close both positions earning Rs. 9,640, that is, your position in Infosys drops by Rs. 66,000 and your short position on Nifty gains Rs. 75,640.

Have you sold a share hoping it will go down? Have you ever felt that a stock was intrinsically overvalued? That the profits and the quality of the company made it worth a lot less as compared with what the market thinks? Have you ever been a `stockpicker' and carefully sold a stock based on a sense that it was worthy less than the market price?

His understanding can be wrong, and the company is really worth more than the market price, or,

AThe entire market moves against him and generates losses though the underlying idea was correct.

The second outcome happens all the time. A person may sell Infosys, expecting that it would announce poor results and the stock price would fall. A few days later, S&P CNX Nifty rises, so you make losses, even if your intrinsic understanding was correct.

There is a peculiar problem here. Every sell position on a stock is simultaneously a sell position on S&P CNX Nifty. This is because a short Infy position generally gains if S&P CNX Nifty falls and generally loses if S&P CNX Nifty rises. It is useful to ask: Does the person fell bearish about Infy or about the index?

Those bearish about the index should just sell S&P CNX Nifty futures; they need not trade individual stocks.

Those bearish about Infy do wrong by carrying along a sell position on S&P CNX Nifty as well.

There is a simple way out. Every time you adopt a short position on a stock, you should buy some amount of S&P CNX Nifty futures. When this is done, the stockpicker has `hedged away' his index exposure. The basic point of this hedging strategy is that the stockpicker proceeds with his core skill, that is, picking stocks, at the cost of lower risk.

Example

July 1, 1999: You sell Infosys of Rs. 10 lakhs.

The expiry date of Nifty July futures is July 30, 1999.

Nifty spot is at Rs. 1,183.20 and Nifty futures are trading at Rs. 1,200.

The beta of Infosys is 1.2.

Hence, you need a long position of 1.2*10 lakhs = 12 lakhs on the index futures, that is, 12 market lots.

July 30, 1999: Nifty rises by 10.7 per cent due to stable political outlook.

On July 30, 1999 Nifty spot/Nifty June futures closed at Rs. 1,310.15.

You unwound both positions losing Rs. 18,250. That is, your position on Infosys loses Rs. 128,400 and your buy position on Nifty gains Rs. 1,10,150.

How to protect your portfolio from nuclear bomb?

Have you ever experienced the feeling of owning an equity portfolio, and then, one-day, becoming uncomfortable about the overall stock market? Sometimes, you may have a view that stock prices will fall in the near future. At other times, you may see that the market is in for a few days or weeks of massive volatility, and you do not have any appetite for this kind of volatility. The Union Budget is a common and reliable source of such volatility: Market volatility is always enhanced for one week before and two weeks after a budget. Many investors simply do not want the fluctuations of these three weeks.

This is particularly a problem if you expect to sell shares in the near future for example, in order to finance a purchase of a house. This planning can go wrong if by the time you do sell shares, S&P CNX Nifty drops sharply. When you have such anxieties, two alternatives have always been available:

Sell shares immediately. This sentiment generates `panic selling' which is rarely optimal for the investor.

Do nothing, that is, suffer the pain of the volatility. This leads to political pressures for government to `do something' when stock prices fall.

In addition, with the index futures market, a third and remarkable alternative becomes available:

Remove your exposure to index fluctuations temporarily using index futures. This allows rapid response to market conditions, without `panic selling' of shares. It allows an investor to be in control of his risk, instead of doing nothing and suffering the risk.

The idea here is quite simple. Every portfolio contains a hidden index exposure. This statement is true for all portfolios, whether one is composed of index stocks or not. In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations (unlike individual stocks, where only 30-60 per cent of the stock risk is accounted for by index fluctuations). How do we actually do this?

Example

May 25, 1998: You have a portfolio of 5 securities of Rs. 1,87,085.

The expiry date of Nifty June futures is June 26, 1998.

Nifty spot is at 1122.95 and Nifty futures are trading at 1141.

The beta of the portfolio is 0.95.

Hence, he needs to sell 0.95*187085 = Rs. 177,731 on the index futures, that is, 2 market lots [187085/(1141*100)]

June 10, 1998 Nifty crashes to 962.90, and Nifty June futures at 970.63

Portfolio value reduced to 154095.

You unwound both positions making a profit of Rs. 1096, that is, the portfolio dropped by Rs. 32990 and your sell position on Nifty gained by Rs. 34,086

Tackling the ups and downs

YOU think the market will go up? Do you think that the market index is going to rise? That you could make a profit by adopting a position on the index? After a good Budget, or good corporate results, or the onset of a stable government, many people feel that the index would go up. How does one implement a trading strategy to benefit from an upward movement in the index?

Today, you have two choices:

Buy select liquid securities, which move with the index, and sell them at a later date, or

Buy the entire index portfolio and them sell it at a later date.

The first alternative is widely used -- a lot of the trading volume on stocks such as Hindustan Lever is based on using it as an index proxy. However, these positions run the risk of making losses owing to Hind Lever-specific news; they are not purely focussed upon the index.

The second alternative is hard to implement. An investor needs to buy all the stocks in S&P CNX Nifty in their correct proportions. Most retail investors do not have such large portfolios. This strategy is also cumbersome and expensive in terms of transactions costs.

Taking a position on the index is effortless using the index futures market. Using index futures, an investor can `buy' or `sell' the entire index by trading on one single security. Once a person buys S&P CNX Nifty using the futures market, he gains if the index rises and loses if the index falls.

Example

January 5, 2000: You feel the market will rise.

Buy 100 S&P CNX Nifty January futures contract at Rs. 1450 costing Rs. 145,000 (100*1450)

Expiration date: January 28, 2000.

January 14, 2000 Nifty January futures rise to Rs. 1,470.

You sell your position at Rs. 1,470.

Make a profit of Rs. 2,000 (100* 20)

You think the market will go down? Do you sometimes think that the market index is going to fall? That you could make a profit by adopting a position on the index? After a bad budget, or bad corporate results, or the onset of a coalition government, many people feel that the index would go down. How does one implement a trading strategy to benefit from a downward movement in the index?

Today, you have two choices:

Sell select liquid securities which move with the index, and buy them at a later date, or

Sell the entire index portfolio and then buy it at a later date.

The first alternative is widely used -- a lot of the trading volume on stocks like ITC is based on using ITC as an index proxy (ITC has the highest correlation with S&P CNX Nifty amongst all the stocks in India). However, these position run the risk of making losses owing to ITC-specific news; they are not purely focussed upon the index.

The second alternative is hard to implement. This strategy is also cumbersome and expensive in terms of transaction costs.

Taking a position on the index is effortless using the index futures market. Using index futures, an investor can `buy' or `sell' the entire index by trading on one single security. Once a person sells S&P CNX Nifty using the futures market, he gains if the index falls and loses if the index rises.

Example

February 8, 2000: You feel the market will fall.

Sell 100 S&P CNX Nifty February expiry contract.

Expiration date February 25, 2000.

Nifty February contract is trading at Rs. 1,560.

Your position is worth Rs. 156,000.

February 15, 2000: Nifty February futures fall to Rs. 1,520.

You square off your position at Rs. 1,520.

Make a profit of Rs. 4,000 (100*40)

Edited-excerpts from Investors' Guide, published by the National Stock Exchange of India (NSE). Source: www.nse-india.com/marketlist/dupdate.htm