8. Trading index futures

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In this chapter, we will discuss the trading index future and its types. Bets which are made on the direction which the equities will take and that track with key stock market indexes are stock index futures.

In spite of the traditional markets closing, the stock index future trade at various times of the day. The stock index future trade can be very active which often leads to fast paced changes in the prices and sales.

What is actually a stock market index? The general movement of the stock prices of various stocks together constitutes a stock market index.  There are certain conditions which the tsocks have to meet in order to make up an index. The conditions are like- high market capitalisation, good liquidity etc. 

As a trader, you can cash in on the general movements in stock prices due to Index futures. 

What are index futures?

Before we begin to understand index futures, let us revise what futures contract is. With a future contract, as a buyer or seller, you can buy or sell a specific commodity in the future at a strike price which is a predetermined price.

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 specific commodity in the future at a strike price which is a predetermined price. 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 the same as future contracts. Index futures are similar to stock futures. Let’s understand this with an example- Shortly, the Nasdaq index will move up by 1000 points. 

Let us understand the advantages of futures

  • Speculation possibilities: As an investor you can speculate on future stock price performance. Even without owning the stock market index which is covered by the futures, you can give them more leverage, and also access to 24/7 securities trading in the markets which are highly regulated.
  • Costs to trade: When buying stock index futures contracts linked to the above indices, you’re paying much less than the listed price for the actual stock market index tracked by the futures contract. 

Cons Explained

The disadvantages of trading in futures are all about high risk and the necessity of holding cash:

  • Leverage risks: One downside of index futures investing is the high level of risk inherent in buying and selling such contracts. It's easy to wind up highly leveraged and lose your entire investment when market conditions go against you.
  • Cash and margins: There is one important distinction when investing in stock index futures. To participate, futures investors are required to keep cash in a margin account at a brokerage firm, which is required to cover steep losses on a futures trade. This occurrence is known as a margin call.

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

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

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 contracts 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.

Wrapping up

Now that you understand - Trading index futures? it’s only logical that we move on to the next module - Using Options Greeks.

A quick recap

  • Index futures are contracts to buy or sell a financial index at a set price today, to be settled at a date in the future.
  • Portfolio managers use index futures to hedge their equity positions against a loss in stocks.
  • Speculators can also use index futures to bet on the market's direction.
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