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Learning Circle - Trading in Derivatives
Introduction to Index Futures
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Stock index futures contracts were first introduced by the Kansas City Board of Trade on February 24, 1982, followed by the Chicago Mercantile Exchange (CME) in April 1982. Trading in futures contract was based on the Standard and Poor's Index of 500 common stocks . The introduction at both centers was successful. The S&P 500 futures contract, came to be adopted by most institutional investors. Stock index futures are traded in terms of number of contracts. Each contract is to buy or sell a fixed value of the index. The value of the index is defined as the value of the index multiplied by the specified monetary amount. In the S&P 500 futures contract traded at the Chicago Mercantile Exchange (CME), the contract specification states: 1 Contract = $250 * Value of the S&P 500 If we assume that the S&P 500 is quoting at 1,000, the value of one contract will be equal to $250,000 (250*1,000). The monetary value -- $250 in this case -- is fixed by the exchange where the contract is traded. We have already seen that, futures contracts were introduced in India by BSE (BSE Sensex) in June 2000, and NSE (S&P CNX Nifty) by September 2000. The operations are similar to that of the stock market, the exception being that, in index futures, the marking-to-market principle is followed, that is, the portfolios are adjusted to the market values on a daily basis. Depending on the position of the portfolio, margins are forced upon investors. The other important aspect of index futures is that the contracts are settled on a cash basis. This means it is impossible to make actual delivery of the index. The difference between the cash and the futures index on the date of settlement is the profit/loss for the players. The introduction of the index futures has actually reduced the volatility in the underlying index. The other important use of stock index futures is for hedging. Mutual funds and other institutional investors are the main beneficiaries. Hedging is a technique by which such institutions can protect their portfolios from market risks 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. The BSE 30 Sensex, first compiled in 1986 is a market capitalisation weighted index of 30 scrips. It represents 30 large well-established and financially sound companies. The Sensex also has the largest social recall attached with it. It was the first index to be launched by any Stock Exchange in India and has acquired a unique place in the collective. For more information on BSE Sensex visit the site. Futures trading will be of interest to those who wish to :-
In the cash market, the issuers issue securities, and investors trade in those securities. However, with futures, there is no issuer company, and hence, there is no fixed issue size. Buyers and sellers determine the quantity of future contracts available in the market. A contract (trade) takes place when a buy order and sell order matches on the screen. The total number of net open contracts that exist at a point is called open interest. SEBI has banned badla trading and instead has introduced futures as a derivative product. It is pertinent to study what is badla trading and how does it compare with futures? In a badla transaction when you buy stocks, instead of paying cash, you can ask your broker to find a borrower to finance your trade. This process of buying stocks with borrowed money is badla trading. The stock exchange acts as an intermediary between you and the actual lender. You will be charged an interest rate for borrowing, which will be determined by the demand for that stock under badla trading. Thus, higher the demand for Infosys under badla trading higher will be the interest rate. You can keep your borrowing unpaid for a maximum of 70 days, after which you will have to repay the badla financier through the exchange. SEBI has also permitted single-stock futures, and you can buy, say, 10 Infosys futures that will at maturity give you 1,000 Infosys shares on payment of money. You will initially pay a margin and buy 10 futures contract. This is similar to the broker placing a margin on badla trades. The futures contract will be marked-to-market on a daily basis. This means that if you buy Infosys futures today at Rs 3,750 and the price in the futures market goes up to Rs 3,800 the next day, you will have to deposit with your broker Rs 50 (3,800-3,750) times 10 (the number of futures contract). You will likewise receive money if the futures price goes below Rs 3,750. Of course, in badla trading, it is the broker who has to maintain a marked-to-market margin and not the buyer/seller as in the case of futures. In essence, however, both futures and badla system allow investors to buy stocks without huge cash outflow. In other words, both help in leveraged trades. It is, perhaps, due to this similarity that SEBI decided to ban badla and introduce futures in line with the trends in developed countries. Stock index futures are considered to be appropriate in the Indian market because they require lower capital adequacy, and margin requirements compared to margins on carry forward of individual scrips. Brokerage costs on index futures is lower. The market is inclined to think in terms of index and and therefore would prefer to trade in terms of stock index futures. They are expected to be extremely liquid because of the speculative nature of our markets Computerized trading undertaken by large institutions to exploit differences in price between expiring stock index futures and the underlying stock when both should be equal. The resulting arbitrage play produces essentially risk-less profit. Program trading has been criticized for creating market turmoil, in effect producing risk-free profits for practitioners while increasing volatility for everyone else. But advocates of program trading say it makes a more efficient market by eliminating price differences between two items that are essentially the same. A long futures position results from buying futures contracts and a short futures position results from selling futures contracts. Generally, you take a long futures position if you anticipate a rise in the price of the underlying commodity and a short futures position if you anticipate a decline in the price of the underlying commodity. Spread trading can mean several things. Using futures contracts to speculate on movements of two assets is speculative spread trading. A hedge fund that bets on the narrowing of the spread between corporate bonds and Treasuries would buy futures on corporate bonds (hoping for falling corporate rates) and sell futures on the Treasuries (hoping for rising Treasury rates). If the spread narrows as anticipated, both contracts make a profit due to the inverse relationship between bond prices and interest rates. Spread trading can also be used to trade on anticipated trends. An investor anticipating a rise in a stock price may buy a call option with an exercise price closer to being in-the-money and sell a call option with an exercise price further out-of-the-money (both calls are on the same stock and have the same expiration date). The premium received on the option sold is used to offset the premium paid on the option bought. Hopefully, the stock price will rise enough to exercise the option bought but not quite enough to honor the obligation on the option sold (allowing the investor to pocket the premium as a profit). Be cautious with spread trading since it looks easier than it actually is. If you don't understand this answer, definitely do not participate in spread trading (and even if you do, still proceed with caution). How do I start trading Nifty futures? S&P CNX Nifty futures can be bought and sold through the trading members of National Stock Exchange. You may contact NSE members before deciding on the member through whom you would like to commence trading. To open an account with the trading member you will be required to complete the formalities which includes signing of member - constituent agreement, constituent registration form and a risk disclosure document. The trading member will allot you a unique client identification number. To begin trading, you must deposit cash or collateral, with your trading member as may be stipulated by him. Upon expiry, the futures contract will be cash settled by a cash amount equal to the difference between the previous day's settlement price of the contract and final settlement price as on the last trading day. Please note that there is no physical delivery of the individual stocks.. S & P CNX Nifty constituent comprise 50 highly liquid stocks. However in order to buy or sell Nifty futures, you need not own any of those securities, since there is no physical delivery. contract specification for Nifty futures
What Determines the Fair Price of an Index Futures Product? The pricing of index futures depends upon the spot index, the cost of carry, and expected dividends. For simplicity, suppose no dividends are expected, Nifty is at 1000 and suppose the one-month interest rate is 1.5%. Then the fair price of an index futures contract that expires in a month is 1015. The difference between the spot and the futures price is called the basis. When a Nifty futures trades at 1015 and the spot Nifty is at 1000, "the basis" is said to be Rs.15 or 1.5%. |
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