As explained earlier any position on a stock involves the inherent
position on the market, so when you have bought Infosys betting on its
superior price performance you also bet on the upward movement of the
index. The degree of index that you have bought into Infosys (or any
other stock for that matter) is measured in terms of “beta” of the
stock.
Following are the basic modes of trading on the index futures market
Hedging Strategies
| Long stock, short index futures |
| Short stock, long index futures |
| Have portfolio, short index futures |
| Have funds, long index futures |
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Speculative Strategies
| Bullish view on index, long index futures |
| Bearish view on index, short index futures |
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Arbitrage Strategies
| Have funds , lend them to the market |
| Have securities, lend them to the market |
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Operators in the Futures markets
There are three classes of operators who use derivative markets :
| Hedgers – operators who want to transfer a risk component of their portfolio |
| Speculators – operators who intentionally trade in index futures in pursuit of profit |
| Arbitrageurs – operators who operate in different markets simultaneously, in pursuit of profit and efficient pricing. |
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Hedgers use Index Futures to mitigate the risk of market downturn
Suppose
a Fund manager of an FII perceives that his carefully selected
portfolio of stocks will be depreciated due to an upcoming political
crisis. In absence of Index futures he would have only two solutions to
counter the problem
Sell the entire holding and sit on cash, waiting
for the crisis to have its play, and reconstruct the original portfolio
at lower levels. |
Hold on to the original portfolio throughout the
ensuing crisis, watch its value shrink, and hope for better days to
recoup the lost values |
However, armed with
Index futures, he sells the entire value of the market risk on his
portfolio by selling Index Futures of equivalent amount i.e. going
short on Index. Suppose the Index is 5000 points when he executes his
sell. During the crisis, the Index loses 800 points to rule at 4200,
the Fund manager feels that the crisis is over, and should recover. The
Fund manager hence covers his short position by reversing the original
transaction, i.e. buying back equal number of Index futures at 4200
which he had sold at 5000.The gains made on 800 point difference would
cover the erosion in the value of his portfolio of stocks.
Thus effectively he has a hedge on the value of his portfolio.
Suppose
that his original assumption is wrong and market moves up instead of
capsizing, in such a scenario the losses made on index futures would be
roughly neutralised by the gains made on the portfolio.
Hedge between two markets
The
FIIs operating in India face risks of Rupee depreciation in addition to
risks of stock markets. Their clients would need to be repatriated
profits in foreign currency of their home country(or US dollars). Under
such circumstances it would be prudent for them to manage the risk of
rupee depreciation by hedging the portfolio value in Forex futures.
Currently derivative-based currency hedging mechanism is not available
in India. The FIIs, it is reported hedge their risks on Indian currency
by taking positions on the informal derivatives market in Singapore.
Thus risks are hedged across markets.
Delayed funds, don’t miss that rally
At
times you may want to enter markets expecting a bullish phase but the
funds flowing to you may take time in coming into your hands.
You
can take exposure to the equity markets by buying long futures
equivalent to the amount you want invested in the market ultimately.
You would have to pay approximately 8-12 percent of the entire
investment corpus to take an exposure of say Rs 5 million. You had say
Rs 500,000 upfront, which you invested, as margin for buying futures
worth Rs 5 million.
Example
You made a list of 14 stocks to buy, at 17th Feb prices, totaling approximately Rs.
5 million and decided to take delivery of stocks as and when your funds came in.
Say the S&P CNX Nifty was at 991.70. You
entered into a LONG S&P CNX NIFTY MARCH FUTURES position for 5000
nifties, i.e. your long position was worth 5,053,600. |
From 18th Feb to 9th Mar you gradually acquired
the stocks each day, purchased one stock and sold off a corresponding
amount of futures. |
On each day, the stocks purchased were at a
changed price (as compared with the price prevalent on 17th Feb). On
each day, you obtained or paid the ‘mark-to-market margin on your
outstanding futures position, thus capturing the gains on the index. |
| By 9th Mar you had fully invested in all the shares that you wanted (as of 17th Feb) and had no futures position left. |
The same sequencing of purchases, without the
umbrella of protection of the LONG S&P CNX NIFTY MARCH FUTURES
position, would have cost more had you to wait for all the funds to
arrive in your hands a month later as by that time stocks you had
listed would have appreciated. You were able to gain the appreciation
by way of long position on the index, which was used to partially
neutralise the rise in cost of your purchases. |
Bearish on Index, but shares not at hand
Reverse
strategy may be employed in case you feel that market is going to fall,
however, your shares are not available immediately. In such a scenario
you could just short the futures equivalent to the amount of your
entire portfolio and then cover your short position on futures when you
actually sell shares as and when they are available. The depreciation
in the sale price of your shares will be covered to an extent by the
profit you make on short-selling the index.
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Speculative Strategies
Speculators
in stock markets take advantage of the high leverage offered
(approximately 10 times to 12 times the funds available) by margin
system in the index futures to punt on index movements and profit from
the index movement.
You can either buy selected liquid securities,
which move with the index, and sell them at a later date, or buy the
entire index portfolio and then sell it at a later date.
The first
alternative is widely used – a lot of the trading volume on stocks like
HINDLEVER is based on using HINDLEVER as an index proxy. However, these
positions run the risk of making losses owing to HINDLEVER-specific
news; they are not purely focused 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 transaction costs.
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
| 5th Jan. – You feel the market will rise |
| Buy 100 S&P CNX NIFTY January futures contract at 1450 costing Rs.145000 (100*1450) |
| expiration date – 5th Jan. |
| 14th Jan. Nifty January futures have risen to 1470 |
| You sell off your position at 1470 |
| Make a profit of Rs. 2000 (100* 20) |
After
a bad budget, or bad corporate results, or the onset of a coalition
government, many people feel that the index would go down.
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
| 8th Feb – You feel the market will fall |
| Sell 100 S&P CNX NIFTY February expiry contract |
| Expiration date 25th Feb |
| Nifty February contract is trading at 1560 |
| Your position is worth Rs. 156,000 |
| 15th Jan. – Nifty February futures have fallen to 1520 |
| You square off your position at 1520 |
| Make a profit of Rs.4000 (100*40) |
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Arbitrageurs lend securities to market to earn return on long term holdings
The
index futures market offers a risk less mechanism for (effectively)
loaning out shares and earning a positive return for them. There is no
price risk (since you are perfectly hedged) and there is no credit risk
(since your counter party on both legs of the transaction is the
National Securities Clearing Corporation).
You would sell all 50
stocks in S&P CNX Nifty and buy them back at a future date using
the index futures. You would soon receive money for the shares you have
sold. You can deploy this money as you like until futures expiration.
On this date, you would buy back your shares, and pay for them.
How do we actually do this?
Suppose
you have Rs. 4 million of the S&P CNX Nifty portfolio (in their
correct proportion, with each share being present in the portfolio with
a weight that is proportional to its market capitalisation).
| Sell off all 50 shares on the stock market. |
| Buy index futures of an equal value. |
| A few days later (on NSE payout day), you will receive money and have to make delivery of the 50 shares. |
| Invest this money at the risk less interest rate. |
| On the date that the futures expire, put in order to buy the entire S&P CNX Nifty portfolio. |
| A few days later (on the NSE pay-in date), you will need to pay in the money and get back your shares. |
Example
You put in sell orders for Rs. 4 million of
S&P CNX Nifty using the feature in NEAT to rapidly place 50 market
orders, in quick succession. The seller always suffers impact cost;
suppose he contains an actual execution at 1098. |
A moment later, you put in a market order to buy
Rs. 4 million of the S&P CNX Nifty futures. The order executes at
1110. At this point, you are completely hedged. |
A few days later (approximately 15 days, at the
end of NSE settlement in which you sold your shares), you make delivery
of shares and receive Rs. 3.99 million (assuming an impact cost of
2/1100) |
| Suppose you lend this out at 1% per month for two months. |
At the end of two months, the money comes back to
you as Rs. 4,072,981. Translated in terms of S&P CNX Nifty, this
is1098 * 1.012 or 1120. |
On the expiration date of the futures, you put in
market orders to buy back your S&P CNX Nifty portfolio. Suppose
S&P CNX Nifty has moved up to 1150 by this time. This makes shares
costlier in buying back, but the difference is exactly offset by
profits on the futures contract. |
When the market order is placed, suppose you end
up paying 1153 and not 1150, owing to impact cost. You have funds in
hand of 1120 and the futures contract pays 40 (1150-1110) so you end up
with a clean profit, on the entire transaction, of 1120+40-1153 = 7. On
a base of Rs. 4 million, this is Rs. 25,400. |
Arbitrageurs lend funds in the stock market to earn superior return
Traditional methods of loaning money into the stock market suffer from
| Price risk of shares and |
| Credit risk, of default of the counterparty. |
Index
futures market supplies a technology to lend money into the market
without suffering any exposure to S&P CNX Nifty and without bearing
any credit risk.
The lender buys all 50 stocks of S&P CNX
Nifty on the cash market, and simultaneously sells them at a future
date on the futures market. It is like a repo. There is no price risk
since the position is perfectly hedged.
There is no credit risk
since the counter party on both legs is the National Securities
Clearing Corporation (NSCC) which supplies clearing services on NSE.
How do we actually do this?
To
buy all 50 stocks in S&P CNX Nifty on the cash market requires a
significant amount of money because of the minimum market lot
Calculate
a portfolio, which buys all the 50 stocks in S&P CNX Nifty in
correct proportion, i.e., where the money invested in each stock is
proportional to its market capitalisation.
| Round off the number of shares in each stock to the nearest market lot. |
| Buy all 50 shares in rapid succession into the NSE trading system. This gives you the buy position. |
A moment later, sell S&P CNX Nifty futures of
equal value. Now you are completely hedged, so fluctuations in S&P
CNX Nifty do not affect you. |
A few days later, you will have to take delivery
of the 50 stocks and pay for them. This is the point at which you are
“loaning money to the market”. |
| Some days later, at your discretion you will unwind the entire transaction. |
| Sell in rapid succession all the 50 shares you had bought at market price |
| A moment later, reverse the future position. Now your position is down to 0. |
A few days later, you will have to make delivery
of the 50 stocks and receive money for them. This is the point at which
“your money is repaid to you”. |
Example
On
1 August, S&P CNX Nifty is at 1200. A futures contract is trading
with 27 August expiration for 1230. You want to earn this return
(30/1200 for 27 days).
You buy Rs. 3 million of S&P CNX Nifty on the
spot market. In doing this, you place 50 market orders and end up
paying slightly more. Your average cost of purchase is 0.3% higher,
i.e. you have obtained the S&P CNX Nifty spot for 1204. |
You sell Rs. 3 million of the futures at 1230. The
futures market is extremely liquid so the market order for Rs. 3million
goes through at near-zero impact cost. |
| You take delivery of the shares and wait. |
| While waiting; a few dividends come into your hands. The dividends work out to Rs. 7,000. |
On 27 August, at 3:15, you put in market orders to
sell off your S&P CNX Nifty portfolio, putting 50 market orders to
sell off all the shares. S&P CNX Nifty happens to have closed at
1210 and your sell orders (which suffer impact cost) goes through at
1207. |
The futures position spontaneously expires on 27
August at 1210 (the value of the futures on the last day is always
equal to the S&P CNX Nifty spot). |
You have gained Rs. 3 (0.255) on the spot S&P
CNX Nifty and Rs. 20 (1.63%) on the futures for a return of near 1.88%.
In addition, he has gained Rs. 7,000 or 0.23% owing to the dividends
for a total return of 2.11% for 27 days, risk free. |
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