What Are Index Futures And How Do They Work? (2024)

Capital markets, which include stock and bond markets, provide a platform for buyers and sellers of stocks, indexes, currencies, and commodities. To mitigate the risk associated with investing or trading in these markets, derivative markets provide unique risk management tools.

Investors, traders, hedgers, and speculators are common participants in such markets. Each of these market participants plays a unique role in the development, growth, and expansion of these markets. More importantly, they add to the market depth and liquidity, which are both required for price discovery.

What Are Futures?

Simply put, futures are risk management tools available in the derivative market. These derivative contracts create an obligation between the buyer and seller to buy or sell an asset at a pre-decided future price and date. The asset in question can be a stock or index. These are forward contracts that are traded on exchanges like NSE or BSE. Futures contracts are standardized in nature, which means the terms of the contract, such as the expiry date and contract size, are decided by the exchange.

The NSE and BSE introduced futures trading In June2000. Initially, futures were allowed in Sensex and Nifty 50. Currently, futures trading is available in NIFTY 50,NIFTY Bank, NIFTY Financial Service and NIFTY Midcap Select and 188 securities.

Futures are used to profit from the trading in short-term price movements of the underlying asset, as opposed to investors who purchase assets like stocks for long-term prospects. By buying a futures contract, one can profit from the expected upward movement of the underlying asset in the future. Similarly, by selling a futures contract, one can profit from the expected downward movement of the underlying asset. Individuals who trade in such contracts are known as traders.

Types of Traders in a Futures Contract

Two main types of people engage in futures contracts: speculators and hedgers.

Hedgers: people who use futures contracts to hedge against adverse price movements in the underlying commodity, index, or stock. To be profitable, cash prices and futures values must move in unison.

Let us understand this with an example of a baker who makes wheat flour biscuits. Assume the spot price of wheat is INR 35/kg and is expected to rise to INR 38/kg by the end of the month. If he needs 100 kg of wheat after a month, he risks price increases in the interim. To mitigate this risk, he can purchase a wheat futures contract at INR 35/kg. If the spot price of wheat rises to INR 38/kg, the wheat futures price will increase in lockstep. Because he will pay INR 3/kg more for the wheat, futures contract gains will offset this loss.

Speculators: Potentially, the second-largest group of participants in futures contracts are speculators. They are responsible for a significant portion of the daily trading activity in the stock markets. They try to make quick money by using as much leverage as possible. They take a chance on the outcome of an event and try to profit from the potential change in the asset’s price, hence the name “speculators.”

How does the Futures Trade Work

For example, Tata Motors Ltd. (TML) will release its first-quarter results next week. The market anticipates stellar results and optimistic guidance for the coming quarter from the company. It is also expected to announce the release of two new models. All of these expectations, when combined, have the potential to raise the stock price, which is currently trading in the cash market at Rs 425/share.

Amit, an investor and trader, wishes to profit from TML’s likely upward price movement. He has INR 2 lakh available for use. Amit has two choices: he can buy TML stock or futures. If he decides to buy the stock, which currently trades at INR 425/share, he can only buy 470 shares. Assume that after a week, when the results are released, TML’s share price rises to INR 450 per share. Amit has an unrealised gain of INR 25 per share (INR 450-425), for a total gain of INR 11,750. It is 6% (INR 11,750 / Rs 100,000) in percentage terms.

Let’s see how much money Amit would make if he bought TML futures. TML’s current futures price is INR 428/share. Because it is a futures contract, he must purchase a minimum of one lot, which is equal to 1425 shares. The contract value will be INR 6,09,900 (INR 428 per share multiplied by 1425 shares). Amit, on the other hand, is not required to pay the entire contract value. He must pay a percentage of the total amount, known as the “margin.” Assume the TML margin is 20%. As a result, Amit must pay only INR 1,21,980. Amit can take a 3x position in TML using futures with the same capital. This is referred to as “leverage”.

Assume the futures price is INR 450/share after a week. In this case, the unrealized gains are INR 22/share or a total gain of INR 31,350. This profit resulted from a capital investment of INR 1,21,980. As a result, it is 26% in percentage terms. This is the power of futures, and it is made possible by leverage.

A word of warning here. The preceding example effectively demonstrated the benefit of futures using leverage. However, there is a downside if the stock price falls. As a result, traders must adhere to a strict stop-loss policy to avoid capital destruction.

Stocks and Index Futures

Stock futures are financial contracts whose underlying asset is a specific stock. Prior to the future date, the buyer and seller agree on a price for the purchase or sale of a specified number of shares. The market lot, expiration date, unit of quotation, tick size, and settlement method of these contracts are standardized.

Index futures are financial contracts whose underlying asset is a specific index like Nifty 50 or Bank Nifty. The lot size on these contracts is the same as on stock futures.Due to the abstract nature of indices, transactions cannot be settled by purchasing or selling the underlying assets themselves.

Stock futures are the only ones that can be settled physically. An open position in index futures can be settled by conducting a transaction opposing it on or before the expiration date of the contract.

Skills and discipline required for futures trading

Traders who are bullish on the market or a specific stock will purchase futures contracts. Those who are bearish on the market or stock will sell the futures contract. This suggests that traders must have a view of the underlying indexes or stock’s potential future direction. Technical analysis, chart reading, and understanding various patterns are useful for futures trading.

Futures have the potential to create an infinite amount of profit, but losses can be equally severe. Therefore, it is essential to implement risk management. Traders must employ a stop-loss order. They must always think rationally and never let emotions influence their decisions. Booking profits and losses in time is the mantra to success.

Bottom Line

In conclusion, futures provide hedgers with a simple, low-cost option for managing risk. Speculators can use leverage to their benefit because of the margin. Futures trading, while potentially lucrative, carries with it the risk of equally large losses. Every trade should have a predetermined stop loss in place. Discipline and emotion control is essential.