Futures

Understanding index futures

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Index futures are all futures contracts where the underlying is the stock index (Nifty or Sensex) and helps a trader to take a view on the market as a whole.

Index futures permits speculation and if a trader anticipates a major rally in the market he can simply buy a futures contract and hope for a price rise on the futures contract when the rally occurs. We shall learn in subsequent lessons how one can leverage ones position by taking position in the futures market.

In India we have index futures contracts based on S&P CNX Nifty and the BSE Sensex and near 3 months duration contracts are available at all times. Each contract expires on the last Thursday of the expiry month and simultaneously a new contract is introduced for trading after expiry of a contract.

Example:

Futures contracts in Nifty in July 2001

                                On July 27

The permitted lot size is 200 or multiples thereof for the Nifty. That is you buy one Nifty contract the total deal value will be 200*1100 (Nifty value)= Rs 2,20,000.

In the case of BSE Sensex the market lot is 50. That is you buy one Sensex futures the total value will be 50*4000 (Sensex value)= Rs 2,00,000.

The index futures symbols are represented as follows:

In subsequent lessons we will learn about the pricing of index futures.

Hedging

We have seen how one can take a view on the market with the help of index futures. The other benefit of trading in index futures is to hedge your portfolio against the risk of trading. In order to understand how one can protect his portfolio from value erosion let us take an example.

Illustration:

Ram enters into a contract with Shyam that six months from now he will sell to Shyam 10 dresses for Rs 4000. The cost of manufacturing for Ram is only Rs 1000 and he will make a profit of Rs 3000 if the sale is completed.

However, Ram fears that Shyam may not honour his contract six months from now. So he inserts a new clause in the contract that if Shyam fails to honour the contract he will have to pay a penalty of Rs 1000. And if Shyam honours the contract Ram will offer a discount of Rs 1000 as incentive.

As we see above if Shyam defaults Ram will get a penalty of Rs 1000 but he will recover his initial investment. If Shyam honours the contract, Ram will still make a profit of Rs 2000. Thus, Ram has hedged his risk against default and protected his initial investment.

The above example explains the concept of hedging. Let us try understanding how one can use hedging in a real life scenario.

Stocks carry two types of risk – company specific and market risk. While company risk can be minimized by diversifying your portfolio market risk cannot be diversified but has to be hedged. So how does one measure the market risk? Market risk can be known from Beta.

Beta measures the relationship between movement of the index to the movement of the stock. The beta measures the percentage impact on the stock prices for 1% change in the index. Therefore, for a portfolio whose value goes down by 11% when the index goes down by 10%, the beta would be 1.1. When the index increases by 10%, the value of the portfolio increases 11%. The idea is to make beta of your portfolio zero to nullify your losses.

Hedging involves protecting an existing asset position from future adverse price movements. In order to hedge a position, a market player needs to take an equal and opposite position in the futures market to the one held in the cash market. Every portfolio has a hidden exposure to the index, which is denoted by the beta. Assuming you have a portfolio of Rs 1 million, which has a beta of 1.2, you can factor a complete hedge by selling Rs 1.2 mn of S&P CNX Nifty futures.

Steps:

1. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to assume that it is 1.

2. Short sell the index in such a quantum that the gain on a unit decrease in the index would offset the losses on the rest of his portfolio. This is achieved by multiplying the relative volatility of the portfolio by the market value of his holdings.

Therefore in the above scenario we have to shortsell 1.2 * 1 million = 1.2 million worth of Nifty.

Now let us study the impact on the overall gain/loss that accrues:

As we see, that portfolio is completely insulated from any losses arising out of a fall in market sentiment. But as a cost, one has to forego any gains that arise out of improvement in the overall sentiment. Then why does one invest in equities if all the gains will be offset by losses in futures market. The idea is that everyone expects his portfolio to outperform the market. Irrespective of whether the market goes up or not, his portfolio value would increase.

The same methodology can be applied to a single stock by deriving the beta of the scrip and taking a reverse position in the futures market.

Thus, we have seen how one can use hedging in the futures market to offset losses in the cash market.

Speculation

Speculators are those who do not have any position on which they enter in futures and options market. They only have a particular view on the market, stock, commodity etc. In short, speculators put their money at risk in the hope of profiting from an anticipated price change. They consider various factors such as demand supply, market positions, open interests, economic fundamentals and other data to take their positions.

Illustration:

Ram is a trader but has no time to track and analyze stocks. However, he fancies his chances in predicting the market trend. So instead of buying different stocks he buys Sensex Futures.

On May 1, 2001, he buys 100 Sensex futures @ 3600 on expectations that the index will rise in future. On June 1, 2001, the Sensex rises to 4000 and at that time he sells an equal number of contracts to close out his position.

Selling Price : 4000*100            = Rs 4,00,000

Less: Purchase Cost: 3600*100 = Rs 3,60,000

Net gain                                              Rs 40,000

Ram has made a profit of Rs 40,000 by taking a call on the future value of the Sensex. However, if the Sensex had fallen he would have made a loss. Similarly, if would have been bearish he could have sold Sensex futures and made a profit from a falling profit. In index futures players can have a long-term view of the market up to atleast 3 months.

Arbitrage

An arbitrageur is basically risk averse. He enters into those contracts were he can earn riskless profits. When markets are imperfect, buying in one market and simultaneously selling in other market gives riskless profit. Arbitrageurs are always in the look out for such imperfections.

In the futures market one can take advantages of arbitrage opportunities by buying from lower priced market and selling at the higher priced market. In index futures arbitrage is possible between the spot market and the futures market (NSE has provided a special software for buying all 50 Nifty stocks in the spot market.

• Take the case of the NSE Nifty.

• Assume that Nifty is at 1200 and 3 month’s Nifty futures is at 1300.

• The futures price of Nifty futures can be worked out by taking the interest cost of 3 months into account.

• If there is a difference then arbitrage opportunity exists.

Let us take the example of single stock to understand the concept better. If Wipro is quoted at Rs 1000 per share and the 3 months futures of Wipro is Rs 1070 then one can purchase Wipro at Rs 1000 in spot by borrowing @ 12% annum for 3 months and sell Wipro futures for 3 months at Rs 1070.

Sale                = 1070

Cost= 1000+30 = 1030

Arbitrage profit =    40

These kind of imperfections continue to exist in the markets but one has to be alert to the opportunities as they tend to get exhausted very fast.

Pricing of Index Futures

The index futures are the most popular futures contracts as they can be used in a variety of ways by various participants in the market.

How many times have you felt of making risk-less profits by arbitraging between the underlying and futures markets. If so, you need to know the cost-of-carry model to understand the dynamics of pricing that constitute the estimation of fair value of futures.

The cost of carry model

The cost-of-carry model where the price of the contract is defined as:

F=S+C

where:

F Futures price

S Spot price

C Holding costs or carry costs

If F < S+C or F > S+C, arbitrage opportunities would exist i.e. whenever the futures price moves away from the fair value, there would be chances for arbitrage.

If Wipro is quoted at Rs 1000 per share and the 3 months futures of Wipro is Rs 1070 then one can purchase Wipro at Rs 1000 in spot by borrowing @ 12% annum for 3 months and sell Wipro futures for 3 months at Rs 1070.

Here F=1000+30=1030 and is less than prevailing futures price and hence there are chances of arbitrage.

Sale                 = 1070

Cost= 1000+30 = 1030

Arbitrage profit       40

However, one has to remember that the components of holding cost vary with contracts on different assets.

Futures pricing in case of dividend yield

We have seen how we have to consider the cost of finance to arrive at the futures index value. However, the cost of finance has to be adjusted for benefits of dividends and interest income. In the case of equity futures, the holding cost is the cost of financing minus the dividend returns.

Example:

Suppose a stock portfolio has a value of Rs 100 and has an annual dividend yield of 3% which is earned throughout the year and finance rate=10% the fair value of the stock index portfolio after one year will be F= Rs 100 + Rs 100 * (0.10 – 0.03)

Futures price = Rs 107

If the actual futures price of one-year contract is Rs 109. An arbitrageur can buy the stock at Rs 100, borrowing the fund at the rate of 10% and simultaneously sell futures at Rs 109. At the end of the year, the arbitrageur would collect Rs 3 for dividends, deliver the stock portfolio at Rs 109 and repay the loan of Rs 100 and interest of Rs 10.

The net profit would be Rs 109 + Rs 3 - Rs 100 - Rs 10 = Rs 2.

Thus, we can arrive at the fair value in the case of dividend yield. 

Trading strategies

Speculation

We have seen earlier that trading in index futures helps in taking a view of the market, hedging, speculation and arbitrage. In this module we will see one can trade in index futures and use forward contracts in each of these instances.

Taking a view of the market

Have you ever felt that the market would go down on a particular day and feared that your portfolio value would erode?

There are two options available

Option 1: Sell liquid stocks such as Reliance

Option 2: Sell the entire index portfolio

The problem in both the above cases is that it would be very cumbersome and costly to sell all the stocks in the index. And in the process one could be vulnerable to company specific risk. So what is the option? The best thing to do is to sell index futures.

Illustration:

Scenario 1:

On July 13, 2001, ‘X’ feels that the market will rise so he buys 200 Nifties with an expiry date of July 26 at an index price of 1442 costing Rs 2,88,400 (200*1442).

On July 21 the Nifty futures have risen to 1520 so he squares off his position at 1520.

‘X’ makes a profit of Rs 15,600 (200*78)

Scenario 2:

On July 20, 2001, ‘X’ feels that the market will fall so he sells 200 Nifties with an expiry date of July 26 at an index price of 1523 costing Rs 3,04,600 (200*1523).

On July 21 the Nifty futures falls to 1456 so he squares off his position at 1456.

‘X’ makes a profit of Rs 13,400 (200*67).

In the above cases ‘X’ has profited from speculation i.e. he has wagered in the hope of profiting from an anticipated price change.

Hedging

Stock index futures contracts offer investors, portfolio managers, mutual funds etc several ways to control risk. The total risk is measured by the variance or standard deviation of its return distribution. A common measure of a stock market risk is the stock’s Beta. The Beta of stocks are available on the www.nseindia.com.

While hedging the cash position one needs to determine the number of futures contracts to be entered to reduce the risk to the minimum.

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?

A person who feels like this takes a long position on the cash market. When doing this, he faces two kinds of risks:

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

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

Everyone has to remember that every buy position on a stock is simultaneously a buy position on Nifty. A long position is not a focused play on the valuation of a stock. It carries a long Nifty position along with it, as incidental baggage i.e. a part long position of Nifty.

Let us see how one can hedge positions using index futures:

‘X’ holds HLL worth Rs 9 lakh at Rs 290 per share on July 01, 2001. Assuming that the beta of HLL is 1.13. How much Nifty futures does ‘X’ have to sell if the index futures is ruling at 1527?

To hedge he needs to sell 9 lakh * 1.13 = Rs 1017000 lakh on the index futures i.e. 666 Nifty futures.

On July 19, 2001, the Nifty futures is at 1437 and HLL is at 275. ‘X’ closes both positions earning Rs 13,389, i.e. his position on HLL drops by Rs 46,551 and his short position on Nifty gains Rs 59,940 (666*90).

Therefore, the net gain is 59940-46551 = Rs 13,389.

Let us take another example when one has a portfolio of stocks:

Suppose you have a portfolio of Rs 10 crore. The beta of the portfolio is 1.19. The portfolio is to be hedged by using Nifty futures contracts. To find out the number of contracts in futures market to neutralise risk

If the index is at 1200 * 200 (market lot) = Rs 2,40,000

The number of contracts to be sold is:

1. 1.19*10 crore = 496 contracts

2,40,000

If you sell more than 496 contracts you are overhedged and sell less than 496 contracts you are underhedged.

Thus, we have seen how one can hedge their portfolio against market risk.

Margins

The margining system is based on the JR Verma Committee recommendations. The actual margining happens on a daily basis while online position monitoring is done on an intra-day basis.

Daily margining is of two types:

1. Initial margins

2. Mark-to-market profit/loss

The computation of initial margin on the futures market is done using the concept of Value-at-Risk (VaR). The initial margin amount is large enough to cover a one-day loss that can be encountered on 99% of the days. VaR methodology seeks to measure the amount of value that a portfolio may stand to lose within a certain horizon time period (one day for the clearing corporation) due to potential changes in the underlying asset market price. Initial margin amount computed using VaR is collected up-front.

The daily settlement process called "mark-to-market" provides for collection of losses that have already occurred (historic losses) whereas initial margin seeks to safeguard against potential losses on outstanding positions. The mark-to-market settlement is done in cash.

Let us take a hypothetical trading activity of a client of a NSE futures division to demonstrate the margins payments that would occur.

• A client purchases 200 units of FUTIDX NIFTY 29JUN2001 at Rs 1500.
• The initial margin payable as calculated by VaR is 15%.

Total long position = Rs 3,00,000 (200*1500)

Initial margin (15%) = Rs 45,000

Assuming that the contract will close on Day + 3 the mark-to-market position will look as follows:

Position on Day 1

New position on Day 2

Value of new position = 1,400*200= 2,80,000

Margin = 42,000

Position on Day 3

Value of new position = 1510*200 = Rs 3,02,000

Margin = Rs 3,300

Margin account*

Initial margin                =       Rs 45,000

Margin released (Day 1) =  (-) Rs  3,000

Position on Day 2                  Rs 42,000

Addn margin                =  (+) Rs  3,300

Total margin in a/c                Rs 45,300*

Net gain/loss

Day 1 (loss)                =     (Rs 17,000)

Day 2 Gain                  =      Rs 18,700

Day 3 Gain                  =       Rs 18,000

Total Gain                   =       Rs 19,700

The client has made a profit of Rs 19,700 at the end of Day 3 and the total cash inflow at the close of trade is Rs 63,300.

How to read the futures data sheet?

Understanding and deciphering the prices of futures trade is the first challenge for anyone planning to venture in futures trading. Economic dailies and exchange websites www.nseindia.com and www.bseindia.com are some of the sources where one can look for the daily quotes. Your website has a daily market commentary, which carries end of day derivatives summary alongwith the quotes.

The first step is start tracking the end of day prices. Closing prices, Trading Volumes and Open Interest are the three primary data we carry with Index option quotes. The most important parameter are the actual prices, the high, low, open, close, last traded prices and the intra-day prices and to track them one has to have access to real time prices.

The following table shows how futures data will be generally displayed in the business papers daily.

Source: BSE

• The first column explains the series that is being traded. For e.g. BSXJUN2000 stands for the June Sensex futures contract.

• The column on volume indicates that (in case of June series) 146 contracts have been traded in 104 trades.

• One contract is equivalent to 50 times the price of the futures, which are traded. For e.g. In case of the June series above, the first trade at 4755 represents one contract valued at 4755 x 50 i.e. Rs. 2,37,750/-.

Open interest indicates the total gross outstanding open positions in the market for that particular series. For e.g. Open interest in the June series is 51 contracts.

The most useful measure of market activity is Open interest, which is also published by exchanges and used for technical analysis. Open interest indicates the liquidity of a market and is the total number of contracts, which are still outstanding in a futures market for a specified futures contract.

A futures contract is formed when a buyer and a seller take opposite positions in a transaction. This means that the buyer goes long and the seller goes short. Open interest is calculated by looking at either the total number of outstanding long or short positions – not both.

Open interest is therefore a measure of contracts that have not been matched and closed out. The number of open long contracts must equal exactly the number of open short contracts.

Open interest is also used in conjunction with other technical analysis chart patterns and indicators to gauge market signals. The following chart may help with these signals.

The warning sign indicates that the Open interest is not supporting the price direction.

Glossary

Backwardation: A market where future prices of distant contract months are lower than the near months.

Basis: The difference between the Index and the respective contract is the basis i.e. cash netted  for the Futures price. A negative basis means Futures are at a premium to cash and vice versa. It is the  strengthening and weakening of basis that is tracked by market players i.e. whether the basis is widening or narrowing. A widening of basis is indicative of increasing longs and narrowing means increasing short positions.

Basis Point: It is equal to one hundredth of a percentage point

Contango market: This is a market where futures prices are higher for distant contracts than for nearby delivery months.

Cost of carry: is an indicator of the demand-supply forces in the Futures market. It basically means the annualized interest cost players decide to pay (receive) for buying (selling) a respective contract. A higher carry cost is indicative of buying pressure and vice versa. Carry Cost is a widely used parameter not only because it is more interpretable being an annualized figure, as compared to basis (Cash netted for Futures) but also because it works well with the trio of Price, Volume and Open Interest in highlighting the market trend.

Delivery month: Is the month in which delivery of futures contracts need to be made.

Delivery price: The price fixed by the clearinghouse at which deliveries on futures contracts are invoiced. Also known as the expiry price or the settlement price.

Derivative: A financial instrument designed to replicate an underlying security for the purpose of transferring risk.

Fair value: Theoretical value of a futures contract derived from a mathematical model of valuation.

Hedge Ratio: The Hedge Ratio is defined as the number of Futures contracts required to buy or sell so as to provide the maximum offset of risk. This depends on the

• Value of a Futures contract;
• Value of the portfolio to be Hedged; and
• Sensitivity of the movement of the portfolio price to that of the Index (Called Beta).

The Hedge Ratio is closely linked to the correlation between the asset (portfolio of shares) to be hedged and underlying (index) from which Future is derived.

Initial margin: The money a customer needs to pay as deposit to establish a position in the futures market. The basic aim of Initial margin is to cover the largest potential loss in one day.

Mark-to-market: The daily revaluation of open positions to reflect profits and losses based on closing market prices at the end of the trading day.

Forward contract: In a forward contract, two parties agree to do a trade at some future date, at a stated price and quantity. No money changes hands at the time the deal is signed.

Futures contract: A futures contract is similar to a forward contract in terms of its working. The difference is that contracts are standardized and trading is centralized. Futures markets are highly liquid and there is no counterparty risk due to the presence of a clearinghouse, which becomes the counterparty to both sides of each transaction and guarantees the trade.

Far contract: The future that is furthest from its delivery month i. e. has the longest maturity.

Speculation: Trading on anticipated price changes, where the trader does not hold another position which will offset any such price movements.

Spread ratio: The number of futures contracts bought, divided by the number of futures contracts sold.

VaR: Value at Risk. A risk management methodology, which attempts to measure the maximum loss possible on a particular position, with a specified level of certainty or confidence.

Strike Price: The price at which an option holder may buy or sell the underlying asset, which is specified in an option contract.