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Some frequently asked questions on futures and their mechanism. What are stock index futures and options? 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. The index covers more than 25 industry sectors and is professionally managed by India Index and Services Ltd. Have you bought a share hoping it will go up? 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?
When doing this, you face two kinds of risks: Your understanding can be wrong, and the company is really not worth more than the market price, or The entire market moves against you and generates losses even though the underlying idea was correct.
The second outcome happens all the time. A person may buy Infosys thinking that it will announce good results and the stock price would rise. There is a peculiar problem here. It is useful to ask: There is a simple way out.
How do you do this? If betas are not known, it is generally safe to assume the beta is 1. Suppose we take Lupin Labs, where the beta is 1. Long Lupin Lab Rs. You buy Infosys for Rs. The expiry date of Nifty June futures is October 29, Nifty spot is at Rs.
The beta of Infosys is 1. You need to sell 1. Nifty spot at Rs. You close both positions earning Rs. Have you sold a share hoping it will go down? Have you ever felt that a stock was intrinsically overvalued? That the profits and the quality of the company made it worth a lot less as compared with what the market thinks? His understanding can be wrong, and the company is really worth more than the market price, or, AThe entire market moves against him and generates losses though the underlying idea was correct.
A person may sell Infosys, expecting that it would announce poor results and the stock price would fall. Does the person fell bearish about Infy or about the index? The basic point of this hedging strategy is that the stockpicker proceeds with his core skill, that is, picking stocks, at the cost of lower risk. Example July 1, You sell Infosys of Rs. The expiry date of Nifty July futures is July 30, Hence, you need a long position of 1.
Nifty rises by You unwound both positions losing Rs. That is, your position on Infosys loses Rs. How to protect your portfolio from nuclear bomb? Have you ever experienced the feeling of owning an equity portfolio, and then, one-day, becoming uncomfortable about the overall stock market? Sometimes, you may have a view that stock prices will fall in the near future. At other times, you may see that the market is in for a few days or weeks of massive volatility, and you do not have any appetite for this kind of volatility.
The Union Budget is a common and reliable source of such volatility: Market volatility is always enhanced for one week before and two weeks after a budget. Many investors simply do not want the fluctuations of these three weeks. This is particularly a problem if you expect to sell shares in the near future for example, in order to finance a purchase of a house.
When you have such anxieties, two alternatives have always been available: Do nothing, that is, suffer the pain of the volatility. In addition, with the index futures market, a third and remarkable alternative becomes available: Remove your exposure to index fluctuations temporarily using index futures. It allows an investor to be in control of his risk, instead of doing nothing and suffering the risk.
The idea here is quite simple. Every portfolio contains a hidden index exposure. This statement is true for all portfolios, whether one is composed of index stocks or not. In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations unlike individual stocks, where only per cent of the stock risk is accounted for by index fluctuations.
How do we actually do this? Example May 25, You have a portfolio of 5 securities of Rs. The expiry date of Nifty June futures is June 26, Nifty spot is at The beta of the portfolio is 0. Hence, he needs to sell 0. You unwound both positions making a profit of Rs. Do you think that the market index is going to rise? That you could make a profit by adopting a position on the index? After a good Budget, or good corporate results, or the onset of a stable government, many people feel that the index would go up.
How does one implement a trading strategy to benefit from an upward movement in the index? Today, you have two choices: Buy select liquid securities, which move with the index, and sell them at a later date, or Buy the entire index portfolio and them sell it at a later date. The first alternative is widely used -- a lot of the trading volume on stocks such as Hindustan Lever is based on using it as an index proxy.
However, these positions run the risk of making losses owing to Hind Lever-specific news; they are not purely focussed upon the index. The second alternative is hard to implement. Most retail investors do not have such large portfolios. This strategy is also cumbersome and expensive in terms of transactions costs. Taking a position on the index is effortless using the index futures market. Example January 5, You feel the market will rise. January 14, Nifty January futures rise to Rs.
You sell your position at Rs. Make a profit of Rs. Do you sometimes think that the market index is going to fall? After a bad budget, or bad corporate results, or the onset of a coalition government, many people feel that the index would go down. How does one implement a trading strategy to benefit from a downward movement in the index?
Sell select liquid securities which move with the index, and buy them at a later date, or Sell the entire index portfolio and then buy it at a later date. However, these position run the risk of making losses owing to ITC-specific news; they are not purely focussed upon the index. This strategy is also cumbersome and expensive in terms of transaction costs.
Example February 8, You feel the market will fall. Expiration date February 25, Nifty February contract is trading at Rs. Your position is worth Rs. Nifty February futures fall to Rs. You square off your position at Rs.