Stock index represents a change in the value of a set of stocks over the base year. This set of stocks constitute the index. For example, the BSE Sensex is a weighted average of the prices of 30 shares and S&P CNX is a weighted average of the prices of 50 shares.
Stock index futures are futures contracts where the underlying asset is the index. Trading in stock index futures means that market participants are taking a view on the way the index will move. Stock index futures are merely a tool to guess the mood of the market over the period of the contract. The market participants buy the entire stock market instead of individual securities by taking a position on index futures. Index futures can be used for hedging, speculating, arbitrage, cash flow management, and asset allocation. Index futures are settled in cash but investors are required to pay a small fraction of the total contract as margins. With relatively small amount of margins, the investor can take a position that is higher than the value of the risk capital actually invested. This is known as leverage or gearing. Stock index futures enable shuffling of portfolios to change the composition of assets. It carries no risk of dishonor of commitment as the clearing corporation of the exchange is a counter party to every trade.
Stock index futures are available on two indices. BSE Sensex and NSE’s S&P CNX Nifty. The permitted minimum lot size in case of NSE’s S&P CNX Nifty is 200 units and multiples thereof. Thus, if the index value is around 1,000 then the appropriate value of a single index futures contract is Rs 200,000. In case of BSE sensex, the minimum market lot is fixed at 50 times the index. In other words, a minimum of 50 contracts of Sensex futures. If the index value is around 5,000 then the appropriate value of a single index futures contract on BSE is Rs 250,000. The minimum tick size for an index futures contract on NSE is 0.05 units and the minimum tick size on BSE points. Thus, single move in the Index value on NSE would imply minimum tick size on BSE is 0.1 Sensex points. Thus, a single move in the index value on NSE would imply a price (gain or loss) of Rs 10 (Re 0.05 x 200 units) on an open position of 200 units. In case of BSE Sensex, the tick size is equivalent to Rs 5 (tick size x multiplier i.e. 0.1 x 50).
Stock index futures are more suitable to institutional and large equity holders as they provide portfolio hedging facility. Pension funds in the US use stock index futures for risk hedging. Stock index is difficult to be manipulated as compared to individual stock prices. Moreover, stock index is much less than individual stock process. Due to low volatility, capital adequacy and margin requirements are low, which induce more players to participate in the market.
Stock Futures: Stock futures are futures contracts on the shares of individual companies. Stock futures are simple compared to stock options. Suppose an investor is bullish on Reliance which is currently quoting at Rs 290 per share. The investor expects Reliance price to move up to Rs 340 in the next month. If the investor buys Reliance for Rs 290 and sells at Rs 350 he makes a profit of Rs 50 which turns out to be a return of 17 percent in one month. Instead of buying the scrip if the investor buys futures, then he has to merely pay a margin of, say, 20 percent and can earn a profit of Rs 50 on an investment of Rs 58. His rate of return is 86 per cent in one month.
As stock futures in India are not linked to delivery, an investor should buy stock futures when he predicts an upward price movements and sell futures when hew anticipates a downward price movement. Stock futures provide the advantage of leverage. Traders can carry forward positions and investors can take a position in the market by paying a small amount called margins. The risks are that losses will also get leverage or multiplied as profits do. A safe strategy for an investor is to go long on futures when they trade at a premium and short when the cost of carrying is negative.