Using index futures: A case for speculation

All of us have speculated at one time or another, be it on the price of petrol, onions or gold. Many of us also have an opinion about the stock market. There are times we believe the market will rise while at other times we are quite sure that it will fall. A few of us have gone far enough to bet on the market movement based on the opinion we hold.

Assume that I am an investor who is bullish on the index. I'm confident that the index is going to rise. Perhaps it is an outcome of a good Budget. Or maybe it is the encouraging corporate performance/results. It may even have something to do with the stability of the government. Whatever be the cause, if as an investor, I believe that the index will rise, is there some way I can implement a trading strategy to benefit from an upward movement in the index?

Until a short while ago, I had only the following two alternatives:

1. I could buy selected liquid securities which move with the index, and sell them at a later date.

2. I could buy the entire index portfolio and then sell it at a later date.

The first alternative has been a widely used strategy. We notice that a lot of trading volume on stocks like ITC is based on using ITC as the index proxy since ITC has the highest correlation with S&P CNX Nifty amongst all the stocks in India. However, note that these positions are not purely focused on the index and run the risk of making losses due to ITC-specific news.

The second alternative as we can see is hard to implement. An investor would need a sizeable amount of money to meaningfully buy all the stocks in the S&P CNX Nifty in their correct proportions. Not many retail investors would be able to implement this strategy. Besides, it would prove to be rather expensive given the transactions costs incurred on the same.

We now have a third alternative - index futures. Using the index futures markets, one can very easily take a position on the index. One can effortlessly "buy" or "sell" the entire index by trading one single security - the S&P CNX Nifty. If I am bullish on the index all I need do is go long S&P CNX Nifty using the futures market. If my hunch is indeed correct and the index moves up, I gain. And if I'm proved wrong and the index actually falls, I lose.

Let us take an example. Suppose on the July 1, 2000, I feel that the index will rise. By paying an initial margin amount of about Rs 30,000, I buy 200 Nifties with expiration date on July 31, 2000. The futures contract on this date costs me 1520 so my position is worth Rs 300,400. By July 20, S&P CNX Nifty rose to 1524 and the July futures contract rose to 1536. I sell off my position at Rs 1536 and make a cool profit of Rs 3200. Note that I could have earned a similar profit by actually buying the entire index and selling it off at a later date. But that would require a sizable up-front investment. By contrast, using the index futures market requires only a small initial margin, with, of course, the mark-to-market margin posting as required. Futures market in effect allows the speculator to obtain leverage. With a relatively small initial outlay, he or she is able to take a large speculative position.

The same logic we spoke of above applies to an investor who is bearish on the index. Perhaps due to sluggish industrial growth, he is pessimistic about the performance of the economy and dreads that the index may fall down soon. He is however willing to bet on his hunch about the possible fall in the market. If he were right, he could end up making a profit by adopting a position on the index.

He now has three choices. One, like we mentioned earlier, he could sell selected securities which move the index, and buy them back at a later date. He would make profits if his hunch about the market were right, however these selected securities positions could run the risk of making losses due to stock-specific news. Two, he could sell the entire index portfolio and buy it back later. Besides the high transactions costs faced on the round trip, this poses to be a rather cumbersome process. Three, he could simply take a short S&P CNX Nifty position using the futures markets. It would save him time, money and the hassle of entering into multiple trades. Using index futures, he can now sell the entire index by trading just one security. So he shorts the S&P CNX Nifty using the futures markets. He will gain if the index falls and lose if the index rises.

Let us assume that on July 15, 2000, the investor feels that the index will fall. He goes ahead and sells 200 Nifties with an expiration date of July 31, 2000. On this day, the S&P CNX Nifty July futures contract costs him Rs 1524, so his short position is worth Rs 304,800. On July 25, the S&P CNX Nifty has fallen to 1480 and the July futures contract has fallen to Rs 1498. If he squares off his position at this point, he ends up making a profit of Rs 5200.

Now a frequently asked question: Given that futures with several different expiration are available at the same time, which one should I use? This mainly depends on my horizon as an investor. If I am speculating based on long term forecasts of movements in the index, then I should be using longer dated futures contracts.

Alternatively, if the speculative position is say a three-week view, then its convenient if the index futures contract that is used also has at least three weeks to go. Based on my horizon, if I can choose between two or more of the existing futures contracts, I should prefer the most liquid of them as it would save me money on impact cost.

Index futures markets are particularly appealing to the speculator because of the leverage and ease of trading that they provide.

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