What Are Index Futures?

Index futures are financial contracts that give traders the opportunity to buy/sell the future value of the financial index at an already predetermined price on a future date. Their value is derived from the stock indices such as the Nifty 50 or the S&P BSE Sensex. Index future instruments are primarily used for hedging the portfolio or speculate on the future market trend for the index. In the Indian market, the index futures are traded on recognised stock exchanges such as the National Stock Exchange or the Bombay Stock Exchange. In this article, we will take a closer look at what is index futures in the stock market, the various types, examples, and other important factors of index futures. 

Example of Stock Index Futures 

Let's take an example to explain how investors can make speculative moves with index futures. 

For instance, the Nifty 50 is a widely followed stock market index in India that reflects the performance of 50 large companies listed on the National Stock Exchange. When investors trade index futures, they do not trade the index at its current level but at a futures price, which reflects the market’s expectation of where the index may move in the future. 

Assume the current Nifty 50 index level is 15,000 points. If an investor expects the index to rise, they may buy a Nifty 50 futures contract quoted at 15,100 points. The futures price of 15,100 indicates that the market expects the index to trade higher by the contract’s expiry. Each futures contract has a fixed value per index point, which in this case is ₹10 per point. 

Illustration: 

• Current Nifty 50 index level: 15,000 points 
• Futures price (expected future value): 15,100 points 
• Contract value: ₹10 per index point 
• One futures contract is purchased 

If the index rises at expiry: 

• Nifty 50 closes at 15,300 points 
• Difference between expiry level and futures price: 15,300 − 15,100 = 200 points 
• Profit: 200 × ₹10 
• Total profit = ₹2,000 

If the index falls at expiry: 

• Nifty 50 closes at 14,900 points 
• Difference between futures price and expiry level: 15,100 − 14,900 = 200 points 
• Loss: 200 × ₹10 
• Total loss = ₹2,000 

This example shows that gains or losses in index futures arise from the difference between the futures price agreed at entry and the actual index level at expiry, multiplied by the contract value. 

After explaining the stock index futures meaning and their example, the process of how index futures work is discussed below. 

How Do Index Futures Work? 

Index futures trade under a standardised system that regulates the structuring, trading, and settlement processes. Let’s see how do index futures work. 

• Contract Structure: 
  Index futures are standardised agreements in which two parties commit to exchanging the cash value of a stock market index at a predetermined price on a specified future date. When the contract is agreed upon, the contract price becomes binding until the position is closed or the contract expires. 
• Trading and Settlement: 
  These derivatives are cash-settled contracts, which implies there will be no delivery of the shares when the contract matures. Parties can close the contract by taking the opposite position in the market before the contract matures without having to wait for the contract maturity date. 
• Purpose of Trading: 
  Investors participate in index futures trading either for hedging against the risk of loss in value of their stock portfolio or for speculating the future movement of the underlying index. The net gain or loss is realised based on the difference between the contract price and the value of the underlying index when the settlement date arrives.  
• Indian Market Example: 
  In India, index futures based on benchmarks such as the Nifty 50 and S&P BSE Sensex are actively traded on recognised exchanges. Traders typically buy index futures when they expect the market to rise and sell index futures when they anticipate a decline in index values. 

Key Features of Index Futures in India 

Index futures share similarities with other futures contracts, featuring a predetermined price, an expiration date, and a margin requirement. However, stock market share index futures possess distinctive attributes that make them appealing to traders. 

1. Liquidity 
   Index futures exhibit high liquidity, ensuring a constant presence of buyers and sellers. This facilitates easy entry and exit from positions and allows traders to obtain favourable prices for their contracts. 
2.  Hedging 
   Share index futures serve as effective tools for risk hedging. For instance, a portfolio manager with a substantial stock holding might use share index futures to safeguard their portfolio from potential declines in the stock market. 
3.  Speculation 
   Stock market index futures are also utilised for speculative purposes. A trader anticipating an upward movement in the stock market may invest in index futures to generate a profit. 
4.  Low Margin Requirements 
   Share index futures generally entail lower margin requirements compared to other types of futures contracts. This characteristic enhances accessibility for smaller investors, making these futures contracts more feasible for a diverse range of market participants. 

What is the Importance of Index Futures? 

Some important reasons why index futures are used by various market participants include: 

• The index future helps manage market risk by protecting the portfolio against unexpected changes in market prices. 
• They give access to the broader market without necessarily investing in stocks, which makes it easier, convenient, and efficient to participate in the market. 
• Index futures also play a part in price discovery, as they reflect market expectations of future index direction. 
• These contracts generally have high liquidity, which allows the trader to easily enter and exit their positions in these investments. 
• Index futures permit the use of leverage, which makes it possible for investors to control large positions with lower capital. 
• Institutional investors utilise index futures for the allocation of assets and also for maintaining diversification in large investment portfolios. 

Types of Index Futures 

There are various types of stock index futures, with some of the primary ones including: 

1. Nifty 50 

This stock market index monitors the performance of the 50 largest companies listed on the National Stock Exchange (NSE). 

2. Nifty IT 

Focusing on the information technology sector, Nifty IT tracks the performance of the 25 largest IT companies listed on the NSE. 

3. Nifty Bank  

This index observes the performance of the 20 largest banks listed on the NSE, providing insights into the overall direction of the Indian banking sector. 

4. S&P BSE Bankex 

Concentrating on top banking stocks, the S&P BSE Bankex index encompasses over 90% of the total market capitalisation of the banking sector. 

5. S&P BSE Sensex 50 

As the oldest and most widely followed index in India, this stock market index reflects the performance of the 30 largest companies listed on the Bombay Stock Exchange (BSE). 

6. S&P BSE Bharat 22 Index 

This index tracks the performance of the 22 largest companies listed on the BSE, offering a popular way to trade the overall direction of the Indian stock market with lower margin requirements. 

Advantages and Disadvantages of Stock Index Futures 

It's important for investors to carefully consider their risk tolerance and investment goals before engaging in stock index futures trading. Let's understand the advantages and disadvantages of stock index futures. 

Who Trades Index Futures? 

Various types of investors participate in trading index funds, reflecting the diverse appeal of these investment vehicles. Here are some key categories of investors who commonly trade in index funds: 

1. Hedgers 

Hedgers in index futures are investors who use these financial instruments as a risk management tool to protect their portfolios from adverse market movements. For example, a portfolio manager with a significant stock holding might purchase index futures to hedge against potential losses in a declining stock market. 

2. Speculators 

Speculators are the investors trading index futures to make a profit. Speculators anticipate future movements in the index's price and engage in futures contracts to capitalise on these projected changes. 

3. Market Makers 

Traders contribute liquidity to the futures market by buying and selling index futures contracts. Market makers profit by establishing a spread between the bid and ask prices of the contracts. 

4. Institutional Investors 

Large-scale investors like pension funds and hedge funds actively participate in index futures trading. Institutional investors employ index futures to manage risk and diversify exposure across different asset classes. 

Disclaimer: All investments are subject to market risks, economic conditions, regulatory changes, and other external factors. Returns are not guaranteed and may vary based on market performance and investment tenure. Investors should assess their risk tolerance and financial objectives, conduct their own research, and consult a qualified financial advisor before making any investment decisions. 

Conclusion 

Investors can utilise index futures as a robust instrument for risk management and accessing the wider market without the need for substantial capital. With investments spread across a basket of shares, the associated risks are diminished. Nonetheless, it is important to highlight that index futures carry inherent risks. Thus, achieving success in index futures trading necessitates a keen understanding of market dynamics, thorough analysis, and the implementation of effective risk management strategies. 

For both experienced and new traders the convenience and accessibility offered by a stock market app are crucial. These apps enable users to monitor their portfolios, execute trades, and stay connected to the financial markets from anywhere in the world.