Personal Finance: Friction-Free Punting

PERSONAL FINANCE: FUTURES
Friction-Free Punting

Futures are in. They are expected to provide the equity markets with critical depth and liquidity. And the players a much-needed hedging instrument.

By Dilip Maitra

Finally, the future is in your grasp. Last fortnight, the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) introduced trading in index futures-their first pure derivative products. For BSE, the index is its 30-share Sensitivity Index (Sensex), and for the NSE it is the 50-share S&P CNX Nifty. The launch of index futures has been greeted with excitement as these instruments are likely to provide more depth and liquidity to the domestic equity market, work as an efficient hedging tool for the cash market, and allow risk-takers to speculate more effectively. Says Manoj Vaish, 44, CEO (Derivatives Segment), BSE: ''Futures trading is a versatile way of playing in the stockmarket. The concept is simple, but investors need to acquire the required skills.''

But before you take a plunge, wait and check out the scene. To begin with, it will be the big boys and not the individual investors who will kick off futures trading. Stock traders, financial institutions, mutual funds, and high net worth individuals are the ones most likely to trade in index futures. The small investors may have to wait till futures trading begins for sectoral indices.

How Index Futures Work

Just what is an index future? When you trade in the futures, you enter into a legally binding contract to buy or sell a specific quantity of an underlying security-in the case of index futures, it is Sensex or Nifty-within a designated time-frame at an agreed price. Currently, three types of futures contracts are available from both exchanges: one month, two months, and three months. On both the exchanges, the contract will end on the last Thursday of the contract month, and the final settlement done by paying the difference in cash. To trade in futures, you will have to go through a designated broker-there are 73 on the BSE (another 200 applications are being processed) and 130 on the NSE.

Futures are very liquid as they are traded on the market, have a standardised format, and do not carry counter-party risk (the risk that the other party is not obliged to pay for) because the stockmarket itself guarantees the payment. Says R.H. Patil, 58, Managing Director, NSE: ''In any financial market, having only cash market is not enough. You need the futures market to complete the picture. Now, index futures will fill this major lacuna in the market.''

Typically, you begin a trade with a view of the future movement of the index. If you expect the market to rise, you'll buy index futures (or go long on future) to make a profit by selling it in the future. Conversely, if you expect the market to fall, you will sell futures (or go short). All open positions will have to be compulsorily closed on the settlement date, but one can get out of the contract any time before the last date simply by reversing the position-sell if you have bought, or vice versa. All future contracts are marked to market, and profit or loss-based on the movement of the index-will be credited to the contract-holders' account each day.

Index futures have a fixed contract size that is usually a multiple of the index level. For the Sensex, the multiple is 50; for the Nifty, it is 200. So, the contract size for a Sensex level of 4,640 will come to Rs 2.32 lakh, and, for a Nifty level of 1,440, it will be Rs 2.88 lakh. Of course, you don't have to fork out the entire amount when you buy a contract. All that you pay is the margin money-10 per cent in case of Sensex and 9 per cent for Nifty. Says Himanshu Kaji, 34, Director, Kaji Maulik & Securities, the firm that bought the first contract on BSE: ''I expect the index futures to develop into a major retail segment, and the volume to grow as much as the cash market by the end of the current year.'' bse's Vaish estimates the market to grow to Rs 2,500 crore by the end of the year.

Making Calculated Bets

Futures trading offers opportunities to make calculated bets. So far, punters so far could speculate only on individual stocks whose prices can be easily manipulated by large players. But since the indices reflect the prices of 30 or 50 stocks, it is not easy to manipulate them. Our example (See The Mechanics Of Futures), which assumes that you square off your contract on Day 6, shows how it works. Of course, you can continue to keep the position open till the contract-ending day. But remember, like all other indices, the size of the gain or loss from index future too depends on the magnitude of the volatility in the market. Says Patil of the NSE: ''In any dynamic market, the prices of shares will change, and so will the index. No change means no gain or loss-in other words, it would just not be market.''

Index futures also offer opportunities to hedge. Let's say you have large stocks of Sensex scrips like Infosys, Reliance Industries, Hindustan Lever, ITC, Ranbaxy, etc., and you expect their prices to go up in the near future. But if you fear that some unusual and unpredictable developments could also lead to a fall in the overall market and, hence, could pull down the value of your portfolio, you should go short (sell) on index futures. That way, if the market goes up, you gain from the higher value of your portfolio, but lose on your index future, and just the opposite if the market heads in the reverse direction.

The extent of hedging will, however, depend on your risk appetite and by calculating the beta (the co-relation of your portfolio price with the change in index). Says Vetri Subramaniam, 30, Chief Advising Officer, Sharekhan.com: ''Since an index represents a basket of different types of shares, it is an extremely effective hedging tool for the cash shares.''

Even if index futures are less risky than punting on single scrips, they aren't risk-free. How an index will move in the future depends on how the heavy-weight stocks in it move. And if you use an index future as a hedging tool, you must be sure that it has a strong co-relation with your portfolio. The thumb-rule: for hedging, use the indices that best represent the cash stocks you have invested in.

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