A futures or options contract which is based on a set of underlying securities is called a Stock Index Futures or Options Contract. When trading takes place in stock index futures, it means that market 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.
S&P CNX NIFTY
S&P CNX NIFTY is a scientifically developed index. Top 50 blue chip companies have been selected to form part of the index. The index covers more than 25 industry sectors and is professionally managed by India Index & Services Ltd (IISL). IISL has a licensing and co-branding arrangement with Standard & Poor's (S&P), the World's leading provider of investable equity indices, for co-branding IISL's equity indices. Daily derivatives trading based on S&P 500 index is over US $ 50 billion.
Uses of S&P CNX NIFTY
S&P CNX NIFTY can be used for the purpose of speculation, hedging as well as an arbitrage tool.
Think market will go up?
Do you sometimes 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 selected liquid securities, which move with the index, and sell them at a later date,
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 like HINDLEVER is based on using HINDLEVER as an index proxy. However, these positions run the risk of making losses owing to HINDLEVER-specific news; they are not purely focussed upon the index.
The second alternative is hard to implement. An investor needs to buy all the stocks in S&P CNX Nifty in their correct proportions. 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. Using index futures, an investor can "buy" or "sell" the entire index by trading on one single security. Once a person buys S&P CNX NIFTY using the futures market, he gains if the index rises and loses if the index falls.
Do you sometimes think that the market index is going to fall? That you could make a profit by adopting a position on the index? 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? Today, you have two choices:
Sell selected liquid securities which move with the index, and buy them at a later date,
Sell the entire index portfolio and then buy it at a later date.
The first alternative is widely used a lot of the trading volume on stocks like ITC is based on using ITC as an index proxy (ITC has the highest correlation with S&P CNX Nifty amongst all the stocks in India). However, these position run the risk of making losses owing to ITC-specific news; they are not purely focussed upon the index.
The second alternative is hard to implement. This strategy is also cumbersome and expensive in terms of transaction costs.
Taking a position on the index is effortless using the index futures market. Using index futures, an investor can "buy" or "sell" the entire index by trading on one single security. Once a person sells S&P CNX NIFTY using the futures market, he gains if the index falls and loses if the index rises.
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? Have you ever been a "stockpicker" and carefully purchased a stock based on a sense that it was worth more than the market price?
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,
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 Infosys will announce good results and the stock price would rise. A few days later, S&P CNX Nifty drops, so he makes losses, even if his intrinsic understanding of Infosys was correct. There is a peculiar problem here. Every buy position on a stock is simultaneously a buy position on S&P CNX Nifty. This is because a buy Infosys position generally gains if S&P CNX Nifty rises and generally loses if S&P CNX Nifty drops. It is useful to ask: does the person feel bullish about Infosys or about the Index?
There is a simple way out. Every time you adopt a long position on a stock, you should sell some amount of S&P CNX Nifty futures. When this is done, the stockpicker has "hedged away" his index exposure. How do you do this?
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? Have you ever been a "stockpicker" and carefully sold a stock based on a sense that it was worthy less than the market price?
The second outcome happens all the time. A person may sell Reliance, expecting that Reliance would announce poor results and the stock price would fall. A few days later, S&P CNX Nifty rises, so you make losses, even if your intrinsic understanding of Reliance was correct.
There is a peculiar problem here. Every sell position on a stock is simultaneously a sell position on S&P CNX Nifty. This is because a SHORT RELIANCE position generally gains if S&P CNX Nifty falls and generally loses if S&P CNX Nifty rises. It is useful to ask: does the person fell bearish about Infosys or about the index?
There is a simple way out. Every time you adopt a short position on a stock, you should buy some amount of S&P CNX Nifty futures. When this is done, the stockpicker has "hedged away" his index exposure. The basic point of this hedging strategy is that the stockpicker proceeds with his core skill, i.e. picking stocks, at the cost of lower risk
How do you do this?
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. This planning can go wrong if by the time you do sell shares, S&P CNX Nifty has dropped sharply. When you have such anxieties, there are two alternatives that have always been available:
Sell shares immediately. This sentiment generates "panic selling" which is rarely optimal for the investor.
Do nothing, i.e. suffer the pain of the volatility. This leads to political pressures for government to "do something" when stock prices fall.
In addition, with the index futures market, a third and remarkable alternative becomes available:
Remove your exposure to index fluctuations temporarily using index futures. This allows rapid response to market conditions, without "panic selling" of shares. 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 a portfolio 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 30-60% of the stock risk is accounted for by index fluctuations).
How do we actually do this?
We need to know the "beta" of the portfolio, i.e. the average impact of a 1% move in S&P CNX Nifty upon the portfolio. It is easy to calculate the portfolio beta: it is the weighted average of stock betas. Suppose we have a portfolio composed of Rs.1 million of Reliance, which has a beta of 1.4 and Rs.2 million of Hindustan Lever, which has beta of 0.8, then the portfolio beta is (1x1.4+2x0.8)/3 or 1. If the beta of any stock is not known, it is safe to assume that it is 1.
The complete hedge is obtained by adopting a position on the index futures market, which completely removes the hidden S&P CNX Nifty exposure equals portfolio value x portfolio beta. In the above case, the portfolio is Rs.3 million with a beta of 1, hence we would need a position of Rs. 3 million on the S&P CNX Nifty futures.
Suppose S&P CNX Nifty is at 1200, and the market lot on the futures market is 100. Each market lot of S&P CNX Nifty costs Rs.1, 20,000. Hence we need to sell 25 market lots, i.e.2500 Nifties to get the position:
Expecting money to invest?
Have you ever been in a situation where you had funds, which needed to get invested in equity? Or of expecting to obtain funds in the future which will get invested in equity. Some common occurrences of this include:
Getting invested in equity ought to be easy but there are three problems:
So far, in India, we have had exactly two alternative strategies, which an investor can adopt: to buy liquid stocks (like HINDLEVER and RELIANCE) in a hurry, or to suffer the risk of staying in cash. With S&P CNX Nifty futures, a third alternative becomes available:
Warning: Hedging does not always make money. The best that can be achieved using hedging is the removal of unwanted risk. The hedged position will make less profits than the unhedged position, half the time. One should not enter into a hedging strategy hoping to make excess profits for sure; all that can come out of hedging is reduced risk.
Want to lend money at a better rate?
Would you like to lend funds into the stock market, without suffering the slightest risk?
Traditional methods of loaning money into the stock market suffer from (a) price risk of shares and (b) credit risk, of default of the counterparty. What is new about the index futures market is that supplies a technology to lend money into the market without suffering any exposure to S&P CNX Nifty and without bearing any credit risk.
The basic idea is simple. The lender buys all 50 stocks of S&P CNX Nifty on the cash market, and simultaneously sells them at a future date on the futures market. It is like a repo. There is no price risk since the position is perfectly hedged. There is no credit risk since the counter party on both legs is the National Securities Clearing Corporation (NSCC) which supplies clearing services on NSE. It is an ideal lending vehicle for entities, which are shy of price risk and credit risk, such as traditional banks and the most conservative corporate treasuries.
How do we actually do this?
To buy all 50 stocks in S&P CNX Nifty on the cash market requires a significant amount of money because of the minimum market lot
On 1 August, S&P CNX Nifty is at 1200. A futures contract is trading with 27 August expiration for 1230. You want to earn this return (30/1200 for 27 days).
Make your idle shares work for you!
Do you have a portfolio of shares which is earning you nothing? Would you like to juice up your returns by earning revenues from stock lending? Most owners of shares answer in the affirmative to these questions. The index futures market offers a risk less mechanism for (effectively) loaning out certificates and earning a positive return for them. There is no price risk (since you are perfectly hedged) and there is no credit risk (since your counter party on both legs of the transaction is the National Securities Clearing Corporation).
The basic idea is quite simple. You would sell all 50 stocks in S&P CNX Nifty and buy them back at a future date using the index futures. You would soon receive money for the shares you have sold. You can deploy this money as you like until futures expiration. On this date, you would buy back your shares, and pay for them.
How do we actually do this?
Suppose you have Rs. 50 lakhs of the S&P CNX Nifty portfolio (in their correct proportion, with each share being present in the portfolio with a weight that is proportional to its market capitalisation).