An index future is a futures contract on a sectoral or a market wide index. For example, on the NSE, you have futures on the Nifty (which is a market wide index) and you also have liquid futures on Bank Nifty (which is a sectoral index of liquid banks). Both these indices are extremely liquid and also actively traded by retail and institutional investors. Why have index futures become so popular in India? What are the benefits of trading in index futures? Index futures trading in India evolved as a corollary to trading in stock futures which was almost akin to the erstwhile Badla system on the BSE. Apart from looking at trading strategies in index futures, let us also see how traders can actually benefit from trading in index futures..
1. You can take a consolidated view and avoid stock risk
Let us assume that you decided to buy banking stocks but the big challenge is to identify the specific stocks to buy. While PSU banks may have NPA concerns, private banks have issues on the valuation front. A better idea would be to look at the banking sector as a whole which will give you a natural diversification. You can do that by buying Bank Nifty Futures and participate in the up movement of banks. The advantage is that you can also roll over your position each month by paying a marginal cost of around 0.50% and carry this position as long as you want.
2. You can trade both ways; long side and short side
It is fine if you are on the long (buying) side. What if you are negative on banks? You can sell banking stocks that you own or you can short sell them in equity markets. But since Indian markets follow rolling settlements, you can only short in equities for intraday basis. The other option is to sell stock futures of specific banks but here again you are running bank-specific risk. You can overcome all these problems by just selling the index futures of Bank Nifty. If you are negative on the Indian markets as a whole you can simply sell Nifty futures.
3. You can trade in index futures with lower margins
Remember, all futures trading are about trading on margins. But the margins on indices like the Nifty and Bank Nifty tend to be lower than the margins on individual stocks. That is because an index is a combination of stocks and hence offers a natural diversification. This lower risk manifests in the form of lower margins required to take a position in index futures. That will ensure that the amount of money that is locked in is also lower.
4. You can hedge your risk with index futures
This is a very important aspect of your portfolio management. As an individual or an institutional investor you may be holding on to a large portfolio of stocks. You are expecting the market to correct by 10-12% once the US Fed hikes its rates. At the same time you are also confident that the fall in the prices of your stocks will be temporary and they will recover in the next couple of months. While one option is to just hold on to your portfolio, a better option will be to hedge your risk by selling Nifty futures. When the market goes down, you book profits on the Nifty futures and these profits will help you reduce your average cost of holding equity. At the end of 3 months you are surely better off!
5. There is limited liquidity risk in these index futures
Quite often we see issues of liquidity in specific stocks or stock futures. On the contrary, index futures being a preferred mode for institutional investors, rarely faces liquidity risk. As a result, the bid-ask spreads are also very narrow. This makes trading in these index futures fairly safe as you are unlikely to get stuck for want of liquidity. Globally, that has been one of the major arguments in favour of trading index futures.
6. You can use index futures to diversify your portfolio
This point is related to the point on risk reduction but has a slightly opportunistic tilt. You are holding a portfolio which is predominantly tilted in favour of financials. You see some risk due to RBI hiking rates and want to add safety through non-cyclical sectors like FMCG and IT. While buying these stocks is one option, it will entail investment outlays and will also lock up funds in case this is a short term opportunity. A better way is to add index futures of FMCG index and IT index to your portfolio. This will help you structurally diversify your portfolio with minimal risk and investment outlay.
7. Cost of trading index futures is much lower
This point needs no reiteration. The commission rates and the STT rates on index futures are much lower compared to equities or even stock futures. In fact, most brokers will also offer you fixed brokerage packages on indices and that makes it more economical than stock futures also. Make the best of this lower cost advantage of index futures.
Index futures are a great product for you to trade with lower risk and higher potential return. But the actual advantages of index futures are beyond pure trading!