Welcome to the era of Index futures. Futures are one of the dimensions of the multitude of innovative instruments from the world of financial engineering. India has had a long wait before derivative trading has been introduced but what does it imply to a layman who still doesn't seem to be comfortable with this concept. As we know a future  is a contract which derives it's value from an underlying asset. This asset could be Shares, Currencies, Interest rate or commodities. Index futures are slightly different in the sense that their value is derived from a set of securities which constitute the index. Trading in index futures means taking a view on how the index will move. Let's see how it helps in hedging the risk. Assume that you are a potential investor and you are bullish on Reliance thinking that the announcements made by Dhirubhai Ambani in the AGM are likely to prop up the prices. Also you feel that the company has performed well in this financial year and is fundamentally strong and well poised to surge ahead. So with this idea an investor is very likely to place bets on the Reliance scrip in the markets. However after some point of time you find to your surprise that markets get trapped in the bear phase and all the major scrips including Reliance plummet. So what do you do in this situation. It's not that your understanding of the fundamentals of Reliance is wrong but unfortunately the markets are down. At this point of time you need to decide on whether to feel bullish about the company or take a view on the market. Well....the index futures are here to bring you out of this dilemma. They'll make life easier for you by reducing your exposure in the index.

Well, a few points need to be kept in mind for understanding futures. One is that any change in the price of any scrip results in a corresponding change in the index. Other important point to note while trading in futures is that an investor should take a firm position on either the scrip or the index and play accordingly. This essentially means that if a person is bullish about a particular scrip he should not be long on the index and the person who is bullish about the index should not trade individual stocks.

To have a better understanding let us play with some numbers :

• May 12th: You buy Reliance 1000 shares @ Rs. 350 per share amounting to Rs. 3.5 Lakhs.

• Let's say beta of Reliance is 1.2 meaning 1.2% change in price for a percent change in Index.

• The Nifty spot is 1360 and Nifty June 15th future (expiry date) is 1400. The market size is 100.

• In order to eliminate your exposure in Index you have to sell Rs.3.5 lakhs * 1.2 = Rs. 4.2 lakhs worth of futures.

• This is equivalent to  4.2/(1400*100)= 3 market lots. So you go 3 short on index futures.

• The Nifty spot on June 15th is 1290.You close your nifty futures position.

• On June 15th the Reliance is @320/share so you lose Rs. 30,000 on Reliance position but you gain
  Rs. 33,000 (110*100*3) on short position at futures. That means you are able to hedge your position which would have otherwise been made on Reliance scrip in the absence of the derivative instrument.

The same logic applies when an investor is bearish about a particular scrip. He can go short on that scrip and go long on index futures to hedge against the index exposure. In case of an individual holding a portfolio too we can extend this concept with the only difference being that here we will have to consider the beta of the portfolio rather than the individual scrips. So in a nutshell the futures provides an effective shield against the fluctuations in the market. Go ahead dear investors shed your apprehensions and equip yourself with this tool to face these volatile market conditions. That is what index futures are all about.

Subhanshu Gupta