The primary purpose of any derivative instrument is to provide a mechanism to market participants to hedge undesirable risks. Equity derivatives are one such instrument.
Index futures -- which derives its value from underlying indices -- trade a component of price risk, which is built into investment in equities.
Price risk involves price movement of securities, held by you, in an unfavourable direction. For instance, if you have bought a security for Rs 100, there is the risk of the price going down.
The price has two components: Specific risk is generated by specific events in the company and industry.
This risk is inseparable from investing in securities and can be reduced to a certain extent by taking well-informed investment decisions based on research.
Also, as the price risk of a portfolio is less than that of a single stock, diversification is the conventional way to reduce this risk - that is have stocks representing major industry sectors.
Market risk is the component of the scrip's price risk, which is generated by factors other than company and industry related factors like economic and political events. All scrips are exposed to market risk. This risk can be hedged with the help of index-based derivatives.
An example will serve to illustrate this - Ram has a portfolio of Rs 2,00,000 with a beta of 1.5 vis-a-vis the BSE Sensex.
(Beta is a measure of systematic risk. Simply put it measures how much your scrip moves with every base movement in the index).
He has taken a call on the markets and expects it to go down in the next one month.
He has two choices: go to the cash market and sell his portfolio and buy it back after the fall in prices. Or he can use index futures to protect the value of his portfolio from the expected fall.
This is how he can hedge his price risk - if Ram decides to hedge his downside risk by using index futures then he will have to sell or go short in the index futures market.
This is called shorting the index, in expectation of it going down in the future.
If the market goes down as expected by him, he will lose in his cash position but gain in futures.
Therefore, he would have compensated his losses, partly or fully, depending on his position in the futures market, by profits in his futures position.
Ram has the flexibility to either partly hedge or fully hedge his exposure in the cash segment, depending upon how confident he is of the call he has taken on the market movements.
The number of contracts he trades in, would of course, determine up to what extent we are hedged but that is a technicality.
If the market behaves contrary to what Ram had anticipated and moves up, then whatever gains he makes on his cash position will be offset by losses in futures. Therefore, with hedging, he loses the opportunity to make money.
Ram could have taken the other option of selling his portfolio when he expected the market to go down, and buy it again after the fall in prices.
But the impact cost and cost of transaction makes this option highly uneconomical. The same objective can be met by using futures at much lesser cost and at higher speed.
The same principle applies when using index options - only here, unlike as in the futures contract, the buyer of the option has the freedom to exercise his option.
If the market moves in his favour then he can forgo the right to exercise the option and his loss would be limited to the premium he has paid to purchase the right.
On the other hand, if the market moves according to his anticipation and for which he has hedged his position, then he will exercise the option.
It works this way - take Ram again. He has shares bought at Rs 100. He is uncertain about the future and purchases an option to sell the stock at Rs 105 one month from now.
If the stock price moves to Rs 110, then he can sell the stock in the cash market itself and he loses his premium.
On the other hand if the stock price moves down he exercises his option to sell and makes a profit.