Why and how to trade in Nifty futures

An index future is a derivative, similar to a stock future, whose value is dependent on the value of the underlying, in this case, the index like the S&P CNX Nifty or BSE Sensex.

By trading in index futures, an investor is buying and selling the basket of stocks comprising the index, in their respective weights.

Stock index futures are traded in terms of number of contracts. Each contract would be to either buy or sell a fixed value of the index. The value of the contract would be the lot size multiplied by the index value.

About Nifty futures

Nifty futures are index futures where the underlying is the S&P CNX Nifty index. In India, index futures trading commenced in 2000 on the National Stock Exchange (NSE).

For Nifty futures contracts, the permitted lot size is 50, and in multiples of 50. Like other futures contracts, Nifty futures contracts also have a three-month trading cycle -- the near-month, the next month and the far-month.

After the expiry of the near-month contract, a new contract of a three-month duration would be introduced on the next trading day. Investors can trade in Nifty futures by having a margin amount in their account. This margin is a percentage of the contract value. It is usually about 10-12 per cent.

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Why should you go for them?

Hedging. In simple terms, hedging is a strategy that helps limit losses. Exposure to a stock is equivalent to exposure to an index. This is because most stocks move in tandem to the market. Exposure to index futures helps hedge this risk.

Speculative gains. If you are certain about future market movements, you can make profits through index futures. If you bullish on the market, buy index futures. If bearish, you should sell index futures.

How do they work? You enter into a Nifty futures contract at a specified index value. On the expiry of the contract, the investor's profits would be the difference between the level of the index on expiry and the level specified in the futures contract at the time of purchase.

Strategies

Short stock, long index futures. There are times when you sell the stock, but there is an upside in the market, thus resulting in lost potential profits. Index futures help you mitigate this risk. By buying index futures when you are short on the stock, you can minimise the amount of potential profits lost.

Equity portfolio, short index futures. There are times when you own a portfolio and are uncomfortable about market conditions. You can hedge this risk by selling index futures. The concept vests on the fact that every portfolio has index exposure and risks are accounted for by fluctuations in the index.

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Long Stock, Short Index Futures

Suppose you are long 500 shares of Reliance Industries at the price of Rs 1,000 per share; spot Nifty is at 5,000; and Nifty futures is at 5,020.

To protect your Rs 5 lakh (Rs 500,000) position from a market downturn, you need to sell 100 Nifty futures. Suppose on the expiry date, the spot/futures Nifty is at 4,750 (5 per cent fall). On closing, both the positions, you would earn Rs 2,000.

Your position in Reliance Industries would have dropped by Rs 25,000 and the short Nifty would have gained Rs 27,000 [i.e., 100 x (5,020-4,750)]

Short Stock, Long Index Futures

Suppose you are short 400 shares of Infosys Technologies at the price of Rs 2,500 per share; spot Nifty is at 5,000; and Nifty futures is at 5,050.

To protect your Rs 10 lakh (Rs 1 million) position from a market upside, you need to buy 200 Nifty futures. If, on expiry, the spot/futures Nifty is at 5,250 (5 per cent rise), on closing both positions, you lose nothing.

Your position in Infosys would result in a loss Rs 50,000 and the short Nifty would have gained Rs 50,000 [i.e., 200x(5,250-5000)]

Hedging Portfolio Risk

Suppose the spot Nifty is at 5,000 and the three-month Nifty futures at 5,015. To protect a portfolio of Rs 5 lakh (Rs 500,000) from a drop in the market, you need to sell 100 December Nifty futures.

Suppose on the expiry date, the spot/futures Nifty is at 4,500 (10 per cent fall). Your hedging strategy would earn you a profit of Rs 51,500[i.e., 100x(5,015-4500)], which compensates you for the Rs 50,000 (10 per cent) fall in your portfolio.