Rules For Futures

Index futures offer immense trading opportunities. Here is an analysis of some trends and tips for traders

Although options are barely into the second month of trading, index futures have been available since June 12, 2000 - that is, a period of 14 months. The market has adapted to these instruments and trading interest in them has expanded.

While the entry barrier is high with 10 per cent of a Rs 2 lakh position as the minimum size, the leverage is very attractive. If you are playing multiple positions, they are netted off when considering margins and thus the burden of margin may be surprisingly low for a heavy trader. Futures trades also allow hedgers to be short on the entire market, which is otherwise impossible.

 

We have enough data to discern a few trends, and perhaps, extract a few useful tips for traders. Some observations follow.

Observation one: The Nifty Futures are far more liquid than the Sensex. Hence, traders should play the Nifty Futures, and not the Sensex. As of this week, there is an Open Interest of more than 4,000 contracts on the August Nifty versus 670 OI on the Sensex.

In theoretical terms also, the Nifty has better market-cap coverage and is a better hedging instrument. In the long run, the NSE could perhaps introduce a rupee instrument on the dollar-denominated Nifty twin, the Defty. This would give the Indian trader an opportunity to hedge away the market risk and play the rupee-dollar risk purely in rupees.

Observation two: Wild fluctuations can be expected in the last week of settlement. Futures contracts are settled on the last Thursday of the month. That leads to wild fluctuations as the futures and spot prices align.

This is also when futures traders shift position from the near month (August at this point) to the mid-month (September) in anticipation of the expiry of the near month instrument. So the mid-month future also sees excessive volatility at this point. This shifting of positions have already started.

Depending on your personal inclinations, you can either stay out of action or take higher risks in the search of higher gains in the settlement week. Be prepared for big margin calls in this period because of the daily marking to market system.

Observation three: There is a lot of backwardation evident. That is, the futures contracts frequently trade at a discount to spot. The opportunity cost of carrying a futures position has often been negative.

The near month future has traded at a discount to spot more than 40 per cent of the time during the last year. In fact, it has often yielded a negative carry.

The mid-month future has traded at backwardation to the near-month as often as 46 per cent of the time. Sometimes the mid-month has traded at a high rate of backwardation of minus 6 per cent or more with respect to the near-month.

The mid-month to far-month relationship is similar, with the far-month often at back-wardation. But the far month future tends to be extremely illiquid and not worth trading.

The market has been trending down throughout this period. The Nifty itself has dropped over 40 per cent so the backwardation is partially caused by correctly bearish expectations.

However, hedging is an asymmetric process in the Indian futures market. Shorting the spot nifty basket and buying the future is not practically possible - at least until such time as FIs are allowed into the derivatives market. So there are opportunities for the speculator who learns how to exploit the backwardation, which could persist even if the market trend turned.

Observation four: Basis differences increase in the pure futures market. The spread between spot and near future or basis, as it