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Index futures are financial instruments that enable investors to speculate on the future direction of entire market indices.
In this article, we will embark on an illuminating journey into the world of index futures, unravelling their mechanics, applications, and the pivotal role they play in modern finance.
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What are index futures?
Futures serve as risk management tools found within the derivative market. Through these derivative contracts, the buyer and seller agree to buy or sell a specific asset at an agreed-upon price and date in the near future. This asset could be a stock or an index.
These agreements, known as futures contracts, are traded on organised platforms like NSE or BSE. Importantly, the exchange itself determines aspects like the contract’s expiration date and size.
At present, futures trading extends to a range of indices, including NIFTY 50, NIFTY Bank, NIFTY Financial Service, NIFTY Midcap Select, and 185 individual securities.
Futures are commonly employed to capitalise on short-term price fluctuations in the underlying asset, unlike investors who purchase assets like stocks with a long-term outlook.
Investors can capitalise on an expected increase in the future value of the underlying asset by acquiring a futures contract. Conversely, selling a futures contract can result in gains when there’s an expected decline in the asset’s value.
Types of index futures
S&P BSE Sensex: The S&P BSE Sensex index comprises 30 underlying stocks, forming the BSE’s Sensex. It reflects the performance of these 30 stocks collectively.
Nifty 50: Nifty 50, tracked by the NSE, consists of 50 underlying stocks. These stocks represent the overall performance of the Nifty index.
Nifty Bank: Nifty Bank consists of shares from the banking industry. Consequently, the performance of Nifty Bank futures is tied to the health and performance of banks.
S&P BSE Bankex: Herein, stocks from the banking industry are found which constitute the Sensex index.
Others: Additionally, you have the option to indulge in trading in index futures through international stock exchanges, such as Standard & Poor’s 500 and FTSE 100 futures, on Indian exchanges like the NSE.
Trading in index futures
Steps for trading index futures:
- Open a trading account: You are required to have a trading account with a registered stockbroker in India that provides access to index futures trading.
- Complete the KYC process: Fulfil the Know Your Customer (KYC) procedure by submitting the required documentation- Aadhar card, PAN card, address proof, and a passport-sized photograph.
- Fund your account: You should keep the requisite funds in your account for trading.
- Research and select an index: In India, popular indexes include Nifty 50, Sensex, and various sector-specific indexes.
- Place your trades: Using your trading account, place buy or sell orders for the chosen index futures contract. Specify the quantity and price for entering into a contract.
Also read: What are NIFTY futures?
Benefits of index futures
Diversification: Trading index futures allows investors to diversify their portfolios by gaining exposure to a broad market index, such as the S&P 500 or Nifty 50, required to reduce the risk of price fluctuations.
Leverage: Index futures typically require a smaller initial investment. This leverage allows investors to hold a position with a comparatively small capital outlay.
Hedging: If traders anticipate a market downturn, they can sell index futures to offset potential losses in their stock holdings, effectively providing insurance against adverse market movements.
Liquidity: Major index futures, like those based on the S&P 500 or Dow Jones, tend to have high trading volumes and liquidity.
Efficiency: Index futures provide market exposure without the hassle of buying and managing a portfolio of equities, saving time and money.
Risks of trading index futures
- Leverage amplification: Index futures involve leverage, which magnifies gains and losses, increasing the risk.
- Market volatility impact: Sudden and unpredictable market swings can lead to substantial financial losses.
- Margin call pressure: Falling below-required account balances can trigger margin calls, necessitating additional funds.
- Interest rate influence: Changes in interest rates can directly impact the prices of index futures contracts.
- Counterparty risk: There is a risk of the other party involved in the contract defaulting, potentially causing financial harm.
While index futures offer these benefits, they also involve risks, including the potential significant losses, especially when trading with leverage. It is important to make a note of the operations of the market and to reduce risk while entering in index futures trading.
Stock index futures are futures contracts on the index for future data at a price determined today. In India, Nifty-50, Bank Nifty, and Nifty Financial Services index futures are offered by the NSE.
Here is a 6-step guide you may follow to trade index futures.
Understand the difference between futures and CFDs.
Select an index.
Choose whether you want to go long or short.
Start trading by placing your first transaction.
Keep an eye on and close your position.
Compared to the stock market, trading in the futures market gives you access to more leverage. For equities, the majority of brokers just ask a 50% margin. You could be able to get 20-1 leverage for a futures contract, which would increase both the profits and losses.
Unlike stocks, that trade perpetually, futures contracts have expiration dates. To avoid the expenses and obligations related to contract settlement, they are carried over to a different month. The two most common methods of settlement for futures contracts are cash settlement and physical settlement.
Yes, you can sell futures before expiry. Trading futures contracts for financial gain is permitted as long as the contract closes before expiration. A lot of futures contracts expire on the third Friday of each month, but each contract is different, so be sure you understand the terms before trading.