What are Index Futures and How Do They Work?

Index futures are derivative contracts in which two parties agree to take a position on the futures at a predetermined price for a future expiry date. Traders speculate on the price direction of an index to earn profits and hedge risk arising from stock investment.

In India, index futures trading is available through the National Stock Exchange and the Bombay Stock Exchange under SEBI regulations.

NSE offers futures trading on indices such as Nifty 50, Nifty Bank, Nifty Financial Services, Nifty Midcap Select, Nifty Next 50 and Nifty Indian FPI 150. BSE offers futures trading on indices such as Sensex, Bankex and Sensex 50.

This comprehensive guide explains what index futures are, how they work, their types, their importance, benefits, and the risks associated with them.

What are Index Futures?

Index futures are exchange-traded derivative contracts whose value is linked to the price movement of an underlying stock market index. The buyer and seller agree to enter into a futures contract at a predetermined price for a future expiry date.

The exchanges standardise these futures contracts. This means exchanges determine parameters such as contract expiry, lot size, margin requirements, and settlement mechanism.

Here, the underlying asset is an index, which cannot be stored in a Demat account, nor can it be bought or sold physically. Therefore, index contracts are cash-settled rather than physically settled on the expiration date. Profit and loss are determined by changes in futures prices and are adjusted through applicable mark-to-market and final settlement.

Example:

• Nifty 50 spot price = ₹24,000
• Nifty Futures trading at ₹24,020
• Lot size = 65 (may change as per the exchange rules)

A trader expects the Nifty price to rise to ₹24,200 before or on expiry. He buys one lot of Nifty futures and waits for the price to rise.

If the index moves to ₹24,200 as expected, he makes a profit of 180 points per lot, which is 180 x 65 = ₹11,700.

However, if the Nifty price declines, the position can result in a loss.

Also Read: What is Futures Trading?

How Does Index Futures Work?

The working of index futures involves several stages, from selecting an underlying index to closing or settling the trade.

• Step 1: Select the underlying index

The trader selects an index, such as Nifty 50, Nifty Bank, Sensex, or another eligible index based on the strategy.

• Step 2: Select the futures contract

Choose the appropriate expiry month index futures and review the contract specifications before placing an order.

• Step 3: Analyse the market

Study market sentiment, broader market trends, technicals, economic developments, and other factors that may influence the index.

• Step 4: Place the order

Place the buy or sell order on the selected index futures based on your own analysis.

• Step 5: Maintain margin

Keep the required margin to enter a futures trade. The broker requires a margin to maintain the futures position. This margin percentage is a portion of the total contract value, as determined by the exchange.

• Step 6: Monitor price movement

The futures contract’s value changes with the price of the underlying index. Set a stop-loss to manage the risk of losses from any adverse move.

• Step 7: Calculate daily profit and loss

Futures positions are subject to mark-to-market settlement, meaning profits and losses are periodically adjusted in accordance with exchange procedures.

• Step 8: Close or carry the trade

A trader can square off the position before expiry or hold it till expiry. It depends on the trader's target and risk management strategy.

• Step 9: Final Settlement

If the trade remains open until expiry, it is settled in accordance with the exchange's final settlement mechanism.

Types of Index Futures on NSE

NSE provides futures contracts for benchmark and sectoral indices. As of now, six index futures are available for trading on the NSE. Exchanges may introduce additional contracts as required.

Nifty Futures

Nifty 50 futures are based on the Nifty 50, a diversified benchmark representing 50 major companies in the Indian share market. They are widely used for directional trading, portfolio hedging and managing broad market exposure.

Nifty futures provide traders with a single derivative position representing movements across multiple sectors and companies.

Nifty Bank Futures

Nifty Bank futures, also known as Bank Nifty futures, track the Nifty Bank index, which represents large, liquid banking stocks listed on the NSE. They provide focused exposure to the banking sector and can be useful when traders expect interest rates, credit conditions or banking-sector developments to influence market direction.

Nifty Financial Services Futures

Nifty Financial Services futures are based on the Nifty Financial Services Index (FINNIFTY). The index covers banks, financial institutions, housing finance companies, insurance companies and other financial services businesses.

These futures allow traders to take positions on the broader financial services segment rather than focusing exclusively on banking stocks.

Nifty Midcap Select

Nifty Midcap Select futures track an index designed to represent 25 liquid mid-cap stocks selected from the Nifty Midcap 150 index. The index focuses on companies meeting specified liquidity and market capitalisation criteria. These futures allow traders to gain exposure to derivatives in the selected mid-cap segment.

Nifty Next 50 Futures

Nifty Next 50 futures are based on the 50 companies in the Nifty 100 after excluding Nifty 50 constituents. The index provides exposure to large companies outside the primary Nifty 50 benchmark.

Nifty India FPI 150 Index Futures

Nifty India FPI 150 futures track the top 150 stocks in the Nifty 500, selected based on foreign investable free-float market capitalisation. This index is traded on the NSE International Exchange (NSE IX). The index focuses on accessibility for foreign investors while covering liquid, high-free-float companies.

Types of Index Futures on BSE

As of now, there are three important index futures available to trade on BSE. However, the exchange may introduce additional contracts with different underlyings, subject to applicable regulatory requirements.

Sensex Futures

Sensex futures are based on the BSE Sensex 30, one of India’s oldest equity market benchmarks. The contract enables traders to take leveraged positions in the expected direction of leading BSE-listed companies.

Investors can also use Sensex futures to hedge diversified equity portfolios against broad market movements.

Bankex Futures

Bankex futures are based on the underlying BSE Bankex, an index representing major banking companies. These futures allow traders to gain focused exposure to banking-sector movements without purchasing individual banking stocks.

They may be used for directional trading or to hedge portfolios containing significant exposure to financial and banking companies.

Sensex 50 Futures

Sensex 50 futures are linked to the BSE Sensex 50, an index designed to measure the performance of 50 large and liquid companies. The index provides wider exposure than the traditional Sensex and represents a broader group of large companies listed on the BSE.

Also Read: Difference Between BSE and NSE

How Index Futures Prices Are Determined?

Index futures prices are determined by the current spot price of the underlying index adjusted for the cost of carry. The cost of carry generally reflects financing costs and expected dividends over the time remaining until contract expiration. It includes interest rates and expected dividends over the time remaining until contract expiration. Futures Pricing Formula: Cost of Carry Model

• Futures Price = Spot Price x [1 + (r*x/365) ] - d

Where:

• Spot price = The current market price of the underlying index.
• Risk-free rate(r) = The risk-free rate; it is the interest earned on a risk-free investment during the contract period.
• Time to expiry (x) = Number of days left until expiry.
• Dividends (d) = The expected dividends attributable to the underlying index constituents over the relevant period.

Note: Despite the cost of the carry model, actual market prices of index futures may differ from theoretical values due to market supply and demand and other market factors.

What is Margin in Index Futures Trading?

Margin is the financial requirement a trader must maintain to open and maintain a futures position.

Margin requirements for index futures depend on exchange rules and risk management mechanisms. The margin consists of SPAN margin and exposure margin, totalling 8% to 15% of the overall contract value.

Margin Components of Futures Contract

• SPAN Margin:

SPAN stands for Standard Portfolio Analysis of Risk. It is the core risk-based margin requirement used to assess the portfolio's probable risk under specified scenarios.

• Exposure Margin:

An additional margin charged above the SPAN margin, fixed at 2% of the contract value for index futures.

• Mark-to-Market (M2M):

In M2M, profits and losses are settled daily through the required process. The losses are deducted from the cash balance and require immediate funds if margin falls below requirements.

Note: The margin requirements are subject to change. Read the futures contract specifications before trading.

Importance of Index Futures in Share Market

Index futures are a crucial element of the derivatives segment in the share market. They provide a means to manage risk.

• Portfolio Hedging:

Investors can use index futures to offset some of the positional losses resulting from declines in diversified equity portfolios.

• Directional Trading:

Traders can take bullish or bearish positions based on their expectation of future price movement.

• Leverage:

Futures are leveraged products; traders need to keep margin to trade futures rather than the entire notional contract value.

• Market Exposure:

A benchmark index futures contract provides exposure to the price movement of a broader market.

Who Should Trade Index Futures?

Index futures are risky instruments, generally better suited to participants who understand derivatives and the associated risks.

• Experienced Traders:

Traders familiar with futures and options can use index derivatives for short-term directional strategies.

• Hedgers:

Investors with diversified equity exposure can use futures contracts to hedge against adverse price movements.

• Institutional Investors:

Institutions can use index futures to efficiently adjust their portfolio exposure.

• Active market participants:

Traders who can monitor charts closely can trade futures to seek opportunities based on their market analysis.

Benefits of Trading Index Futures

Here are some common benefits of trading index futures:

• Leverage:

Futures allow traders to control greater exposure by depositing only the required margin, rather than the entire contract value.

• Portfolio Hedging:

Investors can use index futures to reduce the impact of broad market movements on equity holdings.

• Directional trading:

Traders can use index futures to benefit from rising and falling markets by taking long or short positions.

• Transparency:

Standardisation and central clearing can help reduce counterparty risk and improve price transparency.

Risks Involved in Index Futures Trading

Here are some common risks involved in index futures trading:

• Volatility:

Futures prices can be volatile, which can impact futures positions during significant price swings.

• Leverage Risk:

Leverage magnifies both gains and losses. An opposite move in the index futures can result in losses that may exceed the initial margin deposited.

• Expiry Risk:

Traders who fail to understand expiry and settlement procedures may face unexpected financial consequences when positions remain open near expiry.

• Market Risk:

Unexpected geopolitical events, corporate developments, or global market movements can cause sharp fluctuations in the index.

FAQs

What is the meaning of margin in index futures trading?

Margin is the amount that a trader must maintain with their broker to open futures positions. It includes SPAN and exposure margin. The exchange decides the margin rules and may change them based on market volatility.

What is an index futures contract maturity period?

Index futures contracts follow monthly expiry cycles. Traders can select from near-month, next-month or far-month contracts based on their strategy.

What is the method of settling index futures contracts?

The index futures contracts on NSE and BSE are settled in cash on the expiry date. The difference between the contract price and the final index value determines the final settlement amount.

Who buys and sells index futures?

Participants include individual retail traders, institutional investors, and hedge funds. These contracts are used for hedging, speculation and portfolio rebalancing.