The Nifty Futures

10.1 Basics of Index Futures

In the Indian derivatives market, index futures are the most traded with Nifty Futures being the most actively traded. Its popularity comes from the fact that it is highly liquid meaning traders can easily take and exit positions. In fact, Nifty Futures is one of the most traded index futures contracts in the world. If you are starting out in derivatives, it is important that you understand Nifty Futures as this is often the first instrument that traders use to get exposure to the broader market.

In conclusion, a futures contract is a derivative instrument based on an underlying asset. The underlying for Nifty Futures is the Nifty 50 Index. This means that when the Nifty Index moves higher the Nifty Futures price also moves higher and if the index moves lower the futures contract also follows the downtrend.

Like all futures contracts, Nifty Futures are available in 3 maturities – near month, mid month and far month. Today is November, you’d normally see contracts expiring in November (near month), December (mid month), and January (far month). This rolling structure allows traders to choose contracts based on whatever time horizon they prefer.

Let us consider an example of a snapshot. For example, let’s say the Nifty Index in the spot market is at ₹19,850 and the Nifty Futures contract is priced slightly higher at ₹19,900. The difference between spot and futures prices is caused by the futures pricing formula which includes such things as cost of carry and interest rates. We shall discuss this formula in detail in the next chapter.

The current lot size for Nifty Futures is 50 units. The contract value (CV) is then computed as:

CV = Futures Price × Lot Size = 19,900 × 50 = ₹9,95,000

This means that a Nifty Futures contract has exposure of nearly ₹10 lakh. You don’t need to pay the full value of this contract upfront to trade it. Rather they are required to provide a margin, which is usually a percentage of the value of the contract. Margins mean you need enough money in your long and short positions to pay for the losses.

The biggest benefit of Nifty Futures is liquidity. When volumes are high, bid-ask spreads are tighter, execution is faster and slippage is lower. For traders this means efficiency and reliability and Nifty Futures becomes a preferred instrument for hedging, speculation and arbitrage strategies.

With this background, we can now move on to discuss the concept of liquidity in more detail and understand how it is measured in the future market.

Comparison of Index Futures Contracts

Key Takeaways

• Nifty Futures is the most liquid and traded instrument. It is perfect for hedging or speculating on the overall market.
• Bank Nifty Futures are popular among traders looking to capture volatility in the banking sector.
• Sensex Futures gives you exposure to the benchmark index of BSE but the liquidity is less than Nifty.
• FinNifty Futures are relatively new but gaining popularity among traders focusing on financial services stocks

10.2 Understanding Impact Cost

When traders talk about markets, one word they use often is liquidity. Liquidity is the ease of buying or selling a stock or futures contract without a major change in the price. A very liquid instrument allows large trades to be executed smoothly, attracts institutional investors and tends to have lower volatility. Most importantly, liquidity reduces the risk of putting in a market order, since the difference between the price you see and the price at which your order is filled is small.

Let us take another example of a high-priced stock in the Indian market, that is Page Industries. Suppose an institutional investor wants to buy 3,000 shares. At the current market price of ₹41,200 a share, the deal would be worth over ₹12 crore. “Not unusual for a large institution, but the question is whether the market has enough depth to absorb such a big order. If the investor looks at the order book and sees only 2,000 shares available at the best ask prices then the investor cannot fulfil the order without pushing the price up. Page Industries is relatively illiquid compared to other actively traded stocks due to the lack of depth.

The bid-ask spread and the impact cost are ways to measure liquidity. Impact cost is essentially the loss you suffer when you do a quick round-trip trade – buying at the best sell price you can find and immediately selling at the best buy price you can find. Let’s walk through an example using Page Industries:

• Best Price = Rs. 41,210
• Best Sell Price = Rs. 41,120

The round-trip loss if you buy at ₹41,210 and sell at ₹41,120 is:

41,210−41,120=₹90

The average between the bid and ask prices is:

(41,210+41,120)/2=₹41,165

So the impact cost is:

90/41,165≈0.22%

It implies that a market order in Page Industries might cost you around 0.22% simply due to the liquidity constraints.

Now contrast this with a highly liquid instrument like Bank Nifty futures. Assume best buy price is 44205 and best sell price is 44204. Round trip loss is Rs. 1 only. The average of the bid and ask is then :

(44,205+44,204)/2=₹44,204.5

Impact cost = 1/44204.5 ≈ 0.0023%

It is of no consequence against the 0.22% impact cost in Page Industries. The difference shows the importance of liquidity

10.3 Why Trading Nifty Futures is Practical

The Nifty 50 Index is a basket of fifty top companies from across sectors of the Indian economy. This wide coverage means that the index is a mirror of overall economic activity. The Nifty generally rallies when the economy is on the rise or expected to rise. It however, usually falls when the economy is on the downswing. This makes Nifty Futures a more balanced and trustable instrument for trading than single stock futures.

Why traders prefer Nifty Futures:

Diversification advantage Investing in one company carries risk. Say you buy a future on Tata Motors, hoping that the sales numbers will be good, but they are not, then the stock can crash and you can get hurt on your position. However, Nifty Futures is a portfolio of fifty companies. Yes, there may be impact from heavyweight stocks such as Reliance Industries or HDFC Bank on the index at times, but the overall movement is across sectors. This diversification decreases the company-specific risk, and you are subject to the general market trends.

Manipulation-resistant The index reflects the overall performance of India’s largest companies by market capitalisation. The movement of Nifty is almost impossible to be influenced by any single entity. Compare this to individual stocks, history has shown that companies such as Satyam or Kingfisher Airlines were susceptible to manipulation or sudden shocks. With Nifty such risks are reduced.

Nifty Futures with high liquidity are among the most liquid contracts in India. Traders can buy or sell large amounts without worrying about slippage or wide bid-ask spreads. Market depth ensures smooth execution, no matter if you want to trade one lot or hundreds.

Close margins The margins on Nifty Futures are comparatively lower than stock futures. Margins on Nifty are typically around 12-15% of the contract value but margins on volatile stocks like Adani Enterprises or small mid-caps can be as high as 45-60%. This makes Nifty more capital efficient.

Macro level trading Trading Nifty Futures is more about taking a view on the broader economy rather than betting on the fortunes of a single company. For many traders, it is easier to form an opinion on the overall direction of the market, say on the basis of RBI policy, inflation trends or global cues than on the quarterly earnings of a single firm.

Technical analysis is used Technical analysis works best on liquid instruments that are not subject to manipulation. Nifty Futures are highly liquid and hence their price movements are largely the result of genuine demand-supply equations. Chart patterns, indicators and volume analysis are more reliable here than on illiquid stocks.

Less volatile than stocks Individual stocks can be volatile. For example,Infosys has seen annualised volatility of over 30% in some years while Nifty Futures tend to hover around 16-17%. This makes Nifty a relatively stable instrument and this is good for traders who like to see a smoother price action.

10.4 Key Takeaways

1.In India, NIFTY future is the most liquid contract, which means it has the most trading volume.

2. The underlying asset of the contract is the NIFTY 50 index. Therefore, the value of the contract depends on the level of the NIFTY index.

3. The contract has three different maturities – near month, mid month, and far month and you can choose the one that best suits your trading strategy.

4.The value of the contract is quite large, but at the same time, the required margin is significantly lower than the size of the contract. For example, if we take a contract of ₹19,900, with a lot size of 50, then the value of the contract will be equal to ₹9.95 lakh, but the size of the margin will be much lower.

5.The most critical factor for trading in futures is liquidity. Nifty Futures have the best liquidity among the futures market instruments for trading. Moreover, the impact cost for such a liquid instrument is usually low enough.

6. One of the critical indicators when trading futures is the so-called impact cost, which shows how much the price of a security is likely to change when an investor opens a position. For example, for the Page Industries stock, this value is as high as 0.22%, which is a significant spread. For the most liquid futures on the Nifty and Bank Nifty indices, this value is only 0.0023%.

7. Trading Nifty Futures allows you to reduce the risk of dependence on the fortunes of individual companies since the Nifty Index consists of the 50 largest companies in terms of market value.

8. In comparison with stocks, the Nifty Index cannot be manipulated as easily since it represents the largest companies in the country.

9. One of the most attractive aspects of Nifty Futures is the relatively low margin deposits compared to single stock futures. For Nifty Futures, marginal deposits are 12-15% of the contract value, while for single stock futures, this indicator is 45-60% on average. Such a significant difference is explained by the high volatility of shares of individual companies.

10. When trading Nifty Futures, investors can rely on macroeconomic factors influencing the performance of the indices. This is especially important for Indian investors who need to consider the Reserve Bank of India’s actions and policy rates.

10.5 Fun Activity

You decide to trade 1 lot of Nifty Futures at ₹19,900. Lot size = 50 units.

Calculate your profit or loss in each case below:

1. Nifty rises to ₹20,050
2. Nifty falls to ₹19,750
3. Nifty stays flat at ₹19,900

Formula

(Exit Price- Entry Price)* Lot Size

Answers

1. ₹20,050 – ₹19,900 = ₹150 × 50 = ₹7,500 profit
2. ₹19,750 – ₹19,900 = –₹150 × 50 = ₹7,500 loss
3. ₹19,900 – ₹19,900 = ₹0 × 50 = No profit/loss