Previously in this column, we discussed the optimal route to trading derivatives. To recap, it is preferable to first trade in the spot market (or cash market) and then move to the derivatives market. Within derivatives market, it is optimal to first dabble in futures and then move to options. Some prefer options first because it requires less trading capital. True, but options expose you to frequent losses because of theta (time decay) and delta. This week, we discuss why you should start futures trading with index futures.
Downside risk and multiplier
There are two reasons why index futures are preferable to single-stock futures (futures on individual securities). One, an index constitutes a basket of stocks and is, therefore, less vulnerable to a momentum crash, even when the market tanks. Take TVS Motors, for example. This stock lost a third of its value between November 2021 and March 2022. During the same period, the Nifty Index lost 16 per cent. That is, the downside risk of an index is far less than that of an individual stock.
And two, it is relatively easy to bet on the directional movement in an index than on an underlying. Why? Suppose you have a positive view on the banking sector, and you bet on SBI (micro-level bet). What if SBI marginally declines in price, while ICICI Bank and Axis Bank perform well? On the other hand, a bet on the banking sector (a broader bet) could be still profitable; for, the index can gain if stocks other than SBI perform well.
Of course, there is a flip side to trading an index. The permitted lot size is smaller for index than for individual stocks. The Nifty Index has a permitted lot size of 50. A permitted lot size acts as a contract multiplier if you close your position before contract expiry; at expiry, it represents the number of shares you must buy (for long positions) or deliver (for short positions) under the contract. Note that single-stock futures are delivery-based, whereas index futures are cash-settled.
Relating the contract multiplier to the Nifty Index, this means that your gains will be 5,000 if the Nifty Index futures moves by 100 points. If the futures contract on TVS Motors moves up, say, 25 points, your gains will be 35,000 as the contract multiplier is 1,400. But you lose that much if the stock moves the other way, as futures have symmetric payoff.
Indices, because of lower volatility, do not exhibit sharp price changes as do individual stocks. So, you must typically aim for modest gains when you trade an index. The positive side is that losses are lower too. So, preferring to trade an index is in line with loss-aversion; losses hurt much more than gains can give us happiness.
You must be mindful of liquidity when you trade derivatives. In this regard, two factors are important — market participants’ interest in a contract and NSE’s trading rules that may affect the liquidity of a contract. Trading in Nifty Index futures at the time of writing this article was five times that of the top-traded single stock futures for the near-month expiry.
Then, there is the market-wide position limit (MWPL). This is the maximum number of contracts market participants are allowed to trade in futures and options on an underlying. You cannot add to your existing positions or roll over your existing positions when the open interest (OI) on all derivatives of a stock is 95 per cent of MWPL; for, NSE bans trading in such contracts until the OI falls below 80 per cent. You do not face such issues with index futures.
Importantly, you do not have to be as concerned about non-systematic risk (company-specific and sector-specific risks) when you trade index futures as you would when you trade single-stock futures.
(The author offers training programmes for individuals to manage their personal investments)