Previously, in this column, we discussed our preferred pecking order for trading derivatives. We showed that it is optimal to first start trading index futures, then single-stock futures followed by index options, and finally, equity options. This week, we discuss the benefits and disadvantages of trading index futures.
Betting the basket
The biggest advantage of trading index futures is that it is a bet on a basket of underlying stocks. So, even if several stocks in the basket decline, the index can move up and generate gains on the long futures position. The same argument can be applied for short futures position. This argument applies to both Nifty futures and Bank Nifty futures. Take the latter, for instance. Even if one or two banking stocks decline, the Bank Nifty Index can move up and generate gains. On the other hand, if you bet on, say, IndusInd Bank and the stock declines, you would have lost on your long futures position. Also, both Nifty futures and Bank Nifty futures are actively traded relative to many single-stock futures contracts.
That said, you must be mindful of the disadvantages of trading Nifty futures. Suppose, several stocks in the Nifty 50 Index move up but the heavyweight stocks decline. The Nifty 50 Index is unlikely to move much. As the Nifty futures contract moves almost in lockstep with the Nifty Index, it is unlikely that the futures contract will move up much. So, despite some stocks outperforming the index, your futures contract may not generate gains.
If your objective is to outperform the market in a trading period, then betting on Nifty futures may not be optimal. You should instead initiate single-stock futures positions on stocks that have, preferably, lower weights in the Nifty Index; they are the ones that can outperform the Nifty Index.
Finally, you do not have high flexibility to engage in relative-value trades with index futures. For instance, if you believe that ICICI Bank will outperform HDFC Bank in the near term, you could take long position in ICICI Bank futures and short position on HDFC Bank futures in such a way that you neutralise the market risk in the positions (beta-neutral trade). When futures contracts on multiple indices become available, you can bet, say, the pharma sector will outperform banks or even the Nifty Index. Currently, such trades can be done between Bank Nifty and Nifty Index.
Long futures
Even if several stocks in the basket decline, the index can move up and generate gains on the long futures position
Optional Reading
An optimal trading system would include index futures to bet on the macro-level trend and single-stock futures to bet on an underlying outperforming the Nifty 50 Index. Of course, this would require large trading capital. But this should not be the reason for you to trade options. Options require lower trading capital, but option prices are sensitive to changes in volatility and suffer from time decay. So, betting on options requires you to not only have a view on the underlying but preferably also on the underlying’s volatility.
(The author offers training programmes for individuals to manage their personal investments)
