The futures game

There’s nothing like buying stocks for the long haul. After all, it returned more than 13.7 per cent over the last 10 years. But buying and staying invested in the stock market may have a detrimental effect on your financial health—in the short-term, at least. That’s what this market has done since the beginning of the year. Investors still holding on to their stocks have seen more than a year of gains evaporate as the Sensex nosedived to a 15-month low of 12,575 at closing on July 16. From its peak, the bellwether is down about 39.7 per cent. If the frontline has to rebound to its January 2008 glory, the Sensex has to return a compounded growth rate of about 26 per cent over the next two years.

Many retail investors have a tendency to stay invested in the market, but few are willing to short the market or sell, for instance, the Nifty index to buy it back at a lower price with an eye to making a profit. As the macroeconomic environment deteriorates, the stock markets change course for the worse. And retail investors usually are reluctant to play the dip. Says Rohit Sekhsaria, Head (Derivatives), Enam Securities: “By nature, retail investors don’t short the market. But if you already have a sizeable portfolio, you can hedge in a falling market.”

There are many reasons for the long haul theory. Primarily, it’s that the buy-and-hold strategy pays off in the long run, particularly if the investment is in a sound company.

But the most basic one is that investors are reluctant to book losses in a down-market or even forego a part of their profits in the hope that the stock will bounce back again. Yet, market strategists believe that a long-only strategy (which in other words means buy-and-hold) has its drawbacks. In a severe market downturn like the latest one, these investors lose their valuable earnings to the short-sellers.

Here’s where the futures market can be another alternative for investors. In fact, investors can buy or sell futures, and if the call goes right, they tend to make money.

When trading in index futures, investors are taking a broad call on the larger economy and its prospects. It’s a proxy to investing in the economy as investors are indirectly buying stocks that are present in the underlying index. If the overall economy is progressing well, the stocks of the respective index will also rise in value, resulting in gains for investors. Says Sekhsaria: “If you are bullish on India but don’t want to invest in individual stocks, then index futures are the option.”

And it’s getting increasingly easier for the small investor to access the futures market. Since the beginning of this year, stock exchanges have introduced a new futures contract with much smaller unit sizes than normal futures. These are called the Mini-Nifty and Chhota Sensex.

Natty Nifty

Market experts say about 5-7 per cent of an investor’s portfolio should be invested in futures. Says Siddharth Bhamre, Head (Investor Advisory), Angel Broking: “About 5 per cent of your portfolio can go for trading the Nifty. If you are on the right side, you can make good money.”

The futures primer It pays to know the key futures lingo. Futures: It’s a contract between buyers and sellers to purchase a particular asset at a specified future date. The actual purchase or sale involving payment of cash or delivery of shares of the instrument does not happen till the date of delivery. Both the parties are obliged to fulfil the terms of the contract Margins: Investors have to pay only a small fraction of the total contract value as margin. This allows the investor to leverage his position and enter into a contract with a small exposure. But the gains and losses are equally large Open interest: It’s the number of contracts outstanding in the market at a specified point in time. It shows the market’s interest in a particular stock or index Contract month: This is the month in which the contract will expire. Futures contracts have to be fulfilled on the last day of settlement

Of late, retail investors have been warming up to investing in the Nifty. Bhamre notes that many investors are active in the index futures as compared to direct stocks in the down-market. “Whenever the market rises, people are more comfortable in buying stocks. But in a falling market, investors are comfortable in shorting the index.

There’s active trading in stock futures in a rising market. In a falling market, investors prefer to trade directly in the Nifty,” says Bhamre. Among the reasons why big investors prefer to go through the futures market is because the transaction costs are much lower than normal brokerages. Also, a big bulk order in a stock can distort its price in a big way, and impact the final price of the transaction for a big investor. But that’s not the case when dealing in the futures market as it’s highly liquid.

As risky as it gets

But before getting into the futures market, you should understand the risk involved with investing in stocks, options or futures. With stocks, there’s the risk of price fluctuation. But the risk is vastly different between futures and options.

Unlike options where you can quantify your loss in advance, in futures the risk is unlimited. When you buy futures, you agree to accept delivery of a certain quantity of stocks at an agreed price at a future date. But if the market falls, your future value of the stock will be lower, and you will have to bear the loss.

On the other hand, when you sell futures, you need to deliver the shares in case of stock futures and or in the case of index futures square the difference in cash on settlement day. And likewise, if the market goes up, you will have to bear the loss again. Says Jigar Shah, Country Head, Equity Advisory Group: “An investor should clearly understand the risk involved and the amount of losses he can bear.”Also, look out for particularly volatile days. Investors tend to make big losses in futures when there’s a panic sell-off or when the stock markets tank 10-15 per cent. During such times, as prices fall, brokers demand more collateral from investors. If investors aren’t able to bring in more collateral, brokers reverse the trades. Therefore, investors should not stretch their investments way beyond their means.

Size does not matter Mini index futures provide a cheaper alternative to retail investors. When it comes to investing in the index, large institutions prefer the index futures. But for small investors, there’s another option to invest in the index futures: Mini Nifty or Chhota Sensex. At the beginning of the year, stock exchanges introduced mini index contracts essentially to encourage retail investors to invest in the index or hedge their portfolios. These mini futures are essentially smaller versions of the index futures contract. For example, the Nifty futures have a lot size of 50 units. This means that when you buy one lot of Nifty futures, you are buying 50 units of the Nifty. In other words, your exposure to the Nifty is Rs 2 lakh, if, say, the Nifty is hovering at 4,000 points (4,000*50). A Mini Nifty contract, however, has a smaller lot size of 20 units. If you invest in this contract, your exposure to the market is about Rs 80,000 if the Nifty is trading at 4,000 levels (4,000*20). The margin requirements for mini contracts are low as investors need only about Rs 15,000 to invest in these contracts, depending on the broker. The lower ticket size of these contracts is drawing more retail investors to participate in index futures. With a small investment or margin money, an investor can take a higher exposure in the market, which essentially takes his leverage to roughly about eight times his investment.

“There’s not much risk apart from the risk of overplay,” avers Sekhsaria. “But if markets fall very sharply on a single day, which does happen sometimes, and if an investor doesn’t have any money to pay the difference in the stock price, then he loses his position.”

Very often investors enter the futures market without knowing the risks involved, say market experts. The truth is that the futures market is speculative, and investors don’t know if they will win or lose.

And since the margin levels are also low, many investors are tempted to participate in the futures market. Says Bhamre: “As the margin requirements are low in index futures, it becomes easier for investors to speculate in the market. Investing in futures only is speculative.”

Look before you leap

If you look closely enough, ideally, the futures market is for those investors who have spare capital to face any contingency. If someone plays the futures market with an eye on creating a corpus for his retirement, then he is making a grave mistake.

And since index futures is a short-term instrument, investors must also understand the nuances of stock trading. Also, invest only the amount that you can afford to lose, depending on your corpus and ability.

If you have more cash, particularly if you are a high networth individual, you can perhaps allocate more to the futures market.

Most institutions use the futures and options market to hedge their existing portfolios. If that’s your objective, then go ahead. But if you are going to dabble only in the futures market for trading gains, then remember the stakes are high. If you can’t take it, then avoid the hassle.