What are Index Futures: Meaning, It's Working, Types & Benefits | Espresso

All You Need to Know About Index Futures

Index futures are a combination of two things. Before you understand what are index futures, it is essential to understand an index and a futures contract. The former refers to a benchmark that is used to measure the performance of a particular stock against the index.

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There are different types of indices. The most popular ones include Sensex and Nifty. On the other hand, a futures contract is a contract between the buyer and the seller where the buyer agrees to purchase a stock or commodity at a pre-fixed price and date in the future.

Index futures are futures contracts on the index. Let’s find out more about them in this article.

What Are Index Futures?

Index futures are a type of futures contract where you bet on the stock index’s future price. Index futures let you buy or sell a futures contract derived from an index at a fixed date in the future. The day when the contract ends is known as the expiration date, and the price set at the beginning of the contract is called the strike price.

If the price of the index is higher than the price you place the contract for, you can make a profit. However, if the cost of the index is lower than the price of the contract, you stand to suffer a loss.

The maturity period for an index futures contract can range between one and three months on a rolling basis. However, it usually expires on the last Thursday of a month.

Index futures were initially only open to institutional investors. However, they are now popular among individual investors too.

How Do Index Futures Work?

Index futures work just like a standard futures contract. The contract mandates the buyer to buy the underlying asset as in the case of a futures contract. Likewise, the index future contract requires traders to buy or sell the contract at the pre-fixed price at a specific date in the future. Since this is a futures contract and not an options contract, the traders are obligated to carry out the trade irrespective of how the cost of the underlying index moves. Moreover, the contract can end only after the expiration date and not before.

To trade in index futures, traders need to deposit an initial margin. This is paid to the broker and is equivalent to a certain percentage of the total transaction. Ideally, this amount should suffice for any probable loss in the transaction. Therefore, both the buyer and the seller deposit the initial margin. For instance, if the initial margin is 5% of the trade for a total value of ₹1 lakh, the buyer and the seller have to deposit ₹5,000 each to the broker.

Unlike futures of stocks or commodities where the contract ends in the delivery of the concerned shares or commodities, an index future contract is settled in cash. If the index price is higher than the strike price, the buyer makes a profit while the seller incurs a loss. Alternatively, if the index price is lower than the strike price, the buyer incurs a loss, and the seller makes a profit.

Another critical thing to note when trading in index futures is that they have a contract or lot size. This refers to the number of shares you can trade at a time. For instance, the lot size for the index, Nifty, is 75 shares. So, you can either trade in 75 shares or in multiples of 75.

Types Of Index Futures In India

Here are some index futures in India:

  • S&P BSE Sensex
  • S&P BSE Bankex
  • S&P BSE Sensex 50
  • S&P BSE Bharat 22 Index
  • Nifty 50
  • Nifty IT
  • Nifty Bank

Benefits of index futures

Here are some pros of trading in index futures:

  • Lower margins:The initial margin for indices is relatively lower than most stocks. This reduces the risk involved in taking a position in index futures.
  • Lower costs:The commission charged and the Securities Transaction Tax (STT) paid on index futures are comparatively lower than equities and stock futures.
  • Better diversification:You can spread out risk by trading in index futures that are a basket of different stocks than investing in individual stocks of companies.
  • Good returns:Index futures let you earn money from market indices movements.
    Also Read: Trading in Nifty Futures

Things to Keep in Mind When Trading in index Futures

Here are some things to consider before trading in index futures:

  • Theindices can move in either direction – up or down. There is no guarantee of a profit as with most market-linked products.
  • In some cases, individual stocks can outperform the index and deliver better returns than index futures. 

To Sum It Up

Index futures can be highly speculative and risky and may be ideal for experienced traders. It can take some time to understand how they work. However, proper research and understanding can help you make profitable bets.

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Frequently Asked Questions

All index futures contracts are settled in cash.

Index futures are a type of futures contract derived from an underlying Index. In an index futures contract, the buyer and seller fix a strike price and expiration date based on which the trade is carried out. 

An index futures contract is an obligation that mandates the buyer to carry out the trade at a pre-fixed price regardless of how the index price moves. If the price moves up, the buyer makes a profit. However, if the price moves down, the seller stands to gain.  

The initial margin is charged by the broker and mandatory in every trade. It can differ depending on the broker you choose.