Stock futures are agreements to buy or sell a specified stock, i.e., the equity share of a specified company, in the future at a specified price.
An investor, who is interested in purchasing a share, may buy the share in the stock exchange for cash.
He will receive the share on the second day after the transaction, where the settlement cycle is T+2 days.
The transaction is concluded at the market price prevailing at the time of the transaction. Instead of buying the share straightaway, the investor may agree to buy it in the future at a specified price within a specified time period, such as 1 month or 2 months.
This is done when the share price is expected to rise in the future. The investor is said to take a long position in the share.
This will enable the investor to purchase the share at a lower price later in a rising market.
The advantage of this transaction is that the agreement can be concluded by paying only a fraction of the full value of the transaction as a margin.
A stock futures contract may be settled on the prescribed delivery date by transfer of the underlying share for cash.
Features of Stock Futures
The key characteristics of stock futures:
1. Each futures contract or ‘lot’ represents a certain number of shares depending on the stock.
2. Futures contracts are listed with a variety of shelf lives, some twelve months, others longer.
3. There is only ever one contract per stock expiring in a specific calendar month.
At the end of the life of the contract, a trader can sell it and roll over to a further out stock future or take cash settlement or physical delivery.
He does not need to hold the stock future to expiry. He can always close the trade sooner.
4. Trading can be done electronically through online brokers as well as via phone broking.
Advantages of Stock Futures
Futures on individual stocks score over the traditional ways of buying and selling shares in many ways:
1. Leverage: Before the introduction of stock futures, if an investor expected a large price movement in the shares of, say, Bharat Heavy Electricals Ltd. (BHEL) and wanted to buy 1,200 shares at ₹450 each, he would have needed ₹5.4 lac.
If he did not have ready money or if the money was locked in a fixed deposit or in his PPF account, it would have been difficult for him to buy these shares.
The only other way was to either borrow money from the bank by pledging his FD (and after an irritating amount of paperwork) or borrow from the lock moneylender (at an exorbitant rate).
Now, after the introduction of futures, he can buy one futures contract of BHEL by just paying the margin money.
Margins on scrips generally range from 12 percent to 35 percent of the contract value.
It may be higher in more volatile scrips. Thus, one can easily leverage roughly two-nine times depending on the scrip.
2. Diversification: It is an important concept of investing. Diversification is easily possible with stock futures.
Assuming an investor has ₹5,00,000, he can either buy 1,100 shares of BHEL or buy one futures contract each of BHEL, Tata Motors, and Infosys and still have some money to spare.
He can thus invest in the power, automobiles, and IT sectors with the same amount of money, thus killing two birds – diversification and leverage with one stone.
The more money involved, the higher the flexibility in the allocation and balancing of the portfolio.
3. Short-Selling: After studying a company’s Financial statements and taking other factors into consideration, if an investor feels that its shares are over-valued, he can short the future.
He can hold to this position for three months at a time. In a stock market, it is possible to short a scrip only intra-day, as doing otherwise would require delivery of the stock in two days.
4. Low Impact Cost in the Futures Market: This is true, especially for high-liquidity futures scrips and where the transaction size is large. Investors with large investments benefit the most.
5. Low Costs: Brokerage charged in a derivatives contract is sometimes one-eighth of that generally charged on stocks.
Besides, there is no payment of depository charges, handing depository statements, etc.
6. Efficient Portfolio Management: Fund managers and investors can increase or decrease their exposure to a company or a sector very efficiently.
Thus, if a portfolio manager wants to temporarily increases his exposure in a particular sector, he can buy stock futures of scrips that are falling in that sector by allocating a small part of the funds for the extra exposure.
7. No Payment: There are no depository charges, and handling of depository statements is not required in the case of derivates transactions.
8. Hedging: One may not be able to sell shares one holds for, say, legal reasons like lock-in or minimum shareholding requirement for directors, or for psychological reasons, like attachment to shares that were gifted by persons close to one, etc.
If such shares are expected to lose value, one may be able to recover a part of the loss by shorting the future.