Index futures and options are those whose underlying is an index and not a stock. They allow you to capitalise on market movements and also protect your portfolio during volatile times.

The advantages

Index futures and options have several advantages over their stock counterparts. First is that they have higher liquidity as compared to stock futures and options, ensuring easy entry and exit. Another advantage is the lower margin requirements for trading. For index futures the margin is approximately 10% while in stock futures it varies between 20-30% depending on the stock volatility. And the third is, generally, there is not much difference between trading costs for stock and index futures and options. Brokerage rates are the same for both index and stock futures. Fourth is that index tends to be less volatile compared to individual stocks. So, a first-time investor should keep away from stock futures as the underlying will be far more volatile as compared to Nifty.

When to use

Index futures and options could be ideally used when you anticipate big movements in the market. If you are anticipating a fall in your portfolio in the near future, you could use index futures and options to protect your portfolio. Suppose a long-term investor faces a risk of markets falling in the short-term, instead of selling his investments, he could reduce risks by buying index put options. This is known as hedging. Ideally hedging of portfolio should be done when there is lot of euphoria in the markets and levels of the markets are quite high.

You could also use index futures and options when you anticipate a major event like the budget or reform policies that might have a huge positive impact on the market. However, it is prudent to note that index options might be a safer bet than futures. Retail investors have to bear in mind that naked positions in futures market are highly risky.

How to use index F&O

Both the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) offer index futures and options and the underlying include Sensex, Nifty, Bank Nifty and CNX-IT. Choose the index based on your market sentiment (whether it is as regards the whole market or a particular sector).

How to hedge

One shouldn’t choose an index futures or options at random. The first step is to find the index with the composition that most closely resembles your own portfolio. It might be physically tough to compare stocks if you have too many. So, you could do a correlation between your portfolio and the indices available. The higher the correlation between your portfolio and an index, the closer your portfolio is to that index. You could take the help of your broker or do it on your own using Microsoft Excel.

Once you have done with choosing the index, decide whether you are going to do partial hedging or full hedging. Sometimes a full hedge might be really costly. The third step is to determine what you think will be the market sentiment during the tenure of the option and by the end of the option tenure. You cannot hedge without any underlying thought process on the markets. Your strategies would differ based on your views of the market. Hedging portfolio through options if implied volatility is less and time left to expiry is also high, would be a cost-effective way.

If you feel the market sentiment will be bullish, you could buy index calls or sell index puts. While for the former, the risk is limited and the profit is unlimited, it is totally reverse for the latter. For a bearish market sentiment, one should look at selling a call or buying a put. The former has unlimited risk, limited profits and the latter has unlimited profits and limited risks. It is best to go for At the Money (ATM) options because ATM options are generally more liquid and see higher volumes.

If you fear a big correction in the market, you can buy put options to hedge the portfolio. If you are bearish, you could also look at selling a call. Out of the money (OTM) options can fetch very high returns with low risk. When there is an expectation that market would not move much in either direction, one could go for short strangle., which is also known as sell strangle. It is a neutral strategy in options trading that involve the simultaneous selling of a slightly out-of-the-money put and a slightly out-of-the-money call of the same underlying stock and expiration date.

Here are some strategies for different market scenarios.

Here’s an example of a long strangle. Suppose XYZ stock is trading at Rs 40 in June. An options trader executes a long strangle by buying a JUL 35 put for Rs 100 and a JUL 45 call for Rs 100. The net debit taken to enter the trade is Rs 200, which is also his maximum possible loss.

On expiration in July, if the XYZ stock is still trading at Rs. 40, both the JUL 35 put and the JUL 45 call expire worthless and the options trader suffers a maximum loss which is equal to the initial payment of Rs 200 taken to enter the trade.

If the XYZ stock rallies and is trading at Rs. 50 on expiration in July, the JUL 35 put will expire worthless but the JUL 45 call expires in the money and has an intrinsic value of Rs 500. Subtracting the initial premium of Rs 200, the options trader’s profit comes to Rs 300.

Steps in hedging

• Identify the index that closely resembles your portfolio. Doing a correlation might help.
• Decide whether you are going for a partial or full hedge.
• Ascertain the possible market condition that might prevail during or by the end of the options period
• Choose the strategy based on the ascertained market condition.
• Find out the cost of the hedge strategy and ensure that it is worth hedging.

Beware

It is very important to remember that hedging involves cost. One should see if this cost is worth the uncertainty one is expecting. Hedging cost shouldn’t exceed more than 7% of the portfolio value. You need to be certain that the change will be big enough to warrant your hedge. One should keep in mind the premium being paid for the options and the duration until which one wants to keep the hedge. Also, remember that you are hedging to protect your portfolio, so don’t book profits and lose the hedge.

Want to know more about futures and options? Read this article – What are futures and options? How can you start trading in them?

Kavya Balaji

Kavya Balaji is a senior contributing writer with RupeeIQ. With more than 14 years of experience in the finance space, Kavya loves everything to do with personal finance. She feels financial literacy is important for every household and likes to stick to simple language for explaining personal finance stories. She is a consultant with investment management companies. In spare time, she reads murder mysteries.

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