Market Insight: Opting for futures

Rupee-denominated contracts in dollar-denominated indices will help develop trading volumes of indices.

The induction of 31 new stocks to the NSE stock futures adds depth to an already vibrant market. The lack of delivery means that India's huge stock futures volumes consist purely of speculation/hedging.

The existence of stock futures helps rolling settlement operate more smoothly. Stock futures drive away the manic speculative element. It has led to increased delivery ratios (as a percentage of spot market trades).

The stock futures compensate to an extent for the lack of stock-borrowing and shorting mechanisms. You no longer have the delivery crises that used to plague old badla. The F&O market also protects the small day-trader (generally a spot operator) from the larger player who can commit large margins.

Of course, stock futures are like casino games. In blackjack, you bet on your next card pulling your hand-count closer to 21. In the stock futures market you bet on something going up or down in exactly the same spirit.

Of course you can use F&O to hedge spot positions and Nifty index volumes are a reflection of that. But Infosys is also just a "game" played for a minimum stake of about Rs 2.1 lakh while say, Ad Labs requires a higher minimum stake and has fewer players.

The induction of new stocks creates trading opportunity. The world over, there is clear differentiation in the behaviour of index stocks and of non-index stocks. When a stock enters an index, it is guaranteed institutional following. Analysts start tracking it and ETFs and index funds buy it. A new index-stock will usually rise in the short-term. In the longer-term, fundamentals reassert but volumes swell permanently.

Something similar will happen with these 31 new counters. The dynamics of F&O stocks are different from spot-stocks. A spot stock has circuit filters; F&O stocks don't. Speculating on margin with spot stocks is tough. F&O margin positions are available for months at a time.

As a result, F&O stocks have higher liquidity and the change in behaviour when a stock is moved in or out of F&O is marked. The effect will probably be felt until the end of the June settlement.

If you're holding any of these stocks as a long-term investor, be prepared for gyrations. Also, take a look at what the financial advisories are saying about your positions. It may help fine-tune your own investment focus.

Ideally, the top 500 stocks or so will all eventually be available in F&O. This will make life much easier for the fundamentalist who diagnoses long-term weaknesses that lead to "shorts". One contemporary legend centres on a trader who started shorting Jet Airways at 1100 in September 2005 and finally cashed out at sub-600 in July 2006. He rolled over short futures, for 10-11 months. This seems cumbersome but it's far easier than borrowing the stock for 11 months.

Apart from the mechanics, my point is that this short strategy is just as "fundamental" as buying a stock over the same period. I can think of other such shorts. For example, based on global crude trends, you could have shorted PSU refineries almost any time between 2004 and 2007.

Or you might have tried leveraging the rupee's rise over the past six months by selling the Nifty and buying Defty to profit from lower differentials as the Defty rose relative to the Nifty. But of course, you cannot buy the Defty. This is a great pity.

The NSE Index futures and options segment generates less interest than stock futures, even though the Nifty is by far, the single largest-traded underlying. The interest rate segment is moribund.

One way to develop index volumes would be to offer rupee-denominated contracts in dollar-denominated indices. Say that the NSE also started reporting dollar-denominated and maybe Euro/ Yen versions of bank Nifty and the CNXIT along with the Defty. And say, that it then offered vanilla, rupee-denominated F&O contracts on these indices.

The contracts would attract large volumes because they offered currency-risk hedges. And, while they may induce hedge-fund inflows, the contracts in themselves would not cause currency instability. They would actually increase comfort-levels for people who are prepared to hedge currency risks. They may even draw volumes from the treasuries of cash-rich IT companies.

Think about it. A standard forex contract is denominated in a million USD and it cannot be entered into except by an institutional player. A spread of sell Nifty-buy Defty would cost less than Rs 1 lakh. Dollar-denominated index contracts could be a very cost-effective and safe entry-point into forex trading for Indian players.