9.1 - The Index Futures Basics

The Nifty Futures is a special commodity in the Indian derivatives market. Nifty Futures is the most traded futures instrument in India, making it one of the most liquid contracts on Indian derivative markets. You may be surprised to learn that Nifty Futures is one of the most traded index futures contracts in the world. As soon as you become comfortable with futures trading, I imagine that you will be trading Nifty Futures like many others. It would be logical to learn all you can about Nifty Futures.

Assuming you have a basic understanding of the index, I will now discuss the Index Futures and the Nifty Futures.

The futures instrument, as we all know, is a derivative contract whose value derives from an underlying asset. The Index is the underlying asset in the context of Nifty Futures. The Nifty Index is the underlying of the Nifty Futures. The Nifty futures value will also increase if Nifty Index's value increases. The Index futures would also decline if Nifty Index's value falls.

Here's a snapshot of Nifty Futures contract 

Nifty Futures can be purchased in any of the three options available for futures contracts: current month, middle-month and far month. For your convenience, I have highlighted them in red. For your reference, I have also highlighted the Nifty futures price at Rs. 11,484.9 for each unit of Nifty. The equivalent underlying value (index in spot) was Rs. 11,470.70 The futures pricing formula is responsible for the difference in the spot and futures prices. In the next chapter, we will discuss futures pricing concepts.

You will also notice that the lot size is 75 The contract value is -

CV = Futures Price * Lot Size

= 11484.90 *75

= Rs.861,367/ -

These are the margin requirements to trade Nifty Futures.

These details should give an overview of Nifty Futures. Nifty Futures' liquidity is one of its main strengths. Let's now learn what liquidity is, and how to measure it.

9.2 - Impact Cost

Last updated 24 August 2021. According to the NSE definition of Impact Cost, it is the cost that buyers and sellers must bear in order to execute a transaction in a security. This measure is used to assess market liquidity. It provides traders with a more accurate picture than the bid-ask spread. It is different for the buy-side and the sell-side. The amount of the transaction will also affect it. The order book changes the impact cost dynamically. Stocks that are included in indices, such as Nifty 50 or Nifty 500, must meet a minimum impact cost threshold to be eligible.

Here's how to calculate the impact cost:

Ideal Price = (Best Price in Orderbook + Best Selling Price in Orderbook)

Actual Buy Price = Sum (Quantity * Execution price) / Total Quantity

Impact Cost (for that quantity) = (Actual buy price - Ideal price) / Ideal price * 100

Let's take Infosys as an example to illustrate this.

Let's say that a person wants 350 Infosys. Let's now calculate the impact cost of this transaction.

Ideal price = (1657.95+1658)/2 =1657.9751657.98

Actual Buy Price = (15*1658) + (335*1658.20), / 350 = 1658.19143, 1658.19

Impact Cost of buying 350 shares = (1658.19 -1657.98 / 1657.98 / 100 = 0.12%

These are the key messages I want to convey from this discussion:

1. The impact cost provides liquidity
2. The lower the stock's liquidity, the lower the impact cost
3. Liquidity is also measured by the spread between selling and buying prices.
   1. The spread is a measure of the impact cost.
   2. The spread is lower, so the impact cost will be lower
4. Liquidity is more important than volatility.
5. Market orders are not recommended if the stock isn't liquid.

9.3 - Why Nifty trading makes sense

The Nifty Index is a collection of 50 stocks. These stocks represent a broad range of India's economic sectors. Nifty is a good indicator of India's wider economic activity. Nifty's value will rise if there is an increase in general economic activity or at least the expectation of it. Nifty Futures trading is a better option than single stock futures. This is due to many factors. Here are some:

1. Diversified - Sometimes, making a directional decision on one stock can prove difficult. This is due to the risk perceptive. Let's say, for example, I decide to purchase Infosys Limited in the hope of good quarterly results. If the results are not impressive, the stock and my P&L would be affected. Nifty futures has a diverse portfolio of 50 stocks. The movement of the Index is not dependent on any one stock, as it is a portfolio. While index heavyweights (stocks that influence the Index's movement) may occasionally have an impact on Nifty, this is not the norm. You can trade Nifty futures and eliminate all 'unsystematic risks', and only deal with'systematic risks'. These are all new terms, and we'll discuss them in greater detail when we get to hedging.
2. It is difficult to manipulate - Nifty's movement is a result of the collective movement among the 50 largest companies in India (by market cap). The Nifty index is almost impossible to manipulate. Individual stocks, however, are not subject to the same restrictions (remember Satyam and DHCL, Bhushan Steel, etc.).
3. Highly Liquid (easy fills and less slippage) - We have already discussed liquidity in this chapter. The Nifty is extremely liquid so you can transact any amount of Nifty without worrying that you will lose money due to the impact cost. You can also transact as many contracts as you like because there is so much liquidity.
4. Lower margins Nifty futures have lower margins than individual stock futures. Nifty's margin requirements range between 12-15%. However, individual stock margins can reach as high as 45-60%.
5. A broad-based economic call -Trading Nifty futures requires that one makes a broad-based call and not company-specific directional calls. My experience shows that the former is easier than the latter.
6. Technical Analysis -Technical Analysis is best used with liquid instruments. Because liquid stocks are difficult to manipulate, they tend to move based upon the demand-supply dynamics in the market. This is obviously what a TA primarily relies on.
7. Less volatile Nifty futures are more volatile than individual stock futures. For perspective, the annual volatility of Nifty futures is around 16-17%. Individual stocks such as Infosys have an annualized volatility that can reach upwards to 30%.

To Summarize

1. Nifty Futures' value is derived from the Nifty Index in spot. This index is its underlying
2. The current Nifty futures lot size for the day is 75
3. India's most liquid futures contract is the Nifty Futures.
4. Like other future contracts, Nifty Futures contract also have three expiry options: Current month, Mid Month and Far Month.
5. Round trip trades are arbitrarily quick and instantaneous trade that involves selling at the highest possible buy price and buying at the lowest sell price.
6. Round trip trades always result in a loss
7. The impact cost is the loss of a round trip, expressed as a percentage of average bid and ask
8. Lower liquidity is associated with a higher impact cost and vice versa
9. You may lose money when you place a market or order to transact.
10. The impact cost of Nifty is close to 0.0082%. This makes it one of the most liquid contracts to trade.