Futures on Equities

This chapter deals with the special features of futures markets in equity shares, including equity indices (also known as stock futures and stock index futures). The general principles applicable to futures markets are also applicable to futures in equity markets. The raison d'etre of equity futures is to enable the hedging of equity positions. A special and rather unusual feature of the equity or ‘stock futures’ market in India is that it is increasingly seen not as a supplement to the cash market but as a substitute. The relatively higher volume of trading on the futures markets in India vis-à-vis the cash stock market appears to be explained by two main factors. The first factor is that India's futures market is one of the few that has active futures trading in individual shares (single stock futures) rather than in broad stock market indices. This is partly the legacy of the old Indian badla system that was an indigenous form of forward trading in individual shares that ended in the late 1990s and was replaced by equity futures. Because there are futures markets in individual shares, the Indian equity futures markets allow speculation on specific companies without basis risk. When only index futures are available, an investor in the stock market cannot really use futures to back his view on an individual company. The Indian market allows speculation on individual shares through futures. The second factor is margin or leverage. The cost, extent, and ease of leverage is higher through futures: • India's credit markets are not as well developed as in, say, the United States. Getting a loan in order to trade on equities is not easy or quick. The ‘automatic borrowing’ in the futures market (through the fractional margin system) makes things much easier; there is no formal credit agreement nor the attendant transaction costs and time. • When a speculator borrows from a broker to buy stock and takes a long position with, say, a ‘2x’ (two times) leverage, the broker lends money for half the position to the investor and charges him interest.