How to buy a stock index future

For all the hype and publicity that attended the launch of trading in equity derivatives on the two premier bourses in the country - the and the National Stock Exchange - the nitty-gritty of this rather arcane concept is simplicity itself. Provided one is familiar with the system.

Here is how the derivatives trading works in practice:

Step 1 In this example, the BSE's 30-stock index, the Sensex, is the underlying asset.

Step 2 You feel that the Sensex will close at 5000 on the last Thursday of July (all the contracts whether for one month, two month or three month expire on the last Thursday of the month) for the one month contract. Then, you have to choose the minimum quantity of transaction akin to market lot in the spot market. In the case of the Sensex, it is fixed at 50 times the index. In other words, you are required to buy a minimum of 50 contracts of Sensex futures.

Step 3 At this stage, you have to calculate what is called the Tick size which is nothing but the minimum movement of the Sensex futures. This is taken at 0.1 percent which is equivalent to Rs.5. That is to say, the price of each contract is Rs.5.

Step 4 You decide to buy 50 July contracts of Sensex futures. With the Sensex futures for July pegged at 5000, your contract value is Rs.12.5 lakh (5000 x 50 (contracts) x Rs.5)

Step 5 You are not required to pay the entire money now as all that is needed from you is the initial margin which is fixed at 5 percent. i.e., Rs.62, 500 on the total value of the contract of Rs. 12.5 lakh.

Step 6 On the next trading day, if the Sensex rises to 5200, your July futures contract will have gained 200 points and you will have made a profit of Rs.50, 000 (200 x 50 x 5) which the seller will pay you. On the other hand, if the Sensex falls by a similar margin, you are obliged to pay the seller a similar sum.

Step 7 This kind of transaction can be undertaken on a daily basis till the July contract expires. Alternatively, you can carry on in this fashion till the final settlement is done.

Step 8 When the final settlement falls due, one fact must be borne in mind. On this day, the actual Sensex is related to the Sensex futures of the preceding day, which is the last Thursday of July. Even if the actual Sensex is at 5400 while the Sensex futures is fixed at 5200, you stand to gain Rs.50, 000 (200 x 50 x 5), this being the sum payable by the seller.

Happy Trading!