Stock index futures are the crystal ball of the financial markets. They are a purely cash-settled futures contract based on a stock index. Index futures can be used as strong leading indicators of market sentiment. Speculators such as position traders, day traders, swing traders and hedgers usually trade in stocks futures and index futures. The base of any stock or index prediction is price action and volumes generated in the stock or index.
What is a futures contract? It is an agreement to buy or sell the value of the underlying asset at a specific price on a specific date in the future. We all know that a futures instrument derives its value from its respective underlying, and it moves in sync with that underlying. If the price of the underlying falls, so would the futures price and vice versa.
To understand stocks futures and index futures rates, we need to understand open interest along with price data, whether a market has topped or bottomed, among other things. Open interest provides a more accurate picture of trading activity in the derivative segment. A trader can gather cues from open interest (OI) levels vis-à-vis spot to identify potential trends in a stock or an index. A rise in open interest when accompanied by rising price signals that new or additional money is coming into the market. Thus, it is indicative of a bullish trend. A rise in open interest accompanied by falling price, however, indicates a bearish trend. If the price is rising and Open Interest remains steady, the market has reached a top. When open interest does not rise much after a sharp drop in price, it indicates formation of a bottom and trend reversal. When there is little or no open interest, it means there are no open positions, or all the positions have been closed. On the contrary, high open interest means many contracts are still open, which means market participants will be watching the market closely. Therefore, open interest is a lead indicator of an impending change in trend.
One more interesting parameter, which is easily available, is the basis gap. It is the difference between future and spot prices. Generally, if there is no corporate action, then the basis gap of a stock is positive. As a thumb rule, a positive basis gap indicates bullishness in the stock; inversely a negative basis gap indicates bearishness in the stock. One can track a stock by using the basis gap — whether intraday or positional trade. The basis gap can be further split to look at the cost of carry, which includes factors like risk-free interest rate and time to expiry in calculation.
A stock may have a high cost of carry because of corporate action. If there is no event though, the stock having a high cost of carry would mean strong-hand players are anticipating a good movement in the stock. On the expiry day, a positive cost of carry indicates long rollover, whereas a negative cost of carry indicates short rollover, and they can be read with the open interest to generate insights into the activity going on in a counter.
The higher the rollover and higher the cost of carry, the greater the chances of an upside in the stock. Whereas higher rollover and lower cost of carry raise the chances of a downside. These are basic yet effective tools that a retailer can easily use to take day-to-day trading decision in a stock or an index.
Trading in stocks futures and index futures rates carry market risks. One has to proceed with a degree of caution. Trading in stock and index futures can be very fruitful if done properly. In this type of instruments, investors can have leverage, which can enable an investor to take larger positions. At the same time, if the market does not go in one’s favour, the losses could be huge. So, it calls for abundant caution.
Chairman and MD, SMC Investments and Advisors