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Are Futures Simply Better?


I’ve been railing about the cash volumes in the market recently. With volumes reaching 12,000 cr. – lesser than most of 2007 – and as I recently tweeted, less than the daily volume of one share, Apple, in the US market. Our market has obviously seen very low participation levels since the crisis; volumes in the cash market are lower today than in 2007!

But the F&O volumes are much higher. So is there some other explanation?

Some structural issues exist in the cash markets. And the derivatives bazaar, specifically stock futures, solve these issues.

1. If you buy in cash, you have to put the full money down. So buying a 100 shares of Reliance costs you Rs. 100,000 out of your bank account.

2. You get the settlement after two days. Cash flows out of your account tomorrow, if you purchase today; you get the shares in your account in two days. If the seller did not own the shares, there is then an auction – you get the shares in your account five to six days after your purchase. The interim period is weird – if your stock hits a stop loss then, you can’t even exit.

3. Institutions like mutual funds are not allowed to do margin trading in stocks. So switches are a mess. A purchase has to go into the demat first before it can be sold, and full money has to be available before a purchase. Why is this painful? Imagine you are a mutual fund manager who has 10 crores worth stock which you decide to sell and buy something else. What do you need to do?

  • Sell today. The money will reach your account after two days (T+2), the stock leaves your account tomorrow. 
  • Once you receive the money, place the buy order (on T+2). You can’t place it earlier – the broker and exchange needs the money upfront and if you’re a mutual fund you gotta wait till the money comes in.
  • On T+3, the money goes out, and on T+4 you get the stocks in your account

It takes four days to sell and then buy. Meanwhile, whatever you wanted to buy could have run away!

4. Stocks have low liquidity. Of the top 50 stocks in India – the Nifty 50 – the least liquid trades just 8 crores in the cash market, per day. A 1000 cr. fund, if it chose to allocate just 1% of its portfolio per stock, can’t even buy 10 crores worth of that stock – it will move the market so much that the impact cost can be 4-5%! And buying it slowly, piece by piece, is not fun at all; you never know what price you will get in future days.

5. Regulation does not allow funds to own than x% of a certain stock, or require disclosure if the percentages go greater than 1%. Some stocks have a market cap of just 1000 cr. and funds or HNIs like to expose themselves to beyond 10 cr. but don’t want to report.

6. Can’t go short a stock. The SLBS is dead.

If you buy a future instead of a stock, you pay only 50-60% as margin – the remaining money can sit in your account and earn interest; in fact, even the margin money can be given as a fixed deposit which earns interest. There is no settlement wait period – you buy a future, it is immediately in your account. No problem in intraday switching – you can sell one future and buy another right away, margins are released immediately on selling and is available to buy something else. Futures markets are a lot more liquid: for example today, the notional value of cash market trades was 13,000 cr. versus 66,000 cr. in F&O. Individual stocks too show 2x to 3x more volume in their futures trades than in the cash market. Regulation only provides for an upper limit of all F&O on each stock, but there are no disclosure requirements. And of course, you can go short as easily as you can go long.

Still, the futures markets have challenges.

  • Futures earn no dividend.This would be an issue if the average Indian large cap stock was yielding higher than the ridiculously low 2.5% per year they currently do.
  • Rollovers could be a problem.Since futures expire often – typically the most liquid expire each month – the rolling over of a position may involve a cost. For example, on March 25, the recent expiry, HDFC’s March future closed at Rs. 2586 while the April future closed at 2601. If you were long March, you had to sell March and buy April to stay long. The process would cost you Rs. 15, a 0.57% “cost”. If you incurred that every month, you pay about 6.85% a year to use the futures market.
  • Sometimes rollovers work in your favour. For example, on 26 Nov 2009, HDFC’s Nov future closed at 2756 while the December future was at 2748; a long rollover would be Rs. 8 profitable! In the last two years, average rollover costs of HDFC have been Rs. 1.3 – an insignificant number. And NSE has introduced a feature in NEAT
  • Both the above costs have to be made up by interest that is received on the margined amount + whatever else is in the bank. Funds can’t lever portfolios so whatever is not margined stays in cash. And the interest seems to do it. Let’s say they get something like 7% on a fixed deposit – it needs to cover the loss of dividend (2.5%) and the average rollover cost (say 4%), which it just about does.
  • Futures have a daily mark-to-market potential outflow. If you buy a future worth 2 lakhs, you may only need to give Rs. 50,000 as margin. But let’s say the stock falls 20% – you then need to put Rs. 40,000 (20% of the 2 lakhs) as mark-to-market loss, which is paid to the exchange and won’t earn you any interest. But then, if your shares go up, you receive cash instead.
  • Not every stock is listed in the F&O segment, which has only 250 stocks or so, versus a few thousand stocks overall.
  • Market Wide Position Limits curtail F&O use.The MWPL on a stock is 20% of the free float, which tends to create crazy short squeezes like in Akruti.
  • Mutual funds, Pensions and Insurance corpuses can’t currently only trade derivatives. They need an equity component in their portfolio, and derivatives can only be a small percentage of that. No such restrictions on Portfolio Management Services (PMS) or FIIs or proprietary accounts, which continue to participate through futures.

The cost differential, if you test back the last two years, is very little for the benefits one gets. And in the two years, we have fallen a lot and risen a lot and futures have been a better way to invest. Prior to 2007 liquidity wasn’t all that great in the futures market (for individual stocks) so it’s difficult to test and conclude.

Net of the above, if markets remain volatile a long-only kind of fund is likely to see substantial  benefits using futures instead of buying in the cash markets. For going short, F&O is the only choice. It may just be that the smartest money is moving into the futures markets and cash markets are following through largely because of arbitrageurs.


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