Stock index futures, as the name suggests, allows one to take a futures position on the index of stocks. Most common stock index futures in India are Nifty Futures and Bank Nifty Futures.
Index futures allows the traders to speculate the direction of these indexes and trade on them by buying or selling a standardized value of the stock index on a future date with a specified price.
A trader can either take a long or short position on the index future based on the speculation made by him/her on the movement of the index. In some cases, traders use this strategy to hedge their positions in the market in order to reduce the effect of volatility and reduce the risk on their other investments. In this process the trader also reduces the profit, as there is cost involved in hedging in the form of margins paid.
For example, a trader holds 350 shares of Reliance Industries at Rs.1,300 and 200 shares of HDFC Bank for Rs.2,000 per share. Total value of his holding is Rs. 8,55,000. In order to hedge his position he sells 75 shares (1 market lot) of NIFTY at Rs.11,100, worth Rs. 8,32,500.
If the share prices of Reliance Industries and HDFC Bank go down, trader expects the NIFTY to also fall alongside, benefitting him from the short position in Nifty and reducing his risk as he is holding the shares in cash. However if share prices of Reliance Industries and HDFC Bank rises, NIFTY is also expected to rise thus reducing the profits of the trader on the sale trade of Nifty futures. But his cash holding will be in profit, which will be a good hedge.