Will F&O trading on Nifty Next 50 impact index investors?

Futures and options trading on Nifty Next 50 commenced on April 24, 2024. Will this impact the index and, therefore, its passive investors (via index funds and ETFs) in any way? In particular, how will F&O trading impact the volatility and liquidity of the underlying index (or its constituent stocks in the spot market)?

The spot and futures markets are linked via arbitrage. The spot price of a stock is its current price. This is the price quoted in business channels and financial portals. When you buy or sell a stock using a demat account, the stocks are delivered or off-loaded immediately at the applicable price when purchased or sold.

In the futures market, buyers and sellers do not exchange stocks (or commodities) immediately. The stocks change hands at a future date, but the price is fixed at the time of agreement. Thus, a contract is arrived at. The contract price per stock can vary daily, and the contract can be traded in the futures market.

A difference between the stock price in the futures market and the spot market is referred to as an arbitrage opportunity. This difference arises due to the inefficient flow of information between the two markets and is temporary.

The difference decreases as the due date of the futures contract expiry nears, and the prices tend to become the same. More arbitrage opportunities are available when the markets are volatile.

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People would prefer the former if the futures stock price is lower than the spot market price. The increased demand will increase the futures stock price. There would also be pressure on the spot stock price to decrease. Soon, the two prices will converge.

Thus, although the price difference (arbitrage opportunity) may exist at one point, it will diminish rapidly. For an example of how mutual funds profit from this, see How Arbitrage Mutual Funds Work: A Simple Introduction. This is depicted in the cover image of the Parag Parikh Arbitrage Fund Flyer.

Will F&O trading on Nifty Next 50 impact index investors?

The short answer is that it may decrease the volatility of the Nifty Next 50, but we cannot say for sure as the opposite may also happen! Yes, that is disappointing, but that is how the cookie crumbles.

There are theoretical arguments supporting both sides! Some expect a decrease in volatility because speculators would move from the spot market to the futures market. Some predict an increase in volatility in the spot market due to the participation of uninformed traders in the futures market and the supply vs demand mismatch in the futures market.

There is plenty of empirical evidence supporting both sides! Sometimes, results from indices of the same country do not match! A study published in the Reserve Bank of India Occasional Papers Vol. 24, No. 3, Winter 2003 says, “‘futures effect’ plays a definite role in the reduction of volatility in the case of S&P CNX Nifty, in the case of

BSE Sensex, where derivative turnover is considerably low, its role seems to be

ambiguous”.

That said, studies that support a lowering of volatility form the majority.

A more recent study by P Sakthivel concludes, “Futures’ trading reduces spot price volatility by providing low contingent strategies and enabling investors to minimize the portfolio risk by transferring speculators from the spot market to the future market. The low margins, transaction costs, standardized contracts, and trading conditions attract risk-taking speculators to the futures market. Hence, futures are expected to have a stabilizing influence as they add more traders to the cash market, making it more liquid and, therefore, less volatile”. Article references for other markets can be found in this publication.

So let now go with the majority finding and assume/expect that introducing F&O trading will reduce the volatility of the Nifty Next 50. This means the risk premium and expected returns may also be reduced.

Already, there is some evidence (though far from conclusive) that the Nifty Next 50 has become less volatile due to increased investor participation. Until a few years ago, the Nifty Next 50 had a risk and reward profile similar to Nifty Midcap 150. After the March 2020 crash, the Mid cap index pulled away. See Nifty Midcap 150 beats Nifty Next 50 for the first time.

Also, see more recent data here: Nifty vs Nifty Next 50 vs Nifty Midcap 150 vs Nifty Smallcap 250: Return Comparison April 2024.

Will introducing F&O trading further reduce the risk premium of Nifty Next 50 compared to Nifty Mid cap 150? Yes, this is possible (I am not saying it will or will not; I am just appreciating that it is possible).

Does this mean a Nifty Midcap 150 index fund is a better choice than Nifty Next 50 if I wish to beat the Nifty 50 (aka “diversification”!)?

There is only one aspect that stops me from saying yes. Nifty Midcap passive funds (index funds or ETFs) have not yet seen a market crash or sustained bear market. How efficiently a fund manager can handle these situations is largely untested.

Therefore, our recommendation (at least for the time being) remains the same:

Investors should stick to a simple Nify 50 or Sensex index fund. Nothing more is needed .

. If there is a sense of FOMO, then a small exposure of Nifty Next 50 is sufficient. This can be frustrating to hold from time to time, but that is also true of the mid cap index.

See Handpicked List of Mutual Funds (PlumbLine) for our fund recommendations.

If the data changes, we will be happy to revise our opinions.