As we know, a futures instrument derives its value from its respective underlying asset. For example, the NIFTY futures instrument derives its value from the NIFTY's spot price. Though the futures price and the price of its underlying move in the same direction, they do not maintain the same distance from each other. For example, the futures price may be equal to the spot price, but it can also be less than or greater from the spot price. Thus, the futures can be said to be trading at par (equal to the spot price), with a premium (greater than the spot price) or at discount (less than the spot price).
There are many factors that cause the futures to trade either at discount or at premium. These include market sentiment, inflation expectations, economic strength, availability of substitutes, trends and liquidity, among others.
The general interpretation is that, when the premium increases or widens, the mood in the market is getting incrementally bullish. Just the opposite happens when the premium decreases or discount increases, where the sentiment is said to be getting increasingly bearish.
That being said, we get interesting and important insights to know what happens when a premium reaches certain levels and how it adjusts.
The above chart plots the NIFTY futures premium to its spot price over last two years. On March 29, 2019, the NIFTY futures closed with a premium of 56 points. In other words, the closing price of NIFTY futures was higher by 56 points compared to its spot price.
If we observe the above chart, it shows that, over the past two years, the premiums have never went above 50-55 range except in two isolated instances. Whenever premiums have tested the 50-55 zone, the NIFTY futures has corrected. The shrinking of premium happens either by futures prices not rising in equal proportion the spot price or, alternately, by futures prices reducing more than the spot prices whenever a correction sets in.
In the present context, the high premiums in the NIFTY futures point towards likely shrinkage over the coming days. When the trade opened on Friday, March 29, the NIFTY futures premium was over 90 points, which shrunk to 56 points by the time the session ended. With the NIFTY getting overbought again and visible bearish divergence with the lead indicators on the charts, this also points towards likely a corrective move by NIFTY over the coming days. It should be no surprise if we get some imminent corrective moves happening in the markets with volatility being ingrained in them.
Milan Vaishnav, CMT, MSTA
Consulting Technical Analyst