India’s derivatives market is among the most actively traded in the world by volume, a fact that might surprise those who associate sophisticated financial instruments with only the most advanced economies. Yet the ready accessibility of trading apps offering one-click access to futures and options contracts has created a challenging paradox – a large portion of participants in this high-stakes segment are retail investors with limited understanding of leverage, margin mechanics, and the asymmetric risk profiles these instruments carry. The demat account is the anchor of the equity investing ecosystem, but derivatives operate through a separate but connected trading account, and the risks involved demand a level of financial literacy that most new investors have not yet developed.
Futures Contracts: Leverage That Magnifies Both Gains and Losses
A futures contract is an agreement to buy/sell a particular quantity of an underlying (mostly a stock or an index) at a price pre-set on a future date. The instrument is at the same time powerful and perilous due to the leverage involved. Only about ten to twenty per cent of the total value of a futures contract has to be deposited as a margin to open a position.
This means that even with a relatively small investment, one can make highly leveraged bets. The reward for a correct guess regarding the price movement of the underlying is commensurately large. On the flip side, the losses for an incorrect guess can be prohibitively large as well, many times larger than the initial margin.
If the guess is incorrect, the broker will call for a fresh deposit to cover the losses, and if the trader is unable to do so, the position will be forcibly closed at a loss. In other words, adverse price movements cause losses that far exceed the initial margin deposit. An option is a contract that gives its buyer the right (but not the obligation) to buy/sell an underlying asset at a pre-set price on or before a pre-set date. The buyer pays a premium to the writer of the option for this privilege.
For an option buyer, the potential loss is strictly limited to the size of the premium, which makes naked options long positions an attractive speculation tool. There is no upper bound to the reward for an option buyer (in case of a call option on an appreciating underlying). On the other hand, the value of an option is time-sensitive since the value diminishes with the passage of time (this is captured by the Greek Theta). The closer it is to expiry, the faster the option loses value. An option buyer will find that the premium paid has become nearly worthless if the underlying barely moves. The ‘limited loss’ of an option position tempts many retail traders to use them as vehicles to speculate. But the option market is rife with traps for the uninformed investor.
SEBI Reports on Retail Trading in Derivatives
SEBI conducts and releases reports on the profitability of retail trading in equity derivatives at regular intervals. A summary of the findings shows that a vast majority of retail investors who take up futures/options trading eventually end up losing money over a period of one year or more. The losses for a large majority are deep enough to constitute a serious dent in their net worth.
For those contemplating entering the derivatives trading fray, the reports are an essential eye-opener. For the truly informed minority (discussed below), a derivatives trading position can be rewarding and can help hedge a long equity position. The truly informed minority usually consists of people with significant experience in the markets, quantitative skills, access to reliable market data and lower transaction costs (due to higher trading volumes). They also possess risk management tools that allow them to take well-calculated positions. Competing against such an entity is not an easy task for a novice trader.
For the average Joe, the equity cash market is a far more rewarding arena than the derivatives market. It allows for steady increases in net worth, particularly if the investments are made using a systematic approach. Derivatives, on the other hand, can cause outsized losses if the market moves against one’s position. Moreover, a derivatives position usually has to be wound up (at a loss) if the market moves against one’s position. In such cases, the losses can be far greater than the initial margin (in case of futures) or the premium (in case of options).
How Derivatives Can Be A Useful Addition To Your Portfolio
Despite the dangers of naked speculation, derivatives are incredibly useful tools for use by investors who already have a long position in the equity markets. Buying put options on individual stocks or on the index itself is a tried-and-true method to limit downside risk, especially for investors who cannot stomach a steep drop but wish to stay invested in the long-term bull run of the markets. Writing covered calls (selling options on shares that one holds) is a good way of earning extra income that can help supplement one’s returns in case of a stagnant market. However, these strategies have their own set of intricacies and require one to have at least some working knowledge of the equity markets (in terms of basic stock-picking abilities). One also needs to be aware of the tax implications of exercising an option. All things considered, these strategies make for a useful addition to one’s arsenal, provided one has already laid a strong foundation in the equity cash markets. It is not advisable to get into options trading before having a thorough grounding in the basic principles of the cash markets, especially one’s investing strategy. It is also a good idea to consult with an investment advisor before exercising an option.
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