A few weeks ago, when the stock market went into a tailspin, many investors stuck with buy-side futures were saddled with huge losses. As the markets closed for an hour and margin calls got triggered, brokers unloaded outstanding positions, further compounding investors’ losses.
Many stocks plunged more than 50 per cent in the two days of carnage. Among BSE 500 companies, as many as 66 companies crashed more than 50 per cent from their 52-week highs, whereas 24 stocks tumbled more than 60 per cent.
The meltdown hit more than two-thirds of BSE 500 stocks by 30 per cent. And the worst hit in the toppling markets were derivatives traders.
“The derivatives market is not for the faint-hearted,” says Chiragra Chakravarty, Principal Consultant, Pricewaterhouse-Coopers, explaining that derivatives provide “leverage” to a portfolio. When an investor buys stock or index futures, he pays only the margin money upfront instead of the full value of the asset.
For example, say, an investor “goes long” or buys a standard lot of 1 kg gold futures contract, which is trading at Rs 11,000 per 10 gm, the exposure comes to Rs 11 lakh.
Inside the world of derivatives
Five questions you must ask before you dabble in futures and options.
What are derivatives?
How does it work?
What is the margin system?
What are the risks involved?
Who can participate?
While investors in futures can earn huge profits in a bull market, when the tide turns, this leverage costs a fortune. “But what tends to go wrong is that, with such low margins, they usually mismatch their risk appetite,” says Chakrabarty.
The classic mistake investors make is to think that the margin money is all that they have to pay for the contract. “As investors have to pay only the margin money upfront, they don’t understand the risks involved when they take the leverage,” says Surya Bhatia, Consultant, handling investment portfolios for Asset Managers.
As a result, due to the lower margins, investors buy many more contracts than they can handle. So if the market price, say for gold, falls below Rs 11,000 per 10 gm, the losses mount manifold. This has to be settled with the exchanges.In a frenzied sell-off, margin calls get triggered fast. For example, Reliance Natural Resources (RNRL) crashed 70 per cent from its peak in just 10 trading sessions.
Those who would have gone “long” and bought the futures on January 8 at Rs 250 (per unit) at 20 per cent margin, would have lost 3.5 times the invested capital by the mid-session of January 22, 2008.
Investors in IFCI, MRPL, Essar Oil, as well as many other liquid mid-cap stocks in the derivatives segment, faced similar losses.
Theoretically, margin money is calculated based on the daily-weighted average of stock prices for the past one year.
Says Bhatia: “But it is possible that margins can get breached by volatile stock movements. We have seen that happen from time to time and investors end up paying much more than the margin money to cover their losses.”
And as margins are calculated daily, investors have to make up the losses, or provide additional collateral on a daily basis. “Investors should be prepared to pay at least double the margin money in case of such volatile trading sessions,” Bhatia warns.
“Another habit to watch out for is the decision of not booking losses,” says Chakravarty.
When the markets are down, a waitand-watch policy does help at times to recuperate losses, but luck does not favour everyone.
Studies also show that investors have a habit of holding on to losing portfolios. Says Chakravarty: “First things first, if the losses are rising, don’t wait for the market to turn back,” he says. “Rather, book the loss and square off the position.” It’s the classic stock market mantra and it still rings true—cut your losses and let the profits run.