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The devil in derivatives

Do you make use of futures and options in your strategy? Watch out; the turnaround is unpredictable.

Amit Mukherjee | Print Edition: February 24, 2008

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?
Derivatives are financial instruments whose value is derived from the value of an underlying asset. They generally take the form of contracts under which the parties agree to make payments to each other based on the value of the asset at a particular point in time. The main types of derivatives are futures, forwards, options and swaps.

How does it work?
You just pay an upfront margin, which is decided by the stock exchanges and which varies periodically, and take a “leveraged” position for one, two or three months. In case the stock moves up, you get the profit margin. In case the stock goes down, you might loose the entire margin money or even more in case the net loss exceeeds the margin money.

What is the margin system?
The National Securities Clearing Corporation (NSCCL) has developed a comprehensive risk containment mechanism for the Futures & Options segment. The most critical component of a risk containment mechanism for NSCCL is the online position monitoring and margining system. The actual margining and position monitoring is done online, on an intra-day basis. It uses the Standard Portfolio Analysis of Risk (SPAN) system for the purpose of margining, which is a portfolio-based system.

What are the risks involved?
An individual or a corporation should carefully weigh the risks of using derivatives since losses can be greater than the sums put in these instruments. It should be understood that derivatives themselves are not to be considered investments since they are not an asset class. Investors pay only a part of the value of the underlying asset and settle the remaining when a contract expires. Hence, when asset prices move sharply, profits or losses can be huge.

Who can participate?
Anybody with an appetite for risk can participate in the derivatives market— it can be an individual, a broker or a company. 

But unlike buying from the spot market where the investor would have had to pay the entire Rs 11 lakh upfront, in a futures contract, he pays only the margin of 4 per cent (of Rs 11 lakh) or Rs 44,000. For equities, the margin varies from 25-50 per cent.

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.

Margin call

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.

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