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Weapons of mass destruction

Babar Zaidi     October 31, 2008
Buy 100 shares of a blue-chip company today, urges your broker. Don’t have the money? Pay for 20—but buy 100. And the best part? It’s entirely legal. Futures contracts can be bought by paying just 20-25% of the transaction costs as margin money. Ever since equity derivatives were introduced in the Indian exchanges, small investors have been trying to make money off them. But most have failed miserably in the attempt. Investment guru Warren Buffett called derivatives the “weapons of mass wealth destruction”, but are small investors listening to him? Not when a neighbour or a colleague claims to have made lakhs overnight. However, when the market crashes, as is happening across the world, it’s the derivatives players who are hit the hardest.

In case of derivatives, a little knowledge can be a dangerous thing. And most players function with minimal knowledge. Derivatives can be extremely complex, and if investors want to make money in this field, they need to know a lot more than the difference between a Call and a Put option. How many lay investors know what a long strangle is, or a collar, or a butterfly, or for that matter, an iron corridor? Does it really matter. Yes, it does. Today, the futures and options (F&O) segment of the NSE is larger than the cash segment (see table). Retail investors account for more than 60% of the turnover in the F&O segment. This means that almost Rs 3,000 crore of small investors’ money is at stake.

C.K. Chathrath
C.K. Chathrath, 58, Ujjain

Lost Rs 9.5 lakh in stock futures

Investment:

• Has been investing in equities for 30 years and has made good profits.

• Lost Rs 9-10 lakh in the current meltdown after entering F&O.

Mistakes:

• Was lured into F&O by high returns.

• Bought futures of momentum stocks.

Learnings:

• Don’t buy derivatives, buy shares. It ensures you don’t get too much exposure. If you own shares, you will not panic even if the value falls.

“The derivatives market is too risky and complicated for small investors. One has to constantly monitor the stock prices.”

Imran Jalee
Imran Jaleel, 44, Rampur

Lost Rs 1.5 lakh in the futures market

Investment:
• Has been investing small amounts in equities since 2004.

• Got into stock derivatives in 2005, lost Rs 1.5 lakh and quit in 2007.

Mistake:

• Invested in F&O market without understanding how derivatives worked.

Learnings:

• F&O market is like a casino where you lose more than you earn.

• Equities are not for a short term of 2-3 months. One should stay invested for at least 5-6 years.

“I consider myself lucky because I quit F&O early. In today’s market, I would have been bankrupt.”

On a larger scale, over-leveraging is being seen today as the root of global financial crisis. But small investors like Rampur-based Imran Jaleel aren’t looking at global movements; they want to get rich quick. Jaleel entered the F&O segment in 2005 and lost Rs 50,000 that year. Then, he sank deeper and lost over Rs 1.5 lakh in the next couple of years. He’s no longer in the segment and has learnt enough to know that had he been caught in the current crash, he would have been bankrupt. Then there’s Ujjain’s C.K. Chathrath. This 58-year-old has lost almost Rs 10 lakh in the current meltdown—thanks to his exposure to the F&O segment.

In a survey conducted on behalf of MONEY TODAY last month, more than 80% of the respondents in Delhi and Bengaluru and nearly 55% of all respondents said they had invested in equity derivatives. Almost 95% of the Delhi and Bengaluru respondents and over 80% of all respondents said they had lost money in the segment.

If derivatives and leveraged buying are so dangerous to the financial health of individuals, why do brokers push clients into buying them and why do exchanges allow them to be traded? Because they lead to more active markets and bring in trading volumes. To earn Rs 100-150 as brokerage, a relationship manager will not blink before advising his client to buy a futures contract that puts nearly Rs 40,000-60,000 at stake.

But then, stock exchanges are not philanthropic organisations. It’s every man for himself and the weakest or the most ignorant will inevitably be weeded out. Take the case of Ashok Mittal. The Delhibased executive invests in the futures market, but has no knowledge of options. “I just can’t get the hang of what these differently priced Calls and Puts mean,” he says. Not surprisingly, he too has lost money in F&O. Understanding options (MT Basics, page 49) could help him out of the derivatives maze relatively unhurt. Of course, options are not any less risky than futures. Almost 80% of all options expire worthless. Any investment in which you can lose 100% of your money can hardly be considered safe. It’s only that the amount of money at stake is considerably smaller compared with futures.

Sadly, while futures are widely traded, there is not much depth in the options market. Almost 95% of the options traded are Nifty options. Options of most scrips are just not available, defeating the very purpose of including the scrip in F&O.

Options are especially useful in volatile times. For instance, the price of Tata Steel fell from Rs 440 on 1 October to Rs 208 on 23 October. If someone had bought a futures lot (382 shares) at Rs 440 on 1 October, in three weeks, he would have incurred a loss of Rs 89,000. But if he had covered his position with a Put of Rs 400 strike price, which cost Rs 10 on 1 October, his losses would have been lower at Rs 19,000.

Savvy investors use strategies that combine futures and options to hedge their positions. You can use Put options to protect even your mutual fund investments. If the market falls and your portfolio takes a dent, the Put option makes up for the loss.

Apart from knowledge, options trading requires a lot of selfdiscipline. If you do not stick to the rules on when to buy and sell, the whole exercise can be fruitless, even financially devastating.

Cash and carry

F&O turnover has grown exponentially in the past eight years and overtaken the cash segment

Retail share

Retail investors account for the lion’s share in this rapidly growing segment
YearAverage daily F&O turnover on NSE (Rs crore)Average daily cash turnover on NSE (Rs crore) Category% of F&O turnover% of cash turnover
2000-1115,337 Institutional investors11.752.4
2004-510,1074,506 Proprietory investors27.315.1
2008-9*47,71113,352 Retail investors61.032.5
* Till 30 September 2008
Figures are % of turnover on NSE

What you should do now

• Don’t be tempted to invest in derivatives even if the stock price seems compelling. Stocks could fall even further.

• Derivatives are short-term products. Don’t go by research reports which take a long-term perspective.

• If you must invest in F&O, use a combination of futures and options to hedge your positions.

 


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