Stock market trading is considered to be extremely risky. The problem multiplies when one trades in F&Os because they are contractual in nature. Investors must weigh their options before spending money in them. Associated risks are many
In India, an investor who wants to trade in derivatives, has several options at hand. For stocks, one can trade through the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). On the other hand, commodity trading can be done through Multi Commodity Exchange (MCX) and National Commodity and Derivatives Exchange (NCDEX). Currency trading can be done on NSE-SX, MCX-SX.
The term ‘derivative’ stands for contract, whose price is derived from or is dependent upon an underlying asset. It can be a financial asset, such as currency, stock and market index, an interest-bearing security or a physical commodity. Derivative trading in our country comprises four basic contracts — forwards, futures, swaps and options. The most common derivative that one can trade in is future and options (F&O). Further, important underlying assets for these F&Os are stocks, commodities, treasury bills and foreign exchange. All future contracts have cash settlement over NSE.
Any contract is always made between two persons but clearing corporation always takes the opposite position against any order. Thus, there is always an opposing party by default in each trade. Unlike forward contracts, in future contract, money transfer takes place at the time of signing of the deal.
Similarly, while entering an option contract, the buyer pays the premium. With this payment, he/she gets the right to exercise his/her option to buy on the expiration date. On the other hand, the seller of options receives the premium. Due to this, he/she is obliged to sell/buy the asset in the situation when the buyer exercises his/her right.
However, one must be cautious in trading with derivatives as they are associated with several risks. First, derivative products require large funds. So, it is not for those with limited resources or low-risk appetite. Second, trading in derivatives needs expert knowledge. Trading expertise and experience are mandatory with high-risk tolerance. Third, as the movement of derivatives depends on the underlying assets, their progress is determined by movements of the underlying asset. Both are like a double-edged sword. Their movements can be quite volatile. They may also have huge upswings or downward spirals. A trader should accept the fact that he/she can lose profits. One can incur loss even with the execution of derivatives. Let us understand trading in derivatives with a few examples”
Situation I: Derivatives trading risk with future index: Suppose a buyer purchased 100 Nifty 50 futures at Rs 10,724 on May 10. The expiry date is May 28. Total investment amounted to Rs 10,72,400. The buyer paid an initial margin of Rs 1,07,240. On May 28, Nifty 50 index future closed at 10,678. The buyer’s loss would stand at (1,072,400 -1,067,800)*100 that will be equal to Rs 4,60,000. In this situation, the buyer’s entire initial investment (ie Rs 1,07,240) is lost. Additionally, he/she will need to pay Rs 3,52,760 (4,60,000 —1,07,240).
Situation II: Derivatives trading risk with stocks future: Now suppose the buyer purchased 100 TCS futures at Rs 1,740 on May 15 and the expiry date is May 28. He/she made an investment of Rs 1,74,000. He/she paid an initial margin of Rs 17,400. On May 28, the price per shares of TCS was Rs 1,800. The buyer would stand to gain (1,800 — 1,740) x 100 or Rs 6,000.
Situation III: Derivatives trading risk with index options: Suppose the buyer purchases 100 Nifty 50 call options at a strike price of Rs 10,7000 on May 10. Nifty 50 index was at 10,724. Suppose he/she paid a premium of Rs 10,000 (at Rs 100 per call x 100 calls). The expiry date of the contract is May 28. On the expiry date, Nifty index closes at 10,678. The call expires worthless. The buyer would possess the entire Rs 10,000 paid as premium.
Situation IV: Derivatives trading risk with stocks option: Let us not assume that the buyer buys 100 TCS put options at a strike price of Rs 1,750 on May 10. TCS share price is at 1,740. He/she paid a premium of Rs 5,000 (at Rs 50 per put x 100 calls). The expiry date of the contract is May 2018. On May 28, TCS shares close at Rs 1,800. In this case, the put option will expire worthlessly. The buyer will lose the entire Rs 5,000 paid as premium.
It is a known fact that the stock market is extremely risky to begin with. The quantum of risk gets multiplied in F&O trading. Among the many reasons that make the market risky is contractual trading. All F&O scripts come with a time-frame. For example, if one enters into a contract on June 1, for that month’s scrip, his/her contract will expire on the last Thursday of June. Unlike equity, where one can hold the position till the desired target is reached, in F&O, one is under the obligation to square off his/her position on the stipulated time.
However, due to its high-return potential, it attracts many retail investors. But do they make money? Unfortunately, the answer is no. Most retail investors, who dabble in F&O trading, tend to lose a lot of money.
Hence, to dissuade retail investors from trading in F&Os, the Securities and Exchange Board of India (SEBI) made few changes in the F&O guidelines. It increased the lot size from Rs 2 lakh to Rs 5 lakh. A bigger lot size simply means that traders have to deposit a larger amount with the brokers. High net worth individuals may not feel the heat of the higher lot size, but it will definitely prevent small retail investors from participating in F&O trading.
A study suggested that only two per cent traders make money in intra-day and F&O trading. One has to realise that unlike equity market, in the futures market, money does not get generated. Hence, if one is earning money, someone is losing it. That’s why futures market is also called a zero-sum market. After learning this, every trader should first figure out whether they are good enough to be in this narrow bracket of two per cent successful traders.
(The writer is Assistant Professor, Amity University)
