By Manoj Jena and Prashanta Ch. Panda*, September 8, 2016 :

In our earlier two part articles, we had discussed relevant classified information of market, company, products, competitors or indicators that each individual investor should take notice of. In other words they cannot be overlooked before taking investing decision in equity or stocks of a company. In part III we will be analysing the derivative market and investment in derivatives for different investors.

Derivative Market in India

Derivative market in India started in 2000. Although this market in India is not as old as other global markets, the traded volume in derivatives is quite high in India. Financial institutions such as banks and other large fund management institutions trade in derivatives to hedge the risk of fluctuating prices of the instruments they are invested in. Interestingly in India the proportion of retail participant in trading options and futures are quite significant.

Why the name derivatives

The most interesting reason his derives value from some other asset. Trading in equities involves buying and selling of the stocks of a company. This is a contract between two or more parties. Trading in derivatives involves buying and selling a contract or agreement between two parties. Instead of a real stock here a contract representing that stock is traded between market participants. These contracts are called Options or Futures.

The derivative or (future and options) contracts have a limited lifetime. One cannot hold these options and futures for unlimited time as compared to the stocks. Generally, they have one or two or three-month lifetime. If the underlying asset is not showing any price fluctuations or volatility and is mostly predictable in one way then this loses the appeal. You can find derivatives in commodities, currencies, market indexes, interest rates in addition to the stocks etc.

Contract Period

The contracts in general has one to three-month time period after which they expire. So an investor cannot hold the contracts beyond this period unless roll-over happens in future contracts. For simplicity let discuss options and futures with one-month life or say, time to expire is one month for the contract. Options or Futures are attached to a particular series or month. Last Friday of every month is the starting date and last Thursday of the successive month is the end date of a series.

Example

Let us take an example scenario about why trading in options and future is very attractive at the first sight for a retail investor. OPTION or FUTURE “buying”. Let us take the example of Infosys (INFY), which is traded both in equity and derivative market. INFY is trading at Rs.1000.0 (say on 26 Aug 2016, Last Friday!). Depending on movement of INFY Northward or Southward, the option price derives its value as discussed earlier. If the trader expect INFY will go up then she has two choices depending on the funds available and her risk appetite. Let us say she has Rs.2.0 lakh for trading. She can buy 200 stocks. If INFY goes up 2% or Rs.20 in next week she may exit and get a profit of Rs.4000.

Other choice is to buy options. Options come in lot basis. One lot of INFY represent 500 shares. Call option for September 1100 price point is Rs.10 (say on 26 Aug 2016). So one lot of INFY costs Rs.5000. Let us say she buy 4 lots with paying Rs.20000. If INFY moves up 2% in next week then the option price will move around 40% (we discussed earlier the option price derive their value from the movement of stock price).  So now the call option price of INFY 1100 is Rs.14. If she chooses to exit the profit is Rs.4 * 2000 = Rs.8000. Thus, in the first case she made Rs.4000 while investing Rs.2 lakhs whereas in second case she made Rs.8000 while committing Rs.20000.

Thus the trader is excited with the calculations. Deriving more profit (Rs.4000 vs. Rs.2000) while committing much less fund (Rs.20,000 vs. Rs.2 lakh). Although the example seems quite practical in reality the chances of occurrence of such events for a particular stock are not very frequent. There are around 170 stocks trading under futures and options in Indian market. To choose or time a right stock and decide the entry and exit point are never easy. One time or few trades may give good return but for consistence return on equity, buying options may not be a right choice for a retail investor. Among first few trades a retail investor may make thousands buy option-trading, and that excitement leads the trader to wait for next level of profit before losing some lacks of asset! Why does this happen most of the time?

Reference to the above chart

The price of options follows the pattern as shown in the above diagram. As the time to expiry become closer, price fall rapidly which is shown across 30-0 days part of the chart. Although the chart shows the theoretical price movements, in aggregate the contract price follow the trend with spikes in between for a shorter period. The trader only buys the options with the hope that price will go up but in the stipulated expiry period the chances are quite a few. Practically 90% of options are either traded with loss or expires without exercising or with a zero value.

Hedging the Risk

Buying options is more appropriate for hedging the risk against the underlying equity held by the investor. Let say the investor has 1000 stocks of INFY trading at Rs.1000 and want to hold it for at least 2 to 3 years. The trader anticipate that INFY may go down 10% in the next month but can be positive in long run. She does not want to sell the stocks to achieve the benefits of holding in long run. She can go for buying put options of INFY 950 (INFY 950 PE) and can hedge the risk of falling price with the gain in options.

Needs Time and Consistent Watch

The derivative market needs time and consistent watch on every details of the stock movement. Fundamental studies help in selecting stocks which may grow or fall in a long run such as in 3 years to 5-year time frame. To play within a much shorter time frame such as a week or a month or so, trader may need to have some analysis on technical studies. Technical studies are based on historical stock prices and using various mathematical and statistical plots to predict further movements of stocks.

Riskier Trading for New Retail Players

One should not enter the derivative space unless the trader has significant experience in investing or trading stocks. A steady and prolonged exposure for a few stocks helps to know about the support and resistance limit associated with the stock and its relative movement with the broader market. Thus for a small retail investor entering the stock market, its quite advisable to engage in investing instead of trading in derivatives. As these are much riskier trading instruments compared to trading in equity one should grow enough appetite to take risk before jumping into the options and future market.

This is also in line with the decision taken by the market regulator, SEBI in 2015. SEBI had increased the lot size of most of the stocks and trading index to discourage the unprepared small investors from dumping their equity in these instruments. As example the size of nifty lot has increased from 25 to 75. Lot size of INFY has doubled from 250 to 500 etc.

{We will explain the complex part of the derivatives including players involved in the market in the next edition.}

*Prof. Manoj Jena and Dr. Prashanta Ch. Panda are faculty in KIIT University, Bhubaneswar and Pandit Deendayal Petroleum University, Gandhinagar respectively.

(This is in continuation to authors’ twin online articles in Bizodisha dated 21 December 2015 (http://bizodisha.com/2015/12/travel-some-journey-before-you-enter-the-exchange/ ) and 16 January 2016 (http://bizodisha.com/2016/01/travel-some-journey-before-you-enter-the-exchange-ii/–)