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Tuesday, June 21, 2016

Trading in Derivatives

 

1. What are the risks of trading in derivatives?

For the uniniti ated, it could lead to heavy losses in a short span, frightening the investor away from the stock market forever.

2. How is that ?

Since they are leveraged, deriv atives carry a high risk. Say you put up a 20% margin to trade ABC stock futures.

ABC is priced at `180 and has a lot size of 2,000 shares. The value of the contract is `3.6 lakh. You put up 20% to trade or `72,000. If on the next day ABC falls to `175, the mark-to-market loss will be `10,000. In fact, last year, market regulator Sebi raised the minimum lot size on Nifty to `5 lakh from `2 lakh to dissuade retail investors from playing in the de rivatives segment.

3. Are options safer?

They are safer than futures on stocks and indices to the extent that losses are limited to the premia (price) paid to the option sellers.But the risk is high as few investors are really aware of factors influencing an option's price. The Black-Scholes model used to determine an option's price, has a component called `delta' -change in an option's price with reference to the change in an underlier's price. For instance, if a call option has a delta of 0.2 and the price of a stock rises by `1, the option price will rise by 20 paise. Also, theta or time to expiry plays an important role in determining option price movement.Closer to expiry , an option's value gets eroded by time.

4. Don't be an unwitting victim...

Sometimes, an experienced op tion buyer might be hedging her option purchase by either shorting or going long a stock futures contract, called delta hedging. This might give the uninitiated a false impression of interest to long or short building up in a particular counter. There are a myriad other risks. For example, you see huge open interest in say Nifty call at 7900. That may impress you that Nifty would easily break that level. But in reality the sellers, who usually are wealthier and more astute than buyers, would be selling 7900 calls in the firm belief that the index won't cross that level. They can usually sway counters in their favour which causes huge losses to buyers.

5. Who are the main players?

HNI clients and prop brokers are net sellers of index puts to FPIs.

They are normally net long index futures and net buyers of calls, depending on market direction. FPIs are normally net buyers of index puts and depending on their mood they either net buy or sell calls and index futures.

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