Futures Is An Effective Tool To Protect Returns, But One Must Be Aware Of The Risks
THE DEVELOPMENT in futures markets in India has been encouraging with access available to retail investors in newer asset classes such as currencies and interest rates which hitherto were not available in spot markets due to regulatory or physical restrictions such as minimum exposure size. This has helped the portfolio diversification objective of the retail investors. Exchange traded, cash settlements, standardised contracts, price time priority are some of the advantages of futures contracts in India. The numbers of contracts dealt in a fiscal year in stock index futures (NSE) have grown exponentially by 1,968 times since 2000-01. FIIs have been actively using the short side of the stock futures to hedge their underlying positions in cash markets.
My advice to retail investors is very simple—Don't invest in products where you don't understand the "risks and the downside" of it. Unfortunately in India the futures market, specially in stocks, is used more often as a speculative vehicle rather than a hedging one. And the biggest risk in speculating in futures markets comes from the inherent leverage built into such products, viz the ability to take exposure worth Rs 100, by just paying an upfront margin of Rs 5 or Rs 10. We all know that leverage which is 10 or 20 times here, is a two way sword—it multiplies your returns in rising markets and multiplies your losses in falling ones too. The feedback loop of larger profits-larger confidence-larger positions—larger risk—entices retail investors to take the path of derivatives like futures. But when the feedback loop breaks down, the losses are large due to the leverage. Greed, overconfidence and lack of understanding are the main culprits for losses in futures markets.
A retail investor has to understand the futures market a bit—the pricing of it, which is mainly driven by the underlying spot prices, interest rates, income from the underlying assets as well as delivery restrictions, if any. For a retail investor to use the futures route, he has to decide before taking the position whether it's for hedging an existing position or a speculative one. Arbitrage (between spot and futures markets) is an third but less frequented option for a normal retail investor. If the position is for hedging the investor has to decide on how much of its existing position has to be hedged and for how long. The hedge can be either static or dynamic, with frequent adjustments in response to price movements in underlying. A hedge position should be unwound along with the underlying positions or else it will amount to pure speculation.
In case a retail investor is making the mistake of pure speculation (short-term directional call) by going long or short by using futures, he should have a strict gross position and stop loss limits, which are ruthless and time bound. Ideally the stop loss limits should be equal to the upfront margin put up by the investor. In this way he can mitigate the downside risks.
Futures markets carry some specific risks and the risks a retail investor should be aware of are:
Market Risks or Basis Risk:
Like any other asset, the futures position carries the risks of volatility in spot prices. If it's a hedging position, the risk of futures prices not moving in tandem with the underlying asset (basis risk) for whatever reason, is important for retail investor. This makes the hedge relatively ineffective. Typically the spot and the futures prices should start converging as the future expiry date comes closer.
Liquidity Risk:
In most of the futures contracts, the near months ones are the most liquid. The next and far months are not as liquid. The investor might have to incur higher costs in form of wider bid-ask spreads if the contracts are illiquid. Some of the near month contracts may be illiquid too. Interest rate futures have yet to take off in volume terms. Some futures might have concentrated liquidity, as in the commodity futures (MCX), close to 80% of the turnover comes only from precious metals, crude oil and copper.
Roll over Cost:
The futures contracts are usually dealt for maximum three months ahead. And the near month contract is the most liquid one. A investor or speculator for instance taking a long position for more than three months usually has to roll over his position, viz square off his position on monthly basis in the near month before the expiry and simultaneously take a fresh position in the next month contract. If the next month's futures price is higher (contango), the investor incurs a cost each time he rolls over the contract in a year. Roll over costs is some peculiar situations may eat away some of the profits in a futures position.
Margin Calls:
Most futures contracts have various margin requirements apart from the front end ones as the contracts are marked to market every day. This entails cash flows during the contracts being live, especially in high volatility times. Depending on the position of the investor, the cash flows can get reasonably higher. Failure to pay margin calls may lead to futures position being closed out.
Effecting Physical Delivery:
Though most of the financial futures are settled in cash, some of the futures, specially the commodity ones may require physical settlement, which gets a little tricky for a normal retail investor.
Futures provide a powerful and effective tool for investors to protect returns or take directional calls. But if used without knowledge of the risks and downside or discipline it has the potential to incur large losses due to the inherent leverage factor in it.
