Derivatives markets are basically for hedgers such as manufacturers, millers, exporters, importers, traders and cash-rich speculators, and not for retail investors.

M.R. Mayya

It is a matter of concern that retail investors have entered the derivatives market in a big way. The National Stock Exchange (NSE) data indicate that retail investors have been the largest participants in the last four to five years, accounting for as much as 60 per cent of all derivatives activities.

Brokerage houses, with a view to boosting their income, are now on the trail to spreading awareness of derivatives in tier-II and tier-III cities.

The attractiveness of derivatives markets lies in the lower capital requirements as against the cash market, and chances of gains being in multiples compared to the cash market. This is particularly so in options, where the initial outgo is a small fraction of the contract value.

The daily turnover in derivatives trading in securities is, on an average, about three to four times of the cash market — about Rs 50,000 crore as against about Rs 15,000 crore in the cash market. Added to this is the daily turnover in commodity futures markets of over Rs 15,000 crore.

Derivatives markets a must

In a market economy, subject to fluctuations in prices, quite often sharp ones, derivatives are a must.

Derivatives markets are basically a mechanism for price discovery and transfer of risks arising out of fluctuations in prices from the various functionaries in the spot markets.

These markets are basically for hedgers such as manufacturers, millers, exporters, importers, and traders, enabling them to hedge their spot operations and thereby protect themselves from adverse movement in prices.

Cash-rich speculators are also a must for these markets, for without them markets cannot function as it is they who lend necessary liquidity to the market. A market without speculative forces will be a disjointed, illiquid market with sharp fluctuations in prices. It is the speculators, with varying perceptions about the bullish and bearish trends in the market, who emerge as buyers and sellers at every bulge in prices, thus helping reduce market volatility. Necessary checks and balances, including the strict margin system, and limits on trading and exposure take care of the safety of the operations.

With all the checks and balances, fluctuations in prices can occasionally be violent. For example, in three trading sessions on May 13, 14 and 17, 2004, the Sensex fell sharply by 21.71 per cent from 5399.47 to 4227.50. Futures prices of the Sensex also fell correspondingly. Similar sharp declines in prices have been occurring quite often in the last year, mainly induced by the massive sales by foreign institutional investors.

In such circumstances, a retail investor with limited funds would not be able to finance such sudden losses in futures contracts.

Not only would his outstanding positions be closed by his broker, but he would also be compelled to honour his commitments which would force him to dispose of his other assets and he may also have to borrow. Such things happen almost everyday, ruining the lives of such investors.

The story is entirely different in case of investment in the cash market. The investor can hold on to his investment, if the prices fall sharply, and wait for it to recover.

While this can be done in equities, a retail investor will not be able to do so in the futures markets as all the transactions are settled financially, since there is no provision for physical settlement of transactions. Moreover, he has to finance the mark-to-market margin instantly.

Commodity futures

So far as commodity futures are concerned, although there are provisions for physical deliveries through warehouse receipts, the cost of a unit of trading is quite prohibitive for a retail investor to take delivery. Moreover, with various tenderable varieties with grading, the retail investor may just not be able to comprehend the complexities involved in all these matters.

It also needs to be noted that volatility in commodity prices is much more than in equity prices, as supply of commodities varies constantly from season to season, depending largely upon production which is subject to the vagaries of monsoon.

This is apart from various other factors such as government policies relating to imports, exports, buffer stock operations, technical position of the market, etc. In the case of equities, the supply is constant, except whenever there is a bonus issue, rights issue, warrants, and shares arising out of exercise of stock option plans.

Retail investors and options market

Retail investors should desist from entering the options market without any underlying securities with them.

History of the options market indicates that over 95 per cent of call and put options go unexercised, benefiting the seller of options.

If a retail investor with holdings of shares is uncertain of the movement of prices, but wants to take advantage of a rise or fall in prices against his underlying securities, he can sell his holdings in the futures market and also buy a call in the options market.

In case of a fall in prices, his loss in the cash market is offset by his gain in the futures market. If, however, prices rise, he can exercise his call option and take advantages of the rise in prices.

His loss will only be the premium he has to pay for the purchase of the call options and transaction costs. All these are, however, too baffling for an ordinary investor to comprehend.

Mr B. C. Khatau, Chairman of the Forward Markets Commission, regulating the commodity markets, has recently warned retail investors to stay away from the commodity futures markets without a proper study of the markets.

Even with a study of the markets, it is rather doubtful whether a retail investor can really comprehend the complexities of the derivatives markets, particularly of the options market.

Moreover a retail investor, involved as he is in his daily chores of attending to his domestic and office duties, would not be able to keep a track of the minute-to-minute developments taking place in the markets, particularly so with the progressive integration of the Indian markets with the global markets. In short, retail investors are advised to desist from the persuasion by stock-brokers and investment advisers suggesting they should venture into the derivatives markets.

Instead, they should concentrate on investing their hard-earned savings in the cash market of equity shares of fundamentally sound companies, units of established mutual funds, fixed deposits with banks, post-office deposits, etc.

(The author is former Executive Director of Bombay Stock Exchange.)

(This article was published in the Business Line print edition dated October 4, 2007)
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