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How Profitable are Derivatives?

Derivatives are relatively new financial products in India. So what are these derivatives? Is investing in these profitable? What is the minimum investment amount here and do funds invest in these products?

What are derivatives? Is investing in derivatives profitable? What is the minimum investment amount here? Do funds invest in these products?
Vinni Singh, via e-mail

Introduced in 2000 by the National Stock Exchange, derivatives are a new breed of financial products whose value is derived from an underlying instrument-such as an index, a stock, a currency or a commodity. Thus, instead of directly investing in a stock, you invest in an instrument whose value is dependent on the price of that stock. Futures and options are two popular and actively traded derivative instruments in the Indian markets.

A futures contract is an agreement between the buyer and the seller for purchase or sale of an asset on a future date at a pre-determined price. One can enter into a futures contract by paying the margin money to the stock exchange. The position in futures is settled every trading day and is called mark-to-market. This means that the margin requirement will change every day with the change in value of the underlying asset. Futures can be both stock futures (stock as the underlying asset) and index futures (index as the underlying asset).

Now let us explain this with the help of an example. Mr A buys Nifty futures at 1250, and will make a gain if the Nifty moves above 1250. Say, the index moves to 1300, then the Rs 50-gain will be added to his mark-to-market account. Conversely, if the Nifty moves down to 1200, the Rs 50-loss will be deducted from the mark-to-market account. Similarly, if Mr A sells Nifty futures at 1250, he will benefit from the downward movement of the index and will suffer a loss if the index moves up.

Basically, an option means the right to buy or sell. So an option too is a contract between the buyer and the seller for purchase or sale of an asset on a future date, but unlike a future, it is at a pre-determined price. The buyer of the option pays a premium to own the option, but he is under no obligation to honour the contract. In contrast the seller has the obligation to honour the contract when the buyer exercises the option. Are derivatives profitable? If derivatives are used for complete hedging of the portfolio, then you can't think of profits. The reason is that any gain or loss in the original portfolio will be offset by a similar loss or gain in the derivative products used to hedge the portfolio. Importantly, though hedging will not lead to a loss. Hence, in volatile times, derivatives can be used as an effective hedging tool, which can help manage risk better. But if derivatives are used as a speculation tool, it could be risky.

Put simply, derivatives are complex in nature and retail investors may not understand the risk they bring to the table. There is a risk of mis-pricing or improper valuation of derivatives and the inability of correlating derivatives perfectly with the underlying assets, be it stocks or indices.

Further, derivatives are highly leveraged instruments. A small price movement in the underlying security could have a big impact on the value. Adverse price movements, on the other hand, in the underlying asset can either mean phenomenal gains or it could lead to the erosion of the entire margin money. Due to these inherent risks in derivative products, SEBI allows mutual funds to invest in derivatives only for hedging purposes, and not for speculation.

The minimum investment in derivatives depends on the type of instrument. For index-based derivatives like index futures and index options, the minimum trading lot is 200 units.

Hence, if the Nifty is at 1000 points, the minimum value of 1 trading lot would be 200X1000 = Rs 200,000 (though only initial margin required for entering into a future contract and premium in case of an index option). But for stock futures and stock options, the minimum trading lot varies among stocks. For instance, the minimum trading lot of Wipro is 200 while that of Hero Honda is 800. Readers who want to know more about derivatives may visit the website www.mayin.org/ajayshah/PDFDOCS/ShahThomas2000_dfaq.pdf

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