Thirty-four-year-old Rachit works in an IT company and takes home about Rs 80,000 a month. His wife is a homemaker and the couple is blessed with a five-year-old daughter. They live in their own house, for which Rachit pays an EMI of Rs 23,000. Their other monthly expenses usually vary between Rs 45,000 and Rs 50,000.
Rachit is a little worried as he is unable to save much for his daughter's higher education and his retirement. Recently, he has come across a social-media post on how one can generate an additional regular income by trading in derivatives. Influenced by the post, he has decided to invest about a lakh from his savings and wants to know if this is the right thing to do.
What are derivatives (Futures and options)?
- Derivatives are leveraged financial instruments whose value is derived from an underlying instrument, such as an index, a stock, a currency or a commodity. Futures and options are two major types of derivatives.
- Leveraged financial instruments can magnify both your gains and losses. Many people are attracted to them for their profit potential but end up suffering big losses.
How derivatives can give you mega losses
Since derivatives are leveraged, you can control a much larger quantity of the underlying by buying a derivative. Suppose there is a company whose lot size is 500 shares in the derivatives market and the price of one share is Rs 1,000. Overall, the lot is worth Rs 500 × 1,000 = Rs 5,00,000. When you buy futures of this company, you need not pay the full Rs 5 lakh but just a fraction of it, say 20 per cent or Rs 1 lakh. However, your profits and losses will be calculated on the full Rs 5 lakh. So, if the stock falls by 10 per cent, the lot loses Rs 50,000. But for you, this loss of Rs 50,000 is 50 per cent of your invested capital of Rs 1 lakh. If the stock falls by 20 per cent, your invested capital is fully eroded and you will be asked to put in more money to control your futures position. Of course, this process would work in the reverse direction and your profits would be magnified if the stock gained in value. However, many studies have established that most traders make losses. What's really worrying is their quantum and speed. You could lose all your capital in a matter of minutes.
Should you trade derivatives/stocks?
- Value Research has always been a supporter of long-term investing in equity through SIPs. We don't encourage trading stocks, especially derivatives.
- Warren Buffett has termed derivatives as weapons of mass destruction, given the massive domino effect they can trigger. Indeed, the 2008 global financial crisis was due to the mismanagement of a kind of derivatives only.
- Over time, regulators around the world have done their best to keep retail investors away from the derivatives market, for example, by raising the minimum thresholds. They have also made the rules regarding derivatives trading more stringent.
- For the layperson, making sense of the derivatives market is also a tough nut to crack. Also, there are multiple processes and requirements to be fulfilled. Not to forget the complex taxation and reporting that you will be subject to.
- Seasoned traders see trading as a full-time job, not a part-time endeavour that can start generating returns from day one. Trading requires an even more meticulous approach and better risk control than plain investing. This would require a large share of anyone's time and a lot of perseverance.
- Trading is a zero-sum game where for every winner, there is a loser. Most traders, especially novices, find them on the losing side. Some burn their fingers so badly that they quit investing altogether.
- So, before you start trading stocks or derivatives, consider the points above and weigh the risk- reward for yourself. If you must trade, deploy only so much amount that you can afford to lose completely.
What can Rachit do then?
- In view of Rachit's current monthly expenses, he would need a retirement corpus of about Rs 4.5 crore. Rachit hasn't mentioned how much he wants to accumulate for his daughter's higher education. But assuming that Rs 10 lakh would be sufficient in today's terms and inflation of 6 per cent, it would cost him about Rs 21 lakh after 13 years.
- Rachit can meet both these goals if he continues to invest Rs 12,000 every month in equity funds (at 12 per cent per annum). However, he needs to increase his contribution by 10 per cent every year.
- But he should reduce his discretionary spending and invest more for creating a larger corpus. For this, he must formulate a monthly budget and follow it strictly.
- Rachit should also consider upgrading his skills through a certification or any other way, which may help him get a better-paying job.
Don't ignore these