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The giant underbelly of the markets

Stock investing is only a tiny part of the activity on the stock exchanges, and that's a real shame

The giant underbelly of the markets

Where does that come from when an equity trader sells a stock at a profit and makes money? The obvious answer is that it comes from whoever bought the stock. That's correct, but does that mean the person who bought the stock has lost money? No, at least not unless the buyer has had to sell at a loss. If the price of the stock rises, no one has made a loss. And given that over a period, the markets in general march upwards, equity investors make money on the aggregate. Everyone who invests in stocks understands all this unambiguously.

When someone makes money in futures or options, then what happens? Where does that money come from? What about derivatives? Strangely, the answer to this question is less widely known and even less widely understood, perhaps much less widely.

Some time back, I was chatting with a young man who is part of the recent flood of new investors that have hit the equity markets. In case you aren't aware of this phenomenon, the combination of work-from-home, app-based trading and the lockdown brought in a flood of new investors since mid-2020. A certain number got bamboozled by crypto, lost their shirts, and then went back to the office, but many have stuck to equity. I asked him the above questions, and despite having been talked into F&O trading, he had no idea and, indeed, had never thought about it.

In fact, unlike many investors, he had made an actual effort to educate himself about derivatives and had done so on a variety of material that brokers had given him and also googled and found on all kinds of websites. As a result, he gave me the whole spiel about the advantages of derivatives, how they enable traders to trade safely, how they promote liquidity, how they encourage discovery price, etc. etc. In short, the entire party line. However, in all this R&D and all this propaganda, no one has revealed that every time someone makes a profit, it has to be someone else's loss. Unlike buying actual equity, where the economy's open-ended growth is backing it all, F&O is a zero-sum game.

What I found most interesting is that once I had explained this to my young friend, he became somewhat fearful about all the 'effendo' he was doing. Of course, he believes that he is brilliant, and so is his broker. Still, the knowledge that no money is made in the aggregate in this activity, that a loss balances all profits, changes one's mental attitude towards the activity.

In fact, all the lakhs of crores of derivative trading activity - well above 90 per cent on Indian exchanges - produces no wealth at all in the aggregate, which is a sobering thought. If anyone is getting richer, it's only because someone else is getting poorer. Of course, the brokers and the exchanges are making money from this activity. In India, the theory of what makes F&O useful is just that, theory. A vanishingly small set of investors use derivatives to hedge and limit risk.

When I was a business student, I was told that the purpose of the stock markets was to marshall the investors' resources into businesses so that economic growth is facilitated and all investors can share their fruits. The F&O casino is very far from that vision now.

Of course, let's be realistic - this is not going to change. When I look at 'innovations' like cryptocurrencies and NFTs, then F&O seems quite benign by comparison. In this column, I'm talking to my investor readers and asking them to stick to investing - real investing - and not get lured by this activity that superficially resembles investing but is actually something very different.

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