Maximum profit with minimum risk — it is the ultimate goal that every investor in every asset class thrives for and the derivatives market is where it is done. Welcome to The Derivatives Show on CNBC-TV18.
Over the next 13 weeks, this new show will empower you with the knowledge that will allow you to trade futures or options in equities, commodities or the currency markets.
In this episode, Siddarth Bhamre, head of equity derivatives, Angel Broking explains the basics that anyone with an interest in derivatives must keep in mind. Bhamre explains that derivatives can enhance returns while lowering risk. He adds that an investor’s ability to bear risk will determine the return and what one wishes to achieve with his investment portfolio.
Below is the edited transcript of the show on CNBC-TV18
Q: In today's marketplace, why is it important for any investor who has invested, especially in equities, to take note or have knowledge of derivatives?
A: An investor needs to first understand why one invests in equities and the consequences therein. It is not just a one-sided process where funds are invested and the value keeps growing. It could fall as well and that is the source of the problems in investing. Basically, there are two types of risks in investing. One is the risk of investing in a particular stock and attendant factors that cause the stock price to move up or down.
There is another type of risk which is not related to company, but to the markets in general. All investments are vulnerable to these two kinds of risk. Derivatives are instruments that try to mitigate both these risks while offering reasonable returns.
Q: When the Securities and Exchange Board of India (Sebi) introduced derivatives in June 2000, there was a lot of fear, risk aversion and concerns on it would fare. But now the daily turnover from the futures and options (F&O) segment basis forms a colossal part of market transactions. Give us an idea of how the derivatives market has grown? Has it picked up in popularity?
A: It has become a tremendously popular segment in market and I am sure everybody watching the show is aware of how volumes have significantly moved up. But for a perspective on how this market has shaped up, let us go back a bit in time. In June 2000, the market regulator launched Index Futures and the Stock Options came in November 2001.
Till 2004, the economic growth rate stagnated at around five percent, the market was steadily picking up, but the volumes were not high. The derivatives market kick-started just as growth in the economy and market surged.
Previously, the F&O volume in comparison to the cash volume was lesser. Today, the Options volume is significantly higher. In 2004-2005, the Options volume was five percent of total turnover. Today, the Options volume is 75-80 percent of total turnover. This market has witnessed huge growth and this trend is clearly evident in other asset classes like commodities and currencies.
Q: What about the participants in this market? Are retail investors starting to take interest or is this still the domain of larger investors who either understand the product or who have much bigger portfolios?
A: I believe participants from almost all investor-classes are present in this market. Though retail investors may not be significantly involved, but they are still there. But what differentiates the participants is how much they know about what they are doing.
Retail interest slowly and steadily trickled in. The market caught the retail investor’s attention especially after that crash of 2008, when investors realised that how important it was to play safe in this market rather than just taking a one-way position. From that point, there has been a huge turnaround in Options turnover. There is a huge gap between the knowledge levels of retail and the domestic institutional participants regarding knowledge of the product, the cashflows and repercussions.
Q: Is an investor better off investing in equities than in derivatives?
A: There is a general misconception that that investing in derivatives is speculative in nature. Derivatives reduce risk provided investors use them wisely. So investors not exposed to derivatives are certainly missing out. Investors are mistaken of they think of using derivatives to make money in a very short timeframe. Derivatives not only reduce risk they also enhance returns.
Q: So it can work both for the long-term as well as the short-term investor?
Q: Can you give some examples of how derivatives form an intrinsic part of every transaction that we make in our daily lives?
A: Derivatives are part of daily life. Curd is the simplest and easy example of a derivative. If milk prices go up, definitely curd prices will also go up and vice versa. Curd is made out of milk that is why the prices of curd are dependent on milk.
Similarly, the prices of futures or derivatives are dependent on an underlying asset that can be anything — equity markets, commodities, currencies, bonds, interest rates, metals amongst others. Suppose you go out to search for a property, find one you like and pay a token amount promising to conclude the transaction in a month's time, this is also a derivative and it called a Call Option.
However, what confuses the lay investor is the use of a lot of jargon and terminology.
Q: What are the different kinds of derivatives available in the markets today for the retail investor and their security?
A: Derivatives are classified into two types, Futures and Forwards. Forwards are where two parties sit together and decide on the kind of contract specification, the deal value and the maturity date.
Q: So, it is a bargain struck between two individuals or institutions according to their requirements?
A: Exactly. It is tailor-made according to requirements of two parties specifying the default risk, liquidity risk, and counter-party risks.
In a Future, the specifications are standard. It is traded on the exchange which takes on the onus of counter-party risk and there is a particular date when the contract matures.
There is a third category called Swaps which is beyond the purview of the retail investor. It involves an exchange based on cash flows rather than on the asset.
Financial derivatives offer another category called Options which is further divided into Call Option and Put Option. In matured markets like the US, the UK and Japan there various other types of Options.
Q: What in the Futures and Options (F&O) space is is available to the retail investor and how does he decide which product is better suited for either his risk profile or portfolio?
A: While investing in the F&O segment, it completely depends on the individual's ability to take risk in expectation of an equal quantum of return. Futures allow unlimited returns for unlimited risk.
Options offer a lot of flexibility depending on whether one is a buyer or seller. A buyer’s risk is limited to the premium he pays but his returns can be much higher. However, it depends whether they are used for speculation or hedging.
A seller of Options has to bear very high risk though his returns are limited. So, it completely depends on the investor’s ability to bear risk in anticipation of a certain reward that determines the trade that investors can enter.
Q: So investors have to list out their risk profile, goals and then choose the product that they would like to purchase in the derivatives market. Is that correct?
A: Correct. It all depends on an individual’s ability to take risk.
Q: Is there only one kind of investor that participates in the derivatives market?
A: There are various participants in the derivative market which was evolved basically to mitigate or shift risk from investors who do not wish to take it to those who wish to take it. According to their ability to bear risk, participants are divided into different categories.
Q: What are the broad categories?
A: Theoretically, they are classified into three segments — Arbitrageurs, Hedgers and Speculators.
Q: What is the role of an arbitrageur?
A: No market is ideal or perfect and there is mis-pricing in different asset classes. Now, derivatives reflect that underlying value and there are certain ways of pricing derivatives. Whenever there is a mis-pricing, derivatives are expensive and an asset is less expensive after the mean value is arrived, then you buy where the prices are low and sell where the prices are high.
As the prices merge at the end of the contract cycle, both prices are going to be same so that risk free returns can be generated. It can be done between the derivatives and the underlying value, it can be also done between same asset classes but traded on different platforms, it can be done between the same stock trading on the NSE and the BSE and if the pricing differential is there you can buy where it is trading low. You can sell where it is trading high. That is arbitrage.
Q: So, a far more evolved and a dedicated investor is that the kind of a person you need to be if you want to avail of arbitrage?
A: I won't classify arbitrageurs as investors because they watch the screen with a hawk’s eye.
Q: Are they opportunists?
A: Exactly. Arbitrageurs provide a lot of liquidity into the system and make sure that the price deviation between any two components does not widen.
Q: What is the profile of a hedger?
A: The derivative market was designed first for hedgers, speculators and then arbitrageurs. A hedger has an underlying asset but he doesn’t want to take risk. So, he safeguards his portfolio with a counter position that reduces the risk either in form of Futures, Options or Forwards. Hedgers provide stability to the derivatives market and determine where the market might move.
Q: And speculators?
A: They are the reason for these whipsaws in the market. Speculators are opportunists and take short-term positions and hence don’t provide stability to system.
Q: So, do I need to come up with a profile for myself before I start operating in the derivative market?
A: Yes. No matter what type of participant you are, you have to be aware of what is happening in derivatives market.