Gain more by paying less! That's F&O simplified for you

Doesn't everyone want to make money the easy way? One way of doing it is through the equity market's Future and Options instrument. F&O is a handy instrument to manage risk and improve returns.

CNBC-TV18's Gaurika Chaudhari caught up with F&O market expert Siddharth Bhamre of Angel Broking to learn the tricks and traits of the F&O segment. Also read: Sentiment in F&O segment is very pessimistic: Motilal Oswal Below is the edited transcript of Bhamre’s interview to CNBC-TV18. Q: We have spoken about the products that are available in the derivatives market - Futures and Options. If we start off with Futures, what is Futures? A: Anybody who would like to take more of something by giving less for it. That is what in a basic terminology from trader's perspective Futures is. One pays less and gets more. Let us take an actual example of the market, if I have to buy one share of Reliance and the price of Reliance is Rs 1,000 for simplicity of calculation, then I have to pay broker Rs 1,000 and I get one share of Reliance. We are not talking about any other cost associated with it right now. So, if prices of Reliance go up, my share makes money, if prices of Reliance come down I lose that much of money. Instead of that suppose there is a proposition that instead of paying Rs 1,000 you just pay Rs 100 and take, instead of saying shares of Reliance you take exposure on Reliance share. So if price of Reliance goes up, say to Rs 1,100 I make money. I make money of Rs 100 on investment of not Rs 1,000, but on Rs 100. So, my returns is not 10 percent, my returns is 100 percent on the invested capital. But this is just the positive part of it. If you look on the other side of the coin, if price of Reliance comes down from Rs 1,000 to Rs 900 I lose Rs 100, but on Rs 100 of investment, that is 100 percent loss of capital. So, Futures is nothing, but in a simpler language an instrument which gives you leverage, by paying less you take more exposure. It is a double-edged sword as people rightly say. It can work for you, it can work against you. Q: How is the price of a Futures contract decided? A: There are various factors which affect Futures pricing. First and foremost, the value of the underlying. If Reliance price moves, so would the Futures price of Reliance. There are other factors like interest rates prevailing in the system. By paying less you are getting more exposure. Everybody would like to do that. But there is a cost associated with it, nothing comes for free. Whatever extra exposure which you are getting into the market you have to pay the interest for that particular period and that is what we call cost of carrying that exposure. You do not get it for free. That much cost is added. We also call it premium. Futures price theoretically should be higher than your spot price or the underlying price. If underlying price is Rs 100 then Futures prices if the interest rate in system is 12 percent, that is 1 percent per month then Futures price should be Rs 101. This is how theoretically the pricing is done. Many a time you see that Futures price is trading discount to the spot price or it is significantly higher than what it should ideally be. So, there are various forces which play into market which we ideally call as demand-supply equation. When there is higher demand for particular underlying or Futures of it you would see that the premium or the cost of carry increases. If there is more of supply, people are negative on the underlying then it trades in discount. _PAGEBREAK_ Q: You said one of the factors is cost of carry. The other factor is the volume that is being traded on the live exchanges. What are the other factors, for example we talk about open interest. Does that impact the position that I would want to take in a particular Futures? How does that determine what my call should be on that particular stock? A: First thing that people should understand that there is big difference between volume and open interest. Volume is number of trades which are happening into the system. Say there are only 2 people into the market- you and me and we are continuously trading into the market, but we do not carry any positions with us at the end of the day. Hence, there is huge volume which has happened, but no open position. That is the basic difference between what is open interest and volumes. Sometimes one would see that volumes are high, but open interest is not. Theoretically there are four concepts of open interest. You cannot just see open interest and determine anything. You have to see that open interest in conjunction with price. When we say that open interest has gone up or gone down it does not mean anything unless and until we see with the prices. The four theoretical concepts of seeing open interest with prices is when the price increases along with rise in open interest we say that people are forming long position and the probability of stock continuing to move higher is quite likely. When open interest increases, but price goes down we say short formation has taken place. These two aspects are easier to understand. The other two are slightly bit trickier, but not difficult. If prices come down with the fall in open interest we believe it is long unwinding. Those people who have formed long positions are lower levels are now booking profit. Because they are booking profit, they are putting sell orders, but their open positions are also reducing. So, this is long unwinding. Short covering is covering of short positions, that is short positions when we have formed before. Prices have come down or gone up and if you want to cover those positions you buy and your open position reduces. This is called short covering. This is how you read the open interest and price movement and try to determine where this underlying is heading in a very short-term perspective. You have liquidity in Indian markets only in the one month contract, though you have three months contract, but the liquidity is only in one month contract. This view determined from derivatives cannot be carried forward for prolonged duration of time. So, that is how traders tried to interpret derivatives data in a shorter version. Q: You spoke about how cost of carry, price of the underlying are two factors that contribute to the price of the derivatives product available. Are there any other costs that are involved which decide what price I will be buying a derivatives contract at which I should ask my broker or I should consider before I choose to purchase a derivative? A: When we took the Reliance example, we did not consider any additional cost. We just considered the market dynamics and we did the calculation. Other important aspect which a person has to keep in mind is what the cost of his transaction is then the brokerage and Securities Transaction Tax (STT). These two forms are the major chunk of the total cost. Then you have other costs like service tax on brokerage, stamp duty and exchange tax also. These are the components which are charged. It is just like if you go to a restaurant today, you would read the menu and see that something is available for Rs 400, but by the time you pay the bill, it is like Rs 450-470, because there are so much of VAT and other charges which are applicable. On the same grounds, in equity market when you do a transaction what you are seeing in the screen is the base price, but there are lot of other costs associated with it. Q: We were talking about margins in the previous segment. What are the different kinds of margins that a Futures contract is subject to which we should be aware of? A: It is very important aspect of derivatives trading margin. One should realise why this margins are charged. A derivative is an exchange-traded product and exchange takes the counter-party risk. To cover this counter-party risk exchange charges the margin. Margin is charged upon the underlying depending upon the volatility of the underlying. Lower the volatility, lower would be the margin. That is why you see that the exchange index margins are far lesser than stock margins. Even in underlying stocks you have different kind of stocks. You would have more margins for companies like Unitech or probably GMR Infra compared to companies like National Thermal Power Corporation (NTPC) or Oil and Natural Gas Corporation (ONGC) where the volatility is less. Higher the volatility, higher the margin, lesser the volatility lesser the margin. Exchange cannot take margins on every hourly basis or daily basis. So first they take initial margin, which is calculated and given to the brokers that how much is to be collected. Then there is something called additional margin where brokers take it from clients on day-to-day basis. If the stock moves up by 0.2 percent in a day and I am short on that particular underlying, it means I need to pay 0.2 percent of the contract value, that can be a very small amount. A broker need not get into client shoes and ask for that kind of money. So what brokers usually do is they take additional margin also. So, all this small obligations which client has to face or broker has to face to exchange can be met with. There is something called mark-to-market margin where though the settlement is done on the expiry date, there is day-to-day obligation of exchanges which is cash settled. So to maintain that there is something called mark-to-market. If I have an Rs 100 share and if it goes to say Rs 110; I still hold a position. But that Rs 10 credit should come to my mark-to-market account. Similarly, a person who is on the other side of the trade; there would be a debit of Rs 10 in his mark-to-market account. That is how exchange functions from the margin perspective. _PAGEBREAK_ Q: Explain this to us, the initial margin that is levied by the exchange to the broker for all contracts on a particular stock or index because we have understood that every specific product separately for stock, separately for index invites a different margin. Now is this margin fixed for a long duration of time? For the duration of the contract, can this margin be changed by the exchanges as we have global and domestic conditions which contribute to volatility in either an exchange or a particular category of stocks and therefore their volatility would change. How does that work? A: You will be surprised to hear this. The initial margin volatility file which exchange uploads happens five times a different file in a day. So, forget about the long haul, even during the day exchange changes the margin five times. Q: Explain it to me from the investor’s point of view? I take a position on a particular Monday morning with my broker for a Futures contract and that is at a certain level of margins. But like you said, the stock through the day goes through different paces, volatility and therefore the margin required to be paid by me changes through the day. Is there a range that to be ready as that would affect my risk-taking ability as well? A: The additional margin, which we spoke about, which broker takes on an above initial margin takes care of those small fluctuations. So, a broker need not hassle client for every small change here and there between the two file timing of exchanges coming to the broker. That is the reason that additional margin is taken by broker to safeguard investor as well as exchange and his own interest. So, whatever small volatility changes, which is happening in initial margin requirement, is taken care by that additional margin. Q: What about the instances when we hear a huge hue and cry, which is when margin calls get triggered and the investor especially feels the pinch because a lot of margin money goes out of their kitty? A: Very important point you are highlighting over here. We have seen these things as a cause of significant fall. If you recall there are so many stocks recently where huge falls have happened, 50-60 percent fall in a single trading sessions, which has nothing to do with the fundamentals of the company. Even in larger market we have seen huge falls happening because of margin Calls getting trigger. Imagine a scenario where people are building long positions, they are positive on market or a stock and they are leveraging themselves. End of the day derivatives is a leverage product. All of a sudden there is a fall which is happening into that underlying and people don’t have additional money to take care of those mark-to-market margin requirements. So when you don’t have that margin to pay exchange forces broker to close down the position. So, if I am having a long position and I have bought a stock say at Rs 100 and now stock has all of a sudden fall to Rs 90 and say broker is asking me for additional Rs 10 as a mark-to-market margin requirement and when there is so much of volatility even the initial margin goes up. So that money I cannot provide because I don’t have that much of liquidity. So what exchange and broker does is forcefully square off my position. So, they put a sell order into the system. When there are so many forceful trades happening into market selling the underlying derivatives that time you see the resultant fall. So to avoid this first thing what traders should do is get into a stock where the free float is very high, where there is huge amount of liquidity, generally avoid midcaps, discipline at your end that. If at all you are very bullish on a stock and there is a 10 percent fall and you are still optimistic on it, lack of funds should not forcefully make you square off your positions. So, don’t overexpose yourself because something is available by giving less you are getting more. So, again we come back to that cash management discipline. Q: So nee to have ample liquidity for every position that you choose to make in the Futures market? A: Right and if I add onto this – if I have Rs 100 and I can take exposure and five lots by paying Rs 100 as initial market margin requirement is say Rs 100; I should not do that. Ideally, I should take only Rs 50 worth of initial margin exposure and Rs 50, I should keep for an adverse scenario this way where I have to pay mark-to-market margins because things are not moving according to what I want. Q: When we buy equity, we can buy one share; one unit of the index. But on the Futures side there are lot sizes. How is the lot size determined? A: You cannot buy one unit of any underlying because it is a margin system. So, if you are buying one unit. Say you are buying Rs 100 of shares and you have to just pay 10 percent margin that means you are just paying Rs 10 for that particular transaction. So, it would be quite petty issue. So, a desired lot size is required. Previously the lot size – the contract value was much higher. To encourage retail participant exchanges decided to reduce the contract value and that ideal contract value which exchanges have decided is around Rs 2 lakh. So, suppose there is a stock which is trading at say Rs 1000, its ideal contract lot size would be 200. Lot size is how many shares exposure you can take. So, 200x1000 is around Rs 200000. If there is a stock which is trading at say Rs 500, the ideal lot size would be around 400 shares or 400 units. So, that is how lot size is determined. _PAGEBREAK_ Q: Also tell us how is a Futures contract settled? A: There are two types of settlements. One is delivery based settlement and one is cash based settlement. The important differentiation between these two is on the settlement date in delivery based settlement; the buyer of a contract has to buy the shares and the seller has to sell the shares. In cash based settlement only the difference is adjusted and that settlement is done on cash basis. We have different cycles of the contracts – one month, two months, three months. You have near, next, far. Near is the first month, next is the second month contract, far is the last which is third month contract. Last Thursday of every month is the settlement and if that Thursday is holiday then the settlement is done on the previous working day. This is for equity derivatives. There are some exceptions for commodities and currency. Currency it is the second last working day of the month as a expiry day. You have expiry day for gold on 5th of every month, which is in-line with COMEX because it is a global commodity and you have agri-commodities and crude where the expiry date is somewhere around 19th and 20th of the month. These are the various expiry dates and different cycles in which most of our exchange traded derivatives function. Q: If we come back to equities. The settlement is done either by cash or by delivery. Here too does the investor have a choice of deciding whether he would like to take the shares or does the settlement have to be done in cash and I am assuming that index Futures are always settled in cash? A: Index Futures are always settled in cash because you cannot form a basket and do the settlement. At the same time today, we still have cash based settlement. To have a delivery based settlement you need to have strong SLBM which is stock lending and borrowing mechanism which unfortunately has not picked up in our market as of now. However we are quite confident that going forward it would. There is a perception which is right that if delivery based settlement is introduced, it would reduce the volatility which generally we see on the last trading session – especially last one hour where people are busy squaring off their position. So, this is how the settlement is done. In equity it is only cash based and as I mentioned earlier there are some commodities where you can do a delivery based settlement also. Q: You were telling us how Futures are settled in our current market – in equities and in commodities. Now explain to me what if I have taken a position in Futures of a particular company. I am approaching the conclusion of that cycle, but I do not want to close my contract. My view on that particular stock, on its prospects continues. Can I move from the near month series to the next month series and is there a change in either my costs or the implications that it has for me? A: If you know the time horizon of your view; you should take positions accordingly. In last one, one and a half week of say near month contract and you have a 3-4 weeks view, then instead of taking position in near month you should take in next month. Suppose you have position in near month and you want to carry it forward because your view is of one month then you rollover your position. Rollover is not particular type of trade. It is just an action which is called as rollover. At the end of the trading cycle of near month or slightly before, say you have a long position, you sell the near month and you buy the next month. That means you are just moving from one cycle to other cycle without changing your view. This is called rollover. It is a fresh transaction in your books of accounts and also for a broker. Broker doesn’t see that whether you are rolling your position, he just sees that you have squared off one position and you are getting into a new position. So, whatever costs are involved in terms of doing a trade, brokerage your STT and the other charges which we spoke about, those would be applicable while selling also and while buying the new contract also.