For short-term investors who want to speculate and generate some quick returns on their investments, the Indian equity derivatives market has emerged as a significant platform. The sheer margin by which derivatives trading volumes has been consistently exceeding cash market volumes over the past few years, attests to the attraction of these derived markets (with contracts out to a maximum three months) as short-term investment vehicles.
This emergence of the derivatives market to a dominant position has broadly coincided with an “almost” secular bull run in Indian equities — now into its fifth year. This coincidence, in turn, has created a particular pattern of trading in derivatives dominated by single-stock futures. Single-stock futures indeed have emerged as the most widely used speculative investment vehicle for investors — accounting for as much as 60 per cent, on average, of all derivatives volumes over the past few years.
It is easy to infer from this point onwards that, in the midst of the sustained bull run in the underlying cash market, the positions in single stock futures are mainly long. Short speculative futures positions, indeed, would have been totally unsustainable in the face of the secular run-up in equities, which seems set to continue.
Quite apart from the market trend-driven trading pattern in derivatives, only the following trading positions in derivatives would be optimal or ideal from an investor’s point of view from a conceptual angle. These are: long futures and a long call option position. Only these two positions provide the combination of potentially unlimited profits as well as limiting the downside for the investor.
This combination of pay-offs results from the fact that while asset prices can theoretically rise to infinity, they cannot fall below zero. For a long futures position, therefore, the maximum mark-to-market loss will be the difference between the entry price and zero. For a long call position, the maximum loss will be the premium paid if the option is not exercised.
Leveraging derivatives
Concepts aside, it is the on-going momentum and trend that generally determine the nature of market positions. But in the bull-run context, it is interesting to note that long call option positions (and more generally options as a product class) form only around 3-4 per cent of derivatives turnover despite this product also providing the combination of unlimited upside with limited downside.
One of the unique characteristics of derivatives is that they permit leverage. That is, based on a small outlay, an investor can take exposures, the size of which is many times the initial outlay. This magnifies the profit potential. The loss potential also, of course, is magnified in relation to an investment in the cash market. But the following argument is made in the background of Indian retail investors using the derivatives markets as the prime avenue for speculation. Having chosen derivatives, between futures and options, options are a far more refined instrument of speculation and leveraging. An example will prove this point. Consider an investor who has Rs 25,000 to invest and has the following alternatives:
Investment in the stock of a company currently quoting at Rs 130, or
Buying (the nearest month) call options on the stock of the company at a strike price of Rs 135 for a premium of Rs 3.50 per option
Therefore for an investment of Rs 25,000, the investor will be able to buy around 192 shares of the company or 7100 call options on the underlying stock The Table gives the final pay-offs on maturity, say one month later, assuming t hat the stock price at maturity is either Rs 120 or Rs 140.
As can be seen, the call option position has magnified both the profit and loss positions for the investor. Compared to a loss of Rs 1,920 when the stock is bought in the cash market, the investor will suffer the loss of his entire Rs 25,000 (premium paid) had he invested the money in buying call options. This is because at a final price of Rs 120, the call option will expire worthless as the underlying stock is worth less than the strike price (Rs 135) on the option.
On the other hand, the profits on the call option position if the market moves in the investor’s favour are several times that from the cash market. If at maturity the stock quotes Rs 140, the investor can exercise his call option @ Rs 135 and book a profit of 5*7100 options = Rs 35,500. Net of the premium Rs 25,000 paid, the profits will be around 50 per cent on the investment of Rs 25,000 in a period of 1 month only. That is the effect of leverage. Against that, the profit on the underlying cash market position will be only Rs 1,920.
Futures vs Options
The investor can also go long on futures on the underlying stock by putting up the necessary margin. Assume that the lot size on derivatives (common for both futures and options) on this stock is 2,950 shares. The margin on the futures position will be around 15 per cent of the contract value – which is the product of 2950 and the futures price locked in. Assuming a price of Rs 135, the margin in fact will work out to around Rs 55,000 – which is more than double of what the investor can put up.
(All prices given in the above example are ruling market prices on a particular company’s stock / derivatives).
The contract specifications on futures, by itself, can or should be a deterrent to speculating through futures. On an on-going basis, the mark-to-market mechanism, in case the market moves against the investor’s position, could be an additional drain on the cash flow. On the contrary, options would be a far smoother and more efficient way of speculating as they do not involve marking-to-market and, therefore, would not involve intervening margin calls.
If, despite these advantages, options have not taken off as a speculative vehicle, it just points to the amount of work needed to be done on creating awareness about this product in the retail investor community. Investors have to note that a margin put up on a long futures position is quite the same as the premium paid for a long call option position. Both are investments. And given current regulations regarding contract specifications on futures, investments in options would appear to be more efficient and capable of more smoothly generating the benefits of leverage that derivatives provide.