Derivatives. Making money (Leverage)
There are broadly 4 types of players in the financial markets.
We have visited some strategies used for hedging – for de-risking a portfolio, or insuring the value of an expected receipt of an export transaction. The hedger may also be a trader. More of that later.
The most exciting market participant is a speculator. Mostly identified with the animals, Bulls or Bears, the speculator is in the game to take risks and make money. Leverage is most easily accessed in the derivatives market.
“Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.” Archimedes said over 2000 years ago.
Leverage is the ability to stretch the investible capital. This can be achieved by borrowing against an existing asset, say securities in the demat account could be pledged to raise a loan. An automatic route to leverage is to use derivatives, where the amount risked is automatically multiplied. In the financial world, the automatic leverage provided can actually make a huge impact on the capacity of a trade to multiply its results.
Derivatives traded in the markets are of 2 kinds – Futures and Options.
Looking at futures, these are a direct bet on the price movement of a security – up, or down. A bull, expecting the market price of a security to move up over a short period would buy the futures of that security (called the underlying), selling the futures if the outlook is negative. (The pay-off diagram and an introduction to ‘futures’ is in an earlier blog).
While the margins required in the Indian markets for exposure in equity, fixed-income and their indices are quite low at below 5% at most times, the focus of the regulators to protect the market participants from the risk of contamination in case of a default. The most important margins are an ‘initial margin’ without which it is illegal for the broker to enter an order and the ‘Mark-to-market’ (MTM) margin. The initial margin is based on SPAN (Standard Portfolio Analysis of Risk), an algorithm developed by the Chicago Mercantile Exchange based on the VaR (Value at Risk). The MTM margin is charged, or paid out each day based on the closing price of the asset.
Considering an example of transacting in our favorite securities in the spot market, it is best to buy the bonds or shares and hold them in our demat account. We would immediately pay the entire amount of the purchase to our broker. If the stock rises 10% in the short term and we decide to be happy with that amount we can exit and enjoy the 10% gains.
On the other hand, if we have some short-term expectations, the futures market provides the leverage. Assuming a margin requirement of 10% we could buy, or sell 10 times the value of the security. A 10% movement would get us 100% gains on our investment. The risky part is that if the security moves the other way, a 10% movement away from the direction of our bet would lose our entire money. Dabbling in the futures market calls for a lot of research and a strong stomach. With this, futures is a great place to play.