Margin And Leverage

The Smart Investor gives an insight into how one can relate the pricing movement of a derivative to movements in the underlying scrip

Derivative trading has caught on quite quickly in the Indian markets. Hedgers and speculators of all sorts have enthusiastically embraced instruments ranging from single-stock futures to index futures, stock options and derivatives.

What is the difference between a future and an option on the same underlying? I don't mean just the theoretical differences, which can be ascertained easily from any finance textbook. What difference does it make to the practical trader? Also how does one relate the pricing movement of a derivative to movements in the underlying? Again this is a question that affects the practical trader.

Stock future Vs stock Option: Let's first look at the difference between a stock future and a stock option from the trading perspective. One key difference is that stock options will (eventually) be settled by deliveries, whereas stock futures can be cash-settled.

Another key difference is that a trader can speculate on the premium in an option assuming that the instrument is fairly liquid. A third is that margin considerations are very different in the two separate instruments.

An American-style stock option, which can be availed anytime before expiry like the available Indian instruments, will usually be far more liquid than an European-style option, which is always settled on the last date. The premiums will also be higher in an American-style stock option.

A trader can play on the fluctuation of option premiums rather than being actually interested in using the instrument for delivery of stock. The derivative premiums will always be far more volatile than the underlying in critical situations. Because of the leverage, this leads to higher gains or losses.

The margin consideration is interesting. The stock future requires more money down on the table than the option. In the case of a single-stock future, the trader will need to put down at least 10 per cent of the future price, perhaps more to be adequately covered in case of fluctuations.

In the case of the option, maximum coverage for an option-buyer is laying down the full premium amount. Option premiums for out of the money instruments can be very low and rarely exceed 2-5 per cent of the underlying. (We are ignoring the case of an uncovered option-writer, who has much higher margin considerations).

The option trader thus has higher leverages and also more leeway in the form of combination trades. However the stock future has one advantage over an option