Poor hedging mechanisms make derivative trades risky

Strictly from a trading perspective, there are a few prerequisites one wants from markets. The primary criteria is liquidity. A trade needs to be absorbed instantly with the impact cost as close to zero as possible.

The second desirable consideration is volatility – a fair range of price movement, up or down. The third consideration is leverage – there should be instruments like derivatives to allow seamless high-ratio leverage. A fourth consideration is easy hedging mechanisms to cut off losses.

Given those criteria, a trader can hope to get decent returns when the luck is on his side, or to restrict losses to acceptable limits when the market moves against him. Let’s see how one would classify Indian equity markets using those parameters.

The 200-odd equity underlyings in the F&O segment tick most of the boxes. Equity futures for the top stock underlyings are very liquid. Dealing in normal volumes, impact costs are effectively zero. Volatility range varies from underlying to underlying. But many counters offer high volatility. There’s no circuit filter in F&O stocks.

Leverage on the futures section is approximately 10:1 so that isn’t an issue. A trader who focuses on, say, the top-20 counters in terms of volatility and imposes further restrictions in terms of minimum liquidity, will still be comfortable in terms of having lots of potential trading choices.

Hedging mechanisms could be a point of differentiation. The most convenient hedge for a stock futures position is an option in the same underlying. In practice, very few Indian underlyings offer options liquidity at all, and liquidity is always very low in the put chain.

This means, except for a short-list of, say, five underlyings, there are no direct hedges available. Hence, hedgers must use index options. Here, very good liquidity is available in Nifty options and there’s also a fair amount of liquidity in the BankNifty. So, financials can be hedged off versus the Bank Nifty (as well as versus the Nifty), while other underlyings can be hedged against the Nifty.

Using an index option to offset a primary stock-futures position requires some number-crunching and that introduces a fuzziness to risk:reward calculations. The trader must know both the level of correlation (how often does the underlying move in the same direction as the index), and the beta (how much does it move per unit index change), before working out possible hedge ratios. Reconciliation, lot by lot, must also be rounded off.

If the correlation is low, hedges using index options are not likely to work. That could mean giving up on the concept of hedging if you are interested in a low-correlation underlying. Or else, the trader has to severely restrict focus only to equity futures with high Nifty correlations.

This is one area where there could be an improvement in trading mechanics as the market matures. Until that happens, the riskiness of Indian equity derivative trades remains rather high. More to the point, exact loss factors are error-prone and tough to calculate. One has to fallback on the tried and tested stop-loss.

The author is a technical and equity analyst