Why the need to put up additional margin makes futures trading risky

Not only must your call be directionally right, the price movement must occur within a stipulated time frame for you to make money

8 min read Last Updated : Apr 10 2022 | 9:42 PM IST

According to media reports, officials of the National Stock Exchange (NSE) recently met the country’s biggest stock brokers to enquire whether there are adequate checks in place while on-boarding new investors into the derivatives segment.

When new investors entering the equity markets circumvent mutual funds, and even direct equities, and jump headlong into high-risk futures and options (F&O) trading, it is indeed a cause for alarm.

Aggressive tactics

Many brokers are offering schemes like Rs 500 cash back for opening a trading account. People who refer clients to brokers are offered incentives. Some brokers are crediting exchange-traded funds (ETFs) and shares in the accounts of inactive clients to encourage them to start trading. “A lot of nudging is happening in the market right now,” says Shrey Jain, founder, SAS Online, a Delhi-based discount broking firm.

Once a client opens an account, she is encouraged to trade in F&Os, without taking into account her suitability in terms of capacity to absorb losses, or knowledge of derivatives.

Influencers are playing a big part in the retail influx into derivatives. “Today there is a large army of influencers which uses social media platforms to convince retail investors that they can create an additional income stream by trading in F&Os,” says Jain. He adds that they are finding many takers among college students and housewives with cash to spare.

Once the locked down began in end-March 2020, many people, who had little to do or had lost their regular source of income, turned to trading in the stock market. After a steep fall, the market began to rise from April 2020 and rose almost uni-directionally till October 2021. Many new entrants, including those in the derivative segment, made high returns within a short span. “This recent experience has given people a lopsided view of the risks associated with derivatives,” says Ankur Kapur, managing partner, Plutus Capital, a Sebi-registered investment advisory firm.

Higher sensitivity to price movement

Price movements in the cash segment (stocks) get magnified in the F&O segments, as this example demonstrates.

Suppose that the current price of Share A is Rs 125 (see table). A trader has Rs 1.8 lakh to invest. If she invests in the cash market, she can buy 1,440 shares (Rs 1.8 lakh divided by Rs 125).

The lot size in the F&O segment is 4,500 shares per contract. The margin the investor needs to pay to buy one futures contract is Rs 1.8 lakh. So, she can buy one contract in the futures segment.

In the options segment, the investor can pick up a call option with strike price (the price at which the option can be exercised) of Rs 125. The price of this option is Rs 5, so the investor can buy eight lots (or options on 36,000 shares=4,500*8).

Suppose that on a given day, the spot price rises by Re 1. Let’s assume that the futures price, which tends to be a little more sensitive, changes by Rs 1.01. The option has a delta (the degree to which the option price moves in response to a shift in the price of the underlying asset) of 0.5. So, if the share price moves up by Re 1, the option price will rise by Re 0.5.

The return the investor makes in the spot segment is 0.8 per cent. In futures, she makes a profit of 2.53 per cent, and in options, of 10 per cent.

Thus, with a fixed amount of money, an investor can take much larger positions in futures (4,500 shares in the above example) and options (36,000 shares) than in the cash segment (1,440 shares).

“On account of leverage, if the share price moves up, the return the investor earns is much higher in the F&O segment than in the cash segment,” says Ramabhadran Thirumalai, associate professor of Finance (practice), Indian School of Business.

However, the downside is commensurately higher. “If instead of rising by Re 1, the share price drops by Re 1, the investor’s return will turn negative to the same extent,” adds Thirumalai. In this example, the return will be -0.8 per cent in the cash segment, -2.53 per cent in futures, and -10 per cent in options.

Need to maintain daily margin

Suppose that a person buys 4,500 shares for Rs 125 each. He will have to shell out Rs 5,62,500 to buy them in the cash segment.

“The advantage of paying up fully in the cash segment is that once you have bought these shares, you can hold them for as long as you like,” says Jain.

In futures, the trader pays only the margin money, which in this example is Rs 1.8 lakh. (Exchanges decide the margin based on a stock’s volatility.)

A key risk in futures arises because the trader has to maintain the margin on a day-to-day basis. Suppose that the share price declines by Rs 25 in a day. The value of the trader’s holding is now Rs 4,50,000, down Rs 1,12,500. “At the end of the day, the trader will have to furnish this amount (Rs 1,12,500 in this example) over and above the original margin (Rs 1.8 lakh) he had deposited,” says Jain.

This compulsion to maintain the margin has serious implications. “In the cash segment, even if the stock price declines, the trader can hold on to her position at no extra cost. In futures, if there is a steep decline in stock price, the trader may not be able to furnish the additional margin, in which case the broker squares off her position. Even if the stock bounces back after a while, the investor ends up losing money.”

An option gives a trader the right (though not the obligation) to buy or sell a stock at a specific price by a specific date. Suppose that a trader invests in the call option of a stock. In the above example, she pays Rs 5 (barely 4 per cent of the stock price) to buy a call option with a strike price of Rs 125 (meaning she has the option to buy this stock at this price by a given date).

If the share price rises, she makes a gain. But if the share price declines, she can let her call option lapse, thereby limiting her loss to the extent of the premium paid.

Bets on price declines can also be made via put options.

“One factor that makes it difficult to make money in the F&O segment is that not only must the stock move in the direction the investor desires, it must also do so within the period for which the investor holds the contract. Even if it moves in the right direction later on, she won’t benefit because her contract would have expired by then,” says Jain.

F&O trading is for select few

A new investor entering the markets should ideally begin her journey with passive funds. “Take exposure to a fund based on a broad market index, such as the BSE S&P 500 initially,” says Kapur.

After she has been in the markets for a couple of years, and has educated herself, she may venture into actively-managed funds, which involves selecting a good fund manager.

Once she has built her mutual fund portfolio, she may venture into direct stock investing (if she desires) with a limited portion of her corpus. “I strongly recommend learning fundamental investing by studying the investment styles of great investors. I wouldn’t recommend trading, either in stocks or in F&O, for most retail investors,” says Kapur.

Those who do enter F&O must educate themselves, and also understand the risks associated with this segment. “Before investing, understand the payoffs in derivatives compared to the cash segment,” says Thirumalai.

According to Jain, as in any specialised activity, only a select few are likely to succeed at F&O trading. “Start small and see if you can make a go of it. Increase exposure gradually,” says Jain.\

Sensitivity to price movement is higher in F&O segment