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Question:  What are the risks involved in Derivatives Trading?

Answer:  Investors and traders are required to sign up a Risk Disclosure Document before they begin trading in Derivatives. This document sets out the various risks involved in this trading. These are significant and investors can lose huge amounts within a short span of time in derivatives (much more than possible losses in the cash market given similar invested amounts).

Question:  How practical is this issue on a day to day basis?

Answer:  Risk is a very live issue as was demonstrated by the April 10th saga. On this day, we saw Infosys fall by 27% and Mastek fall by 49%. These kind of price falls are unanticipated and most investors in short positions have lost substantial amounts of money on this day.

Question:  Aren’t margins able to cover these situations? Is the investor not aware that his entire margin could be lost on a bad day?

Answer:  Margins are designed to cover 99% of the possible losses on a single day. Technically, margins are based on a statistically calculated level of possible losses based on historical stock price movements. However, once in 100 days a disaster is technically possible where price movements can go beyond the limits set up the statistical model.

When this happens, the statistical model limits get violated. As a result, investors can lose more than their margins, brokers can lose if investors do not pay up the incremental margins and exchanges and the entire settlement system can be at risk if many brokers fail to pay up.

Question:  How can margins become insufficient? Can the exchanges not foresee the maximum possible losses?

Margins are calculated in the following fashion (a simplified explanation for ease of clarity):

1. Take the daily closing prices
2. Work out the daily change in prices (termed as daily return)
3. Express this daily change in percentage
4. Work out the standard deviation of this daily change
5. Apply a factor of 3.5 to this standard deviation

A period of one year is considered for these calculations, but a weightage factor is applied in the sense that recent data is given more weightage and earlier data is given lesser importance.

The essence is that the volatility of the past one year is the basis for assuming future volatility. Now in the past one year (and more particularly in the recent past), if the volatility has been at a level of say 3% per day, then the margin would be taken at 10.5% (on the basis of 3% x 3.5 times). Thus, if Infosys were trading at say Rs 4,100 a margin of 10.5% would have been collected on Infosys Futures.

Now the statistical model expects that the daily movement in Infosys would be within the range of 10.5% of the current price of Rs 4,100 (i.e. Rs 430 approx) on the next trading day. Accordingly, a margin of Rs 430 would be collected from investors (both buyers and sellers of Futures).

If Infosys moves more than Rs 430 (up or down) on the next day, the margin will be insufficient. The investor will find that the broker is calling him up the next day and asking for more margins. Brokers will find that investors need to pay up far more and they are (typically) not in a position to pay enormous amounts overnight and exchanges might find that brokers are unable to pay enormous amounts overnight either.

Thus, the entire system can be at risk in case of huge movements in stock prices.

The current system (Value at Risk Margining as it is termed) is the internationally followed practice inspite of whatever limitations it may have. At the systemic level, it is dangerous to follow this practice especially if some players have relatively large market share (which is quite possible in the Indian markets). If some large players suffer losses, the entire settlement system is at risk. Internationally, there are several players and the system is not so concentrated as it is in India and hence risk levels are much lower.

Question:  Are there no circuit filters which can stop stocks from moving so much within a day?

Answer:  Circuit filters are not applicable to stocks which are traded in the Futures & Options segment and to those stocks which are part of the Sensex thirty or the Nifty fifty. Hence, any level of movement is possible on these stocks.

There is instead, a market wide filter. If the entire market (meaning the Sensex or Nifty) moves up 10% or more within a day, the entire market will be closed for specified period (say half an hour or more).

On the 10th of April, the Sensex and Nifty did not move to this level (movements were less than 5%) and hence this filter did not apply.

Question:  What is the lesson in all this for me, a retail investor?

Answer:  If you invest in Futures (buy or sell) or you sell Options, you need to be very careful. You should be mentally prepared to lose the entire margin that you paid to the broker. Further, once in a while (rarely), you might be called upon to pay double that margin amount and hence you should be mentally prepared for such losses.

If you buy Options (calls or puts), the losses are limited to the amount of premium you invested.

If you had sold Put Options on Infosys, you could have typically earned Rs 130 on an At the Money Put before April 10, and it could have gone up all the way to Rs 1,100 on that day. Thus, you could have lost nearly 700% or more of your Option Premium Income on a single day. The story on Mastek would have been worse.

Question:  Can I protect my positions in some manner?

Yes you can. Some examples can be discussed. If you buy Futures, you face a downside risk. To cut off this downside risk, you could buy Puts. For example, you could buy Satyam Futures (assuming you are bullish). But if you go wrong, to cover you possible losses you could buy a Satyam Put. Depending on how much losses you can bear, you could buy an Out of the Money Put.

If you sell Futures, you face an upside risk. You can hedge this risk if you buy Calls. This combination will eliminate this upside risk.

If you sell an At the Money Call, you could buy another Out of the Money Call and limit your losses. If you sell an At the Money Put, you could buy another Out of the Money Put and limit your losses.

Question:  Would you advise such hedging on a regular basis?

A hedged strategy is certainly advisable because of the huge potential for losses. As a retail investor, you should be prepared to compromise your profits a bit in return for some protection.