Derivatives trading : How to go about it?

Sometimes, in volatile markets, it is difficult to predict which sector will do well. But it is easier to predict the direction of the market. In such cases, futures are useful. Derivatives, as the name suggests, are financial instruments which derive their value from an underlying asset, which could be a foreign exchange, a treasury bill, a debt instrument, a commodity, an equity or share index. BSE and NSE have started index futures which has flagged off derivatives trading as the first step to hedge risk of an unfavourable movement in the market. Index futures are like normal options or futures contracts with a stock market index (Sensex or S&P CNX Nifty) as the underlying security. Whenever a position is taken on stock index futures, it means that the investors are taking a view on how the index will move. So by trading in index-based futures or options, one buys or sells the ‘entire stock market’ as a single entity.

Derivatives are all about risk. Therefore, it is important for an investor to decide whether he wants to take risk by speculating in the futures market or reduce risk by hedging in the derivatives market.

The average contract size in the futures market is equivalent to approximately two lakhs (index x contract multiplier, ie, 50). The margin charged is 6% of the contract value. Therefore, one can take a position of two lakhs in the futures market by paying a margin of Rs 12,000. The margin is decided by the exchange and can change from time to time depending on the volatility of the market. Some of the brokers charge 10% margin for safety reasons. If a retail investor wants to trade in the futures market, he should pay a deposit to the main broker. For example, if one deposits Rs 1 lakh with the main broker, he can take a position worth Rs 16.66 lakhs in the futures market (6% being the margin). The daily accounting will take place whether the client is ‘in the money’ or ‘out of the money’. The investor has to pay the difference if he is losing or the mark-to-market (MTM) profit will be credited to his account. It is to be noted that the investor has to trade only with the main broker who is registered as a trading member/clearing member with the exchange.