The art of going long and short

PERSONAL FINANCE/ F&O PRIMER

Warren Buffett calls them financial weapons of mass destruction. Their returns can be seductive but at the same time if used for speculative purposes you can lose not just your shirt but everything else as well. Abhay Jha lost Rs 2.8 crore and his equity portfolio reduced from Rs 4 crore to Rs 1.2 crore in a matter of a few weeks by dabbling in futures. While Jha can still afford to buy a shirt and a suit as well, there are many who have been taken virtually to the point of no return. Welcome to the world of derivatives.

What are derivatives?

A derivative is an instrument that derives its value from the underlying asset. The value of the derivative is determined by price fluctuations in the underlying asset, which could be anything""stocks, bonds, indices, commodities or currencies. The key characteristic of derivatives is the principle of high leverage. The two most important types of derivatives are:

Futures: Suppose you have been planning to buy a TV for quite some time and there is a television on sale for a limited period. You now enter into a contract with the dealer to buy this TV at the sale price after 30 days. This contract with the dealer is similar to how a futures contract is structured, in that you have agreed to receive a product at a future date, with the price and terms for delivery already set. You have secured your price even if the price of this TV rises in the future. By getting into this agreement with the retailer you have reduced your risk of higher prices.

Options: An option on the other hand is a contract that gives the holder the right (not any obligation) to buy or sell a security on or before a particular date. An option is a contract between two parties wherein the buyer receives a privilege for which he pays a fee (premium) and the seller accepts an obligation for which he receives a fee. Options come in two flavours: call (option to buy) and put (option to sell).

Derivatives are often used to speculate in stocks but at the same time, professional investors also use them to hedge or provide risk reduction to investments. An active use of buying put options or selling futures can help investors hedge the risk of stock prices coming down.

At the same time when the market goes up, you can benefit if you had bought call options or futures. The good part is that you can use financial leverage as upfront cash requirements are low and thus cheaper than other forms of leverage such as loans against shares. At the same time this good part can turn ugly like you saw in Jha's case above.

What are the types of derivatives?

In India, futures are available in commodities, stocks, interest rates etc but we will restrict our discussion to stocks. Here we have index futures and options (on Nifty, Sensex etc), futures and options on stocks. Traders have shown a keen interest in derivatives and volumes have increased hugely (See Deriving Growth).

How does one make money in futures and options?

1. If you are confident that the market will tank from its current high and whether you have stocks or not, you can sell index futures and ride comfortably.

2. Similarly if you feel that the Sensex can touch 17,000 levels from current levels, you can buy index futures at the current spot price and profit from it.

3. If you are like many who cannot decide whether the market will go up or down, and if you have a sizeable stock portfolio, you can sell index futures. If the market falls then the gains from index futures will compensate for the loss in the cash market. However, if the market goes up, then the gains from your stock portfolio should compensate for the losses in the index futures.

4. You can also make money by writing options (selling call and put options) called a premium and also reduce by buying put options if you feel that particular stocks will fall and buy call options if you feel the stock price can go up. Remember the use of the words 'feel' or 'believe' above. These are dangerous words as they amount to a certain amount of speculation and hence the risks are much higher.

Does this mean that one should stay away from these instruments?

The answer for most people would be 'yes'. For professional investors and the adventurous ones, the answer could be 'yes' depending on the view of the market, the need to hedge risks, returns on expectations and the urge to increase the velocity of money.

Before you get into futures and options, make sure you understand the nuances and, more importantly, the risks associated with them. Derivatives can work for you and work against you in a big way. Make sure you understand how they can work against you and the implications of the same before you take a leap.