Derivative Financial Instruments - All You Need to Know

Derivative Financial Instruments - All You Need to Know
11/06/2019

Derivatives, as the word suggests, are contracts and not investments. They are referred to as derivatives because their value is derived from an underlying asset. That underlying asset could be an equity stock, an index, a bond, a commodity, a bond index, a commodity index, forex currency pairs, cross currency pairs etc. Financial derivatives can also be traded on concepts like volatility by buying or selling derivatives on the VIX.

Derivatives broadly fall into four categories:

Forwards are an agreement to buy or sell an underlying asset at a future date at a fixed price in the over the counter (OTC) market.

Futures are exactly like forwards, the only difference being that they are traded on a recognised stock exchange and they are standardised with reference to lot sizes and expiry periods.

Options are a right to buy or sell an underlying asset, popularly referred to as call and put options.

Finally, there are swaps which entail exchanging a set of cash flows for another; fixed versus floating rates or one currency versus the other.

Popular derivative contracts available in India

While derivatives have historically existed for more than hundred years in different forms, the derivatives in an organised form on the exchanges are just about 16 years old. Here are some popular derivative products available in India.

  1. Rupee forwards offered by authorised banks (Forward Cover)

  2. Stock futures and options on the NSE and BSE

  3. Index futures and options on the NSE and BSE

  4. Commodity futures and options (industrial metals, agri, energy and precious metals)

  5. Interest rate futures (IRFs)

  6. Volatility futures (futures on the VIX)

  7. Rupee pairs (USDINR, EURINR, GBPINR and JPYINR) futures and options

  8. Cross currency pairs (non-rupee) futures and options

These represent the most popular types of derivative products available for trading in India and most of them are liquid and actively traded. The derivative market has to been seen in contrast to the spot market for assets.

Some specific features of derivative contracts

Any derivative contract has some unique features. Remember, derivatives are contracts and not assets. Hence, you don’t hold derivatives contracts in your demat account. Here are some unique features of such derivative contracts.

  • Derivative contracts have counterparties. For every derivative contract, there has to be a buyer and seller. This is the case in OTC forward contracts since it is a private contract. However, in case of exchange traded derivatives like futures and options, the Clearing Corporation of the stock exchange acts as the counterparty to every transaction.  This ensures there is no risk of default.

  • Forwards and futures are fairly straight forward. They just have a spot price and a futures price. Options can be a lot more complicated. There is a strike price, which is the price at which it may be exercised. For every underlying asset there are multiple strike prices. In addition, options are also driven by volatility.

  • Unlike stocks where the view is bullish or bearish; derivatives are a lot more nuanced. There can be a bullish view, bearish view, moderately bullish view, moderately bearish view, volatile view, range-bound view or even a hedge view with limited loss and profit parameters.

  • From the above point, it logically follows that investors typically use derivatives for three reasons. The first reason is to hedge a position. You can hedge your equity position by either selling futures or by purchasing lower put options. The second is to increase leverage or speculate on an asset's movement. Here you use derivatives as a proxy for borrowing and trading. This is risky and must be done cautiously. Lastly, derivatives can also be used for arbitrage (riskless profits).

Understanding the all-important options strategies

Futures are plain vanilla. You either use futures as a proxy for long position, short position or to arbitrage spreads with cash price. But options are better known for hybrid strategies. Here are four popular strategies.

Protective Put – Buy a stock and buy a lower strike put. Downside risk is limited and upside profits can be unlimited.

Covered Call – Buy a stock and sell a higher call. The premium on call helps to reduce your cost of holding the stock.

Bull call spread – Buy a lower call and sell a higher call. The higher call premium reduces your lower call premium cost. Profits and losses are limited.

Long Strangle – Buy a higher strike call and a lower strike put. You make profits both ways if the breaches the range.

You can have an elaborate discussion on options strategies but these are the four most popular options strategies in the derivative markets in India.

Getting the hang of swaps

Swaps are not very common in India but it is big globally. In a swap, counterparties exchange cash flows where they perceive a relative advantage. Here are some common swap categories.

Interest Rate Swaps - If one party has a fixed-rate loan but floating rate liabilities, they can enter into a swap with another party and exchange to a floating rate to match liabilities.

Currency Swaps - Interest payments and principal repayments in one currency can be exchanged for another currency based on risk perception.

Commodity Swaps – This entails a swap to exchange cash flows by two parties where flows are dependent on the price of an underlying commodity (gold and silver).

Derivative markets offer the facility to hedge, speculate and exchange cash flows. But it is a high risk game and must be played with caution and expertise.

Next Article

Should You Opt For Direct Plans of Mutual Funds?

Should You Opt For Direct Plans of Mutual Funds?
13/06/2019

Direct Funds or Direct Plans of Mutual Funds are of fairly recent origin. Till August 2009, mutual funds charged entry loads, which were used to pay commissions to sales facilitators. Since entry loads were to the tune of 2 to 2.5%, it imposed a huge upfront cost on the investor. SEBI abolished entry loads on funds effective August 2009 and asked distributors to separately negotiate any advisory commissions with the client. However, this was a non-starter till the time the benefits were palpable. Effective January 2013, all funds had to classify their schemes into “Regular Plans” and “Direct Plans”. The difference was that Direct Plans did not incur marketing, distribution and trailing costs and commissions and hence the load was lower on Direct Plans. Direct Plans had a lower TER (total expense ratio) and that helped these Direct Funds to generate better returns to customers.

What are the principal merits of opting for Direct Plans?

There are some clear advantages for investors in opting for Direct Plans over Regular Plans.

  1. Direct Plans save the sales and distribution commission for the investor. Of course, that means that the investor will have to directly go and invest with the fund AMC, which is not really too difficult. But the savings are to the tune of nearly 1-1.5% on a typical equity fund.

  2. The saving may look quite small in percentage terms but these are the annual savings. When you compound the same over a period of 20 to 25 years (which is your normal planning horizon), Direct Plans can make a huge impact on your wealth.

  3. One can argue that the Direct Plan misses out on the advisory services provided by the distributor. But you always have the option of opting for an independent investment advisor who can weigh multiple options and advise you accordingly.

  4. What is more important is that Direct Plans help you to delink the investment role from the advisory role. When you opt for a Direct Plan, you only pay for the basic operating costs of the fund, which is why your TER is much lower. But more importantly, there is more transparency in the Direct Plan because you exactly know what you are paying for.

  5. Can Direct Plans fit into a financial planning exercise? Actually, Direct Plans will fit perfectly into an overall financial plan because the cost saving in a Direct Plan helps you to keep your overall cost low.

  6. Direct Plans are more conducive to wealth creation in the long run. Let us take the same fund with Direct Plans and Regular Plans. The TER is taken 1.25% lower in case of Direct Plans and this gives the Direct Plan an edge of 1.25% each year. Consider the table below for a hypothetical 25 year return analysis.

Alpha Fund

Expense Ratio

CAGR Returns

Monthly SIP

Final Value

Regular Plan (G)

2.55%

11.85%

Rs.10,000

Rs.1.85 crore

Direct Plan (G)

1.30%

13.10%

Rs.10,000

Rs.2.31 crore

In the above case, it is the same fund over a 25-year period. By opting for a Direct Plan your wealth is higher by 25%. That is surely a very good deal for you. That is what the merits of Direct Plans are all about. They manifest better over the long run.

Do Regular Plans really have a role to play?

Interestingly, the shift to Direct Plans is not yet too rapid and as of now, just about 10% of investors have opted for Direct Plans. That is because Regular Plans offer you some advantages. Firstly, it is simple and easy to execute because the distributor or agent takes care of everything. That is something a lot of investors place a premium on. Secondly, if your investments are small, then the Direct Plan advantage may not be too great but as we said earlier, it makes a difference in the long run. At the end of the day, the choice is entirely yours!

Next Article

10 Steps to Being Profitable in Intraday Trading

10 Steps to Being Profitable in Intraday Trading
20/06/2019

Is it possible to be consistently profitable in intraday trading? Now that sounds too simplistic but you need to understand that intraday trading is less about risk taking ability and skill and a lot more about how you manage your risk. In intraday trading, you start with the premise that you need to protect your capital and then start trading. To consistently make profits in intraday trading over a longer period of time, you need to start off with simple things like documentation, setting limits and managing risks. Here are the 10 steps to focus on.

10 steps to intraday trading

  1. Have you created your trading rule book and if not, then start the process right away. The trading rule book basically lays down all the rules and regulations for your intraday trading. This includes questions like - the loss you are willing to take, the capital depletion you can afford, preferred risk-reward ratio etc. It is your trading constitution book which you must adhere to.

  2. Define your maximum loss at various levels. Define how much of your capital you are willing to lose. At that point, you must stop trading and get back to the drawing board. You must also define the maximum you are willing to lose in a day. If that loss occurs in the first one hour, then have the discipline to shut your terminal for the rest of the day.

  3. In any intraday trade, stop loss is the Holy Grail whether on the long side or on the short side. Normally, stop losses are linked to support and resistance levels but can also be set at your affordability level. Stop loss must be a part of your order and not an afterthought. Secondly, when the stop loss is triggered, just close the position and don’t try to average it.

  4. In intraday trading, always work with a reasonable profit target in mind and be flexible about it. These profit targets must also be imputed in the system as part of a bracket order so that once the stop loss or profit target is triggered; the other leg automatically gets cancelled.

  5. Buy on hope and sell on reality. As an intraday trader, you largely deal with expectations. Once the street knows about it, there is hardly any trade left in the stock. If you are trading based on news flows, you will have to initiate the trade based on expectations and then book your profits when the actual announcement is made.

  6. You can’t outsource charting and research as an intraday trader; you need to do it all by yourself. If you are an intraday trader, the basic route to being successful is to be your own chartist. It is not too complicated and a few basic rules are good enough for you to consistently trade intraday.

  7. Ensure that you are in control of your open positions. Don’t have too many positions open at one point of time as they can be hard to track. This is a mistake intraday traders often commit. Your mental bandwidth only allows you to track a limited number of positions in terms of fundamentals, charts and news flows.

  8. A very important rule in intraday trading is “doing nothing” and it is also an intraday strategy. Quite often, when you look back, it is the most profitable strategy. Intraday trading does not mean that you must either be long or short at all points of time. When the market is too confusing or volatile, take a conscious call to sit out of the market.

  9. As an intraday trader, you are most likely to be successful if you stay close to the market trend. The trend is your friend because it always has a story to tell you. When the market shows a trend it is your job to listen to that message and trade accordingly. At the end of the day, the market is collective wisdom and is always smarter than you. Once you develop that humility in intraday trading, you are on the profitable path.

  10. Documenting and recording may look like mundane jobs but they are the core for your successful intraday trading. Start maintaining a trading diary. It is not just a record of your trades and the logic, but also a daily end-of-day evaluation of how it fared. Make notes on where you went wrong and how you could trade better. Over time, your intraday trading skills gets fine-tuned!

Next Article

Is Your Demat Account Safe From Fraud? Know How To Safeguard It

Is Your Demat Account Safe From Fraud? Know How To Safeguard It
20/06/2019

Your demat account is your gateway to stock ownership. In fact, it is a lot more. You can hold shares, bonds, ETFs, gold bonds and even your mutual funds in your demat account. The demat account is a statement of ownership and SEBI mandates that it is compulsory to have a demat account in your name before trading in equities. This demat account is linked to your trading account and your bank account. When you buy shares, the bank account is debited and the demat account is credited with shares. On the other hand when you sell shares, the demat account is debited and the bank account is credited. As an electronic stock ownership account, the demat account requires protection and care. Here is how you can safeguard your demat account.

Keep your DIS booklet safe and under lock and key

The Debit Instruction Slip (DIS) booklet is the demat account equivalent of your bank cheque book. Normally, each time you sell shares you must sign the DIS mentioning the name and ISIN of shares sold, number of shares sold in words and figures and sign in the appropriate column. Hence you must ensure that you don’t leave your DIS booklet lying around and never leave your signed DIS booklet with your broker or anyone else. Make it a point to never use loose DIS slips. Insist on a pre-printed DIS booklet with your Demat Account number printed. This problem is largely obviated in online trading accounts as you normally give a power of attorney (POA) to your broker to debit your demat account when shares are sold. When you sign the POA with your broker, insist on signing a limited purpose POA rather than a general purpose POA. In the former case, the DP can only debit your account for the settlement related transactions. This makes it a lot safer for you.

Do a regular reconciliation of your demat account

SEBI rules make it mandatory for the DP (NSDL or CDSL) to send you an SMS intimation when the shares are debited to your demat account. In case you find debits for any shares not authorized by you, immediately bring it to the notice of your broker and your DP. Demat leaves an audit trail so it is very easy for the DP to locate how and where the shares were transferred. If you are a regular trader, you must do the reconciliation of your contract notes, trading ledger and demat account at least once every week. As the saying goes, “eternal vigilance is your best defence”.

Ensure to regularly update your Mobile / Email with the DP

Quite often investors are not vigilant enough to immediately inform the DP in the event of change of email or mobile number. This is very important. If you change your mobile number and don’t intimate the DP, then the debit intimations may go to the old contact number and you may not even be aware of it. The same applies to your residential address also. These small things can go a long way in improving your safety quotient.

Use the freeze facility when you are not going to use the account

This is one of the common cases of fraud in demat accounts. Quite often people travel abroad and leave their demat account unattended. During this period, you may not get intimations as your local phone may not be in use. Under these circumstances you can give a signed application to the DP to freeze the demat account. When the account is frozen, the demat account can continue to receive corporate actions like dividends, bonus and splits. It is only debits to the demat account that are barred. The only limitation is that you can only freeze the entire DP account. Freezing of specific shares is not permitted. However, the process is quite simple and once you are back, the account can be immediately de-frozen. The freeze facility is something you must use when your demat account is likely to be idle for long. It can go a long way to protect you.

Remember, the demat system has been designed with a lot of checks and balances internally. A little bit of care from your side will contribute towards making the demat account safer. It is your wealth after all!

Next Article

5 Key Rules for Successful Investing in Stock Market

5 Key Rules for Successful Investing in Stock Market
20/06/2019

Stock market investing is as much a mind game as it is about skill and experience. In fact, it is a lot more about the gut than about the brain. However, investment is for the long term and hence cannot be totally impetuous. There has to be a body of knowledge underlying your investments and that comes from some basic rules. Let us look at five such basic rules that can guide your investments in the stock market.

Always try to diversify your risk; it is not just about returns

The best of investors and traders diversify their risk because there is really no choice. This is an age-old wisdom and means you must not put all your eggs in one basket. Smart investing is about hedging your risk and the first step is to diversify your portfolio. Warren Buffett may have made all his money on a handful of stocks but even he looked at risk at all points of time. For investors, avoid too many stocks of the same type or the same sector or the same theme. More diversified the portfolio, less vulnerable you are to specific cyclical shocks. A diversified portfolio gives you a better chance of being profitable in the long run.

Investing need not be forever, but at least have a 5-year perspective

Warren Buffett once said that even if he bought a stock and the markets shut down for 10 years he would not worry. He may have exaggerated, but the bottom line is to take a long term approach to stock investing. Investors have made huge amounts of money by taking a long term approach to quality stocks. The long term returns on stocks like Infosys, HDFC Bank, Havells, Eicher, Escorts are all classic examples. Markets can be notoriously volatile in the short to medium term, so unless you can think about the next 5 to 10 years don’t even start investing. Typically, you only earn profits on a handful of stocks and that is not possible with a myopic approach.

Smart investing is all about managing your liquidity

It has happened so often to most investors. When markets peaked and started correcting, you held on hoping for a bounce. Then when markets bottomed you were stuck in shares. At some point, you did not have the heart to take a loss and that created liquidity problems for you. The bottom line is that you must have cash handy when opportunities arise in the market at lower levels. At that point don’t get stuck with MTM losses. This is where the best of investors falter. So hold your profits long and cut your losses short.

Focus on stocks you understand, even if you have to miss some stars

In one of his annual newsletters, Warren Buffett mentioned that Amazon and Google were two of the biggest stories that he had missed out. That was largely because Buffett was never comfortable investing in technology stocks. Of course, it is a different issue that Apple is among his largest holdings today. But the moral of the story is that it does not matter if there are 5 trends in the market you do not understand. Rather, you must just focus on the 2 trends that you perfectly understand. That is what matters. Don’t go too much by themes and hot trends. Instead, focus on the business model of the company and its prospects.

Finally, you stand a better chance if you let your head rule your heart

Two common sentiments in the stock market are fear and greed. The irony is that most investors tend to become greedy when they should be fearful and get fearful when they should be getting greedy. You are willing to buy at 28 P/E but not at 14 P/E and when it comes to selling, it is the other way round. Such emotions normally cloud your judgement. That is where you need to let your head rule over your heart. Take decisions based on hard numbers and cold calculations. You can never perfectly be on target in stock market investing but going by hard facts and dispassionate analysis largely reduces your risk and gets you a better deal.

Stock market investing is based on some basic and simple rules.  Just understand the business and buy for the long term. Returns will follow as a corollary!

Next Article

7 Quick Tips to Choose the Best SIP Plan

7 Quick Tips to Choose the Best SIP Plan
20/06/2019

SIPs give you the advantage of matching outflows to inflows and also proffer the benefit of rupee cost averaging. But even in SIPs you need to make a selection. Here is how you should go about investing in a systematic manner.

Step 1: Set out long term goals and tag SIPs to goals

For those who are planning for retirement or for child’s education, the best way is through equity SIP. SIPs work best when they are designed around equity funds. But for SIPs to be meaningful, they must be tagged to a long term goal. You can have multiple SIPs tied to a single goal or a single SIP tied to multiple goals. This induces discipline in your SIP investment as you know the purpose and hence tend to be glued to it over the long term.

Step 2: SIP on products based on your risk-return trade off

You can do SIPs on equity funds, debt funds or even liquid funds. That entirely depends on your goal, the time horizon and the criticality. If the tenure is shorter then you must rely on a liquid fund or liquid plus funds. SIPs on equity funds work best when the goal is for the long-run like beyond 7 years. Ideally, structure these long term goal SIPs on diversified equity funds or multi cap funds. Sectoral and thematic funds are best avoided.

Step 3: What is better – direct plan or regular plan?

You need to make a conscious choice depending on the extent of advisory support you are looking at. In direct plans you do not pay the distribution and trail fees. Hence the total expense ratio (TER) is 100-125 basis points lower and therefore the returns are higher. You need to evaluate the cost benefit analysis. Another midway is to opt for direct plans and then rely on an independent advisor to partner you through the goals.

Step 4: Equity SIPs are for long term

Equity SIPs are not for instant gratification. In a longer time-frame, SIPs make the power of compounding work in your favour. For example, if you try 3-year equity SIP, you could be disappointed as the cycles may not work in your favour. The longer your SIP sustains the more rupee cost averaging works in your favour. In the event, the cost of acquisition is brought down and the returns are enhanced.

Step 5: Make a conscious choice of funds for SIPs

All equity funds in the market may appear to be equal. Get the right framework to select funds for your SIP. For starters, look at the pedigree and the AUM of the fund. Secondly, avoid buying into funds where the fund management team changes too often. This leads to inconsistent investment philosophy. When you look at returns for comparison, focus less on absolute returns and more on risk-adjusted returns and the consistency of returns.

Step 6: Decide on a fixed SIP amount and stick to it

Investors often debate if they should increase the SIP amount when markets correct and reduce when markets go up. That is a lot like timing the market. It is difficult and also does not add value. In SIP the whole idea is that you allow time to work in favour of your cost and the compounding to work in favour of your returns. Invest in a good SIP and don’t try to time the market.

Step 7: Benchmark SIP performance with index and the peer group

These are two different issues. You invest in a SIP so that you get the benefits of active fund management since index returns can be earned through an index fund. Your equity SIP must outperform the index fund SIP by a reasonable margin on a sustained basis. That is when you know that the fund manager is doing her job. You look at the peer group to assure yourself that your fund manager is not out of sync with reality.

Don’t treat your SIP as an all passive affair. There is a method you can apply for profitability!