Derivatives trading - removal of stocks

The decision of National Stock Exchange to remove 50 stocks from F&O trading is a very welcome step for ordinary retail investors. This will particularly benefit traders who like to trade in futures contracts but do not quite know which stocks to select . Streamlining the list of F&O stocks by removing the weed will ensure that ordinary traders don’t get trapped in unsuitable stocks. Modification of the criteria for inclusion in the F&O list such as market cap etc will ensure that dud stocks don’t find a place in the list. This is very important because through the derivatives products one is able to take a far greater exposure in the market than the cash available with him. Such exposure can be 3,4 or 5 times the cash deployed. If the market goes in his favor the trader makes high profits in relation to the cash deployed. But more often ,as is the case , if the trade goes against him he incurs 3,4 or 5 times more losses than he would otherwise have incurred due to his leveraged position.

Having seen how leveraged trading as in the case of futures trading has a multiplying effect on profits or losses lets see how this is converted into a domino effect if such trading is undertaken in shallow stocks. By shallow stocks what is meant is that these are stocks having low market cap and with low liquidity. These stocks are subjected to wide price fluctuations. Which means these stocks have high impact costs that is any buy sell order results in large price changes. For these stocks therefore gains are comparatively large when prices are rising and losses are also large when prices are falling. Trading in such stocks in the futures segment is therefore fraught with a great deal of risk.

To contain the risks though one can put a system of 'stop loss' in which the losses are cut short when the trade turns unfavorable while the profits are allowed to run. But these are techniques for disciplined traders, which very few of us are. Many may correctly be able to cut the losses but cannot figure out when to re-enter the stock thereby missing out on the opportunity when markets turn.

When derivatives trading was introduced in the Indian stock market the lot size was made such that the contract value had to be a minimum of Rs. 2 lakhs. With an average margin of around 25% a trader had to pay about Rs 50000 upfront as margin money with more kept ready for margin call requirement. This served as a good deterrent for ordinary retail traders to dabble in stock futures. However as the bear market was setting in and prices were taking the plunge the cash required to buy or sell a stock futures contract also came down to mouthwatering levels. A single stock futures contract of most blue chip companies were available for around Rs 10000 to Rs 12000. In the bear market that was prevailing the bears were having a field day while the traders on the buy side lost heavily with very few among them being able to catch the recent up move .

In contrast, what about the investor who buys only as much as he is capable of paying for. This is delivery trade where stocks are held till they are sold and when sold, delivery of the stock is given. Since he doesn’t have to sell out as soon as prices dip for any reason and as a response to a stop loss trigger price, he is free from the worry of timing his re-entry . And if he has bought in a market which is trending up he can wait out the temporary dips and can be successful in making a profit. This is not to say that he will never sell . He will of course sell when he is required to, out of a decision taken on various other factors that he has set for himself. In a derivative trade he is required to square up his trade on the expiry day bearing whatever losses he has made. He may however roll over to the next series but there is no certainty at all whether he will be able to recoup his losses. And for all you know the following month series might add to his losses. Having experienced consecutive losses he soon gives up and is worse off. In a delivery based trade on the other hand a patient wait can see him make profits as markets invariably get better after a beating

There are other ways though in which derivatives can be used .For example derivatives can be used for hedging a portfolio via the options route. But those techniques may be useful for protecting a portfolio for the short term. In a raging bear market its utility is doubtful.

In the short term, one has to be very adept at using derivatives since the risks are many fold. Ordinary retail traders should therefore resort to a more sedate approach of delivery based trading where there may not be spectacular and quick profits, which in any case may be a mirage, but there can be steady profits. Generating profits few times in a year may not be such a bad idea after all.

Happy investing.

The contrarian approach

What is the contrarian approach. In a contrarian approach we do exactly the opposite of what the majority is doing. To understand that lets see first what is crowd behaviour
in the stock market. Crowd psychology in the stock market is no different from that seen anywhere else. Crowd behaviour is the mentality of following the herd. It is going with the majority opinion. This means when the market is trending i.e. continues in its direction whether up or down , everybody is eager to join the bandwagon so to say. In the early stages of the trend though this gives the desired result and more people join in giving further boost to the already developed trend. But all trends reverse at some point. The trouble with the crowd is that it does not know when and where to get off the bandwagon. That is because crowd behaviour essentially precludes any logical or rational thought process and all actions are dictated by following what everybody else is doing.

Now everybody cannot be right at any given point of time. This should be very simple to comprehend. For if every body is right and is able to make profits where are the losers going to come from. In any transaction both the buyer and the seller cannot be right . Either the buyer is right or the seller is right. If the buyer is right he stands to make profit on his investment and vice versa. In fact a buy sell takes place as a result of opposing views of the buyer and the seller. Since there are as many buyers as there are sellers simple arithmatic tells us that at least 50% of people are loosers. This without any further mistake on the part of the investor. If investors make further mistakes, which they invariably do, the number of loosers far surpasses the winners in the stock market. This is a very important aspect of investing in stock markets and has to be kept in mind. Winners in the stock market are few. So following the majority does not pay.

This is the contrarian approach. You sell when others are buying and buy when others are selling. That is buy in an atmosphere of gloom and doom and sell amidst euphoria. Buy into companies which have been neglected by the market, if the fundamentals are right and wait patiently because markets will eventually catch up with the fundamentals and reward you. But here is a caveat . This approach works when a majority opinion has indeed been formed among the participants in the market. But if one takes the approach before that , i.e. when the majority opinion is under formation one will miss out on the opportunity thrown by a trending market that is a rising or a falling market.

But how does one go about figuring out whether a majority opinion has indeed been formed. Tracking the P/E multiple can be a very useful method. The P/E ratio is obtained by dividing the price of the stock with it's earnings per share. Obviously it indicates how far the price has gone in relation to the company's earnings. P/E multiples are very high or low at around the time when the trend is maturing that is when a reversal is imminent as the trend does not seem to have any more legs to go on whether up or down. In such a situation the P/E ratio has strayed very far from the value it normally commands. Following the P/E ratio therefore gives us a reasonable idea as to the extent of the price rise or decline. But one has to be careful here, as sometimes, price of a company's stock rise or fall dramatically following some unexpected news on the company and so does the P/E multiple. In such a situation it is helpful to compare with other companies in the sector. Sometimes also unexpected events take their toll on the markets which then stands rerated or derated depending on whether higher or lower P/E multiples are paid. But that is a different thing. These days P/E ratios are given with stock quotes of most newspapers and it is very good practice if one makes it a point to keep tab on the P/E multiple.

Happy investing.