Trapping naive investors

I received an SOS call from a very close acquaintance. I knew he had ventured into equity market just when corona pandemic made its entry. Even as I was counseling him to stay away from the market, as he was naive and lacking financial investment skills, he would always come out with investment theories, trying to convince me about the opportunities thrown by the COVID19 pandemic in equity markets. The pandemic destabilized the financial markets all over the globe and shares were witnessing unprecedented fall in price.

Now the acquaintance who was in the market since April 2020, feels ‘cheated’ as his investment in some company shares has fallen to considerable levels. One of the blunders he committed in the market was indulging in Futures & Options trading. Though he made some quick buck, but at the end of the day, his portion of capital investment stands lost. Another blunder he committed was that he raised a loan from the broker and started trading in the market, only to earn financial worries.

Let me first deliberate upon Futures & Options.

During my childhood days, one of our family acquaintances had a few walnut trees in his compound. The trees used to be full of walnuts and our acquaintance used to earn hefty sums every year by selling the produce. He used to fix the price in advance, much before the produce (walnuts) were ripe. Every year, some traders used to come to his home and bid for the future produce. The top bidder used to own the rights of the expected produce during the season at a fixed price. After selling the commodity rights of the walnut trees, it was the trader’s call about the selling price of the produce. During my childhood I had no clue about the nomenclature of this kind of transaction, when a commodity is sold at a fixed price which was at that time non-existent. Interesting part is that even today when whole financial transactions have been modernised, and even regulated, these kinds of transactions still exist in Kashmir, particularly in rural areas, outside the ambit of formal financial system.

So, what’s this kind of transaction known as? This is basically a future contract – a contract to take delivery of a product in the future, at a price set in the present. So when our family acquaintance and the trader agreed that he (the trader) would be buying produce of the walnut trees from him at a particular price to be delivered to the trader when they’re ripe, they (our acquaintance and the trader) just entered into a futures contract.

In today’s investment scenario, people here are looking for more and more investment opportunities to multiply their savings for future needs. They are curious to know more about lucrative and less risk prone investment areas. Mostly people are lured by capital market and stock investment has become their preferred investment arena with a hope to multiply their money at faster speed. It’s here they overlook huge risk which this market is carrying along.

It’s interesting to note that many readers want to know about various products available in the capital market and a good number among them has sought details about Futures and Options.

A futures contract is not equity in a stock or commodity. It is a contract – a contract to make or take delivery of a product in the future, at a price set in the present.

In formalized trading of futures contracts on exchanges, standardized agreements specify price, quantity and the month of delivery. Futures markets have their roots in agriculture, but today futures and options on futures are traded on a wide range of products like natural gas to stock indexes, precious metals and currencies.

Now, what are options? Options on futures can be thought of like insurance. An option buyer (the insured) pays a premium to an option seller (the insurance company) for the right to buy or sell a futures contract at a specific price. However, just like with insurance, the option buyer may or may not exercise his right (use his insurance).

Businesses associated with volatile prices use futures and options to hedge risks. They lock a particular price of the commodities to insulate themselves against higher or lower prices in future.

Futures and options markets also provide the economy with price discovery. Futures prices are determined by supply and demand. An exchange itself does not set prices; it simply provides a place where buyers and sellers can negotiate. If there are more buyers than sellers, the price goes up. If there are more sellers than buyers, the price goes down. The prices discovered through futures markets offer valuable economic information about supply and demand in a competitive business environment.

Similar to stocks, gains and losses in futures trading are the result of price changes. If you have sold a futures contract, your trade will show a profit if prices fall. If you have bought, higher prices will produce a profit. To make a profit on a futures trade you can first buy low and then sell high, or reverse the order and sell high, then buy low.

It’s important to note that futures and options trading is not for everyone. Futures and options markets can provide an investor the opportunity to diversify and to increase returns.

In investment matters, investors always look for enhancing their purchasing power. Here they look beyond their means (funds they own) and take route of credit (loan) facilities to buy additional securities. In investment market, the investors have facility of availing margin loans from a broker when they look to invest without having their own money in hand.

Let me explain this mechanism. For example, you have Rs.50,000 in hand to purchase some shares of the companies from the market. While doing so, you find some more opportunity of buying some stock, but your purchasing power doesn’t allow you. It’s here the broker offers his services; lends you the required money to seize the opportunity and buy more stocks beyond your means. To do so, you are required to open a margin account with the broker.

This margin account, which is different from a trading account, will allow you to borrow money from the broker to buy stock. To use margin you must set up a margin account, which is different from a regular trading account at a broker. Notably, a margin account requires an initial deposit, also known as minimum margin, decided by the broker. In most cases you can margin up to 50 per cent stock’s price, which means, If you wanted to buy 100 shares of a company selling for Rs 50 per share for a total of Rs5000 you could margin Rs.2,500 of the purchase price. In other words, you would contribute Rs.2,500, known as the initial margin, and the broker would loan you Rs.2,500.

There are certain conditions in margin trading. Your broker will charge you interest on the money you borrow. When you sell stocks bought on margin the money goes into the margin account to settle the loan to the broker. Of course it provides a way to magnify your trading power, but any missteps can be extremely costly. All stocks in your account are held as collateral for a margin loan. The margin maintenance requirement varies from broker to broker, stock to stock and portfolio to portfolio.

Now, let me tell you about a margin call. When you borrow money to buy stocks, the broker (lender) basically wants to be sure that he gets paid back. And so, he will insist on having some sort of deposit in order to protect his loan. The problem occurs when your stock falls, and the collateral you have pledged isn’t worth what it once was.

In this situation, the broker’s money is at stake and will call you to have enough cushion by putting in additional cash, or deposit more stocks into your account. That in essence is what a margin call is.

It’s very important for you to understand margin calls. As soon as your account falls below the broker’s maintenance requirement, you will get a margin call.  If you fail to raise your account to the minimum required level, your broker can sell off your holdings without any notice.

So, trading in a margin account is a double-edged sword. It can cut both ways. And remember, your brokers lend you the money because they want your trading business. So use this option cautiously. Don’t underestimate the risks of trading on margin. Margin calls can have large portions of your investment portfolio liquidated under unfavorable market conditions.

(The views are of the author and not the institution he works for)