The recent volatility in stock prices has really hurt the short-term trader. This time, in our view, the losses are greater than ever before. The reason? Large-scale exposure to stock derivatives, especially stock and index futures. What until recently seemed to be an easy way to make quick money, have suddenly become a pariah for many an investor. This was always in the coming.

As this note is meant for you, the retail investors in India, this is what we think of derivatives from your perspective.

One, derivatives like futures or options are primarily hedging instruments. They are not tools to take leveraged exposure to the underlying stock/index or in other words, to speculate.

Two, there is nothing like easy money. Even if your broker, who has made a lot of money for you, tells you so, do not go for it. The implicit assumption people make in case of unlimited liability products in India is that the markets will be rational (which they are not). To understand why this is not so one just needs to look back at what happened in May 2006. With the markets falling more than what anyone had anticipated, the margin requirements for investors who had bought futures increased dramatically; unable to meet these requirements their deals were squared off at huge losses. This squaring off further perpetuated the fall in the cash and derivatives markets as investors sold-off other holdings to meet margin requirements and/or protect themselves from further erosion in stock prices. It was a vicious circle, which inflicted huge losses on traders.

Three, often you are told of risk-free arbitrage opportunities between the cash and futures markets. While theoretically these seem true and therefore attractive, executing such deals as planned is not a certainty. Also, the implicit assumption is that the markets will be orderly i.e. there will be no sudden surge in volatility or any other market related issue (like we witnessed in May, and are sure to witness at some stage in the future). Our recommendation is that if you find such deals compelling, be sure not to expose any more than 5% of your portfolio to these risk-free opportunities (which they aren't). In some instances, such funds are expected to generate about 8.0% in a year; liquid funds now generate about 6.5% pa. Ask yourself - Is this additional risk worth it?

Four, in India, futures and options that are available for investment, range from investment tenures of one month to three months i.e. if you wish to stay invested in a limited liability derivative (say, buy a call option), you will need to have a three month view at best. In fact, only derivative products with about a month to mature are really liquid in India. In effect, you need to take short-term calls on the market. Apparently, the exchanges are contemplating on introducing even shorter term derivatives! It's almost as if the exchanges are telling the long-term investor to stay away!

Derivatives are not all bad. You can use derivatives for hedging purposes as mentioned above. However, with the absence of long-term derivative contracts, this option is not available to you in India as yet.

Given the limitation of the products that are available, our recommendation is that you steer clear of the derivatives market. Also, do not give money to a mutual fund, which is only punting, as against hedging in the derivatives market.

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