“Derivatives are financial weapons of mass destruction.” - Warren Buffett

The BSE Brokers Forum does not seem to value the advice of this world’s most renowned value investor. The Forum wants to encourage retail investors to increase participation in the derivatives segment. Soon it will meet the chief of Securities and Exchange Board of India (SEBI) to discuss the way to increase the engagement of retail investors in Futures and Options (F&O) segment. This is how the Forum positions itself, “Direct participation of retail investors has reduced significantly in the last three years as they are preferring to participate in the capital markets through mutual fund route. Even though derivatives market is about ten times the size of equity markets in terms of volumes, the retail participation in the segment is very limited.”

Moreover, according to it, the remedy for this lies in this—“SEBI needs to adopt a procedure that would first increase the awareness levels of the investors. It also needs to simplify the KYC procedure so that opening a Demat account becomes easier for a common man.” “

PersonalFN believes individual investors do not need derivative products at all. In the first place, derivatives do not qualify as an investment option for retail investors. Futures and Options (derivatives) don’t have any intrinsic value. They derive their value from the underlying securities. So basically, they are just the contracts.

For example, investing in “XYZ” company and entering the futures of “XYZ” companies are not the same investment decisions. A person taking a position in the derivatives of “XYZ” company, agrees to buy or sell the predetermined quantity of “XYZ” Ltd. for a pre-specified exercise price on or before the last date (expiry) of the contract. In this case, it is immaterial whether the shares trade at a higher or lower price on that day at the stock markets. Options give you a right to buy or sell the underlying securities/indices. Of course, there’s a cost associated with these rights. Unfortunately, what was invented as a means to beat market volatility and hedge the portfolio of underlying stocks is now being used as a profile-making tool. A derivative is a friend of institutional investors and a foe of retail investors.

Suppose a mutual fund scheme just finished collecting Rs 1,000 crore through a New Fund Offer (NFO). However, the fund house expects the equity markets to fall about 10% shortly. In such a case, it is tough to deploy money, as expected, if markets fall by 10%, the fund will stand to lose a massive Rs 100 crores. It cannot hold so much of cash anticipating that the markets will fall. Holding cash may prove to be a very pricey decision in the end, if markets don’t fall as expected. Now the fund can cut short an index (meaning it can sell the derivative contract on an index future) and invest the entire NFO proceeds in the stock markets. By doing this, it safeguards itself from falling markets. The contract on the index it sold would turn profitable if markets fall, limiting its losses in the stock markets.

How many times must a layman face such arduous situations? Systematic Investment Plans (SIPs) offered by mutual funds help them deal with the market volatility. Usually the contract value in derivatives segment is high, and unless the portfolio size is large enough, hedging may not be economically viable. So what retail investors do? They take positions only in derivatives market (without having any position in the stock market). Investors burn their fingers in un-hedged positions.

Although the Forum talks about educating investors, the question is, do they actually require derivatives? Do you as an investor think derivatives can help grow your wealth? Share your views with us by writing a comment below.

PersonalFN believes, retail investors do not need such complicated products. The derivatives market might be ten times bigger than the stock markets, however retail investors should focus more on their long-term goal before investing their money, for them the size of the market should not matter, fulfillment of their goals definitely do.

PersonalFN hopes SEBI will discourage all efforts to get investors to participate in derivatives.
 

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