If derivative investing is profitable, why is my planner advising me against it?

In the last 15 years that derivatives have been in the Indian markets, a lot has transpired. They are termed as derivatives because their value is derived from an underlying instrument such as an index, stock or even commodity and currency. What this effectively means is that instead of directly investing in stocks, one can invest in derivatives, whose value depends on stocks. The two most popular variants of derivatives are—futures and options. Simply put, a futures contract is an agreement between a buyer and a seller for purchase or sale of an asset on a future date at a pre-determined price. Effectively, one can enter into a futures contract by paying the margin money to the stock exchange. The position in futures is settled every trading day and is called mark-to-market. This means that the margin requirement will change every day with the change in the value of the underlying asset. An option means the right to buy or sell and is a contract between a buyer and a seller of an asset on a future date. Like a future, options are also at a pre-determined price, but the buyer of the option pays a premium to own the option, and is under no obligation to honour the contract. In contrast, the seller has the obligation to honour the contract when the buyer exercises the option. If you think derivatives are profitable—they actually are not because if derivatives are used for complete hedging of the portfolio, then you can’t think of profits. The reason is that any gain or loss in the original portfolio will be offset by a similar loss or gain in the derivative products used to hedge the portfolio. At the same time, understand that hedging does not lead to a loss. So, in volatile times, derivatives can be used as an effective hedging tool, which can help manage risk better. However, if derivatives are used as a speculation tool, it could be risky.

olmdesk@outlookindia.com