Derivatives and the Retail Investor

chillibreeze writer — Hrishikesh Rajadhyaksha

Warren Buffet, one of the world’s most successful and well known investors, once called derivatives the real weapons of mass destruction in an almost-prophetic declaration. The world would soon see them being used recklessly as gloom and doom descended upon us in the form of the worst economically perilous period since the Great Depression.

However, if it is possible to keep one’s greed in check and just step back a bit when it matters, it is clear that derivatives can very well be used by retail investors to manage their portfolios efficiently and optimize returns in the process. Buddhist philosophical teaching tells to tread back the path that got us to the problem to find the true answer to it. Go to the beginning. Similarly, if we go back centuries in time, we can understand the uses and origins of derivatives contracts.

Farmers skeptical about their produce during times of uncertain weather conditions would fix a price with buyers in advance for the crop, much before the actual harvest. Thus were born futures contracts. Using futures/forwards contracts to protect one’s portfolio is a time-tested practice called hedging.
Assume this scenario: You hold 100 shares of company ABC Holdings. You are certain through your research that ABC Holdings has terrific long term prospects and could be a multi-bagger. However, due to certain short-term aberrations, the latest results are expected to be poor. You do not want to dispose off the shares but at the same time, you would hate to take a notional hit on your investment.

What you could do to save yourself some strife is to Short Sell the shares in the futures market, i.e. you could enter into a contract with a counter-party to sell the shares to him at the current price, irrespective of what the future price of the shares will be. If the share price falls, you acquire the shares at a lower cost and deliver them to the other person at the previously agreed upon higher cost (price prevalent at time of contractual agreement). Thus the amount you would lose on your shares would be nullified through the profit made on the futures contract.

Now, retail investors may not hold the minimum number of shares required to execute a completely hedged short sale for a single company. This type of hedging thus may not be feasible for certain investors. What can be done by such an investor is hedging using a market index. To hedge your portfolio against a market index:

Step 1: Calculate weights of each company in the portfolio relative to the total size of the portfolio
Company Weight = Total Market Value of Shares / Total Market Value of Portfolio
Step 2: Find individual stock ‘beta’ (β) from various online databases available
Beta is the relative volatility of a stock compared to the market (or index)
Step 3: Calculate the portfolio Beta
Portfolio Beta = Company Wt. 1 x Stock Beta 1 + Company Wt. 2 x Stock Beta 2 + Company Wt. 2 x Stock Beta 2 + ………. + Company Wt. n x Stock Beta n
Step 4: Hedge portfolio by short selling index futures worth
Portfolio Beta x Portfolio Size

And there you have it. You are theoretically protected against losses.

A common mistake investors make is speculating on markets without proper study. Now it is important to understand that speculation is deeply engrained in the human psyche and is almost impossible to eliminate. It is important and even advisable to speculate to a limited extent and in a controlled manner so that your speculative instincts don’t get the better of you in a more crucial situation. Whenever possible, even this kind of speculation must be backed up by sound reasoning.

A small part of your portfolio may be reserved for speculative bets using equities or derivatives. If pure directional calls need to be taken through naked (un-hedged) positions, one might want to consider using Options instead of Futures. Options have a limited risk, unlimited reward profile. The use of options as a purely speculative tool is strongly discouraged, but the point being made is that if one has to use derivatives as a speculative tool, the use of futures should be avoided.

The exchange traded derivatives market is several times the size of the equities market globally. The use and study of derivatives as a tool for retail investors should be encouraged and a concerted effort should be made to increase awareness about these highly powerful products.!

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Hrishikesh says, "Dreamer, traveler, music lover, perpetual student. finance professional by day. My ambitions in life are to be a serial entrepreneur, travel the world and live to write about it!"

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