Should Retail Investors / Traders indulge in Derivatives

Twitter is a place for discussions, collaborations, fights and what not. Today’s post has much to do with one such discussion which more or started when while replying to a friend, I put it out that I was long in Nifty (as we dwelled on how markets may behave on Monday following the carnage (if one could say that) one saw in Dow on Friday).

Vijay Pahwa commented on the tweet and tweeted “Even the best of traders lose money. A layman shd focus on investing in stocks. No trading system can predict mkts!”. Well, for starters he thinks too high of me to place me in the same box as the best of traders. If anything I hope I am above average (especially since I have survived) and not  in the bottom of the bracket.

This comment started a new thread on its own and in one such tweet, he tweeted the following

While I don’t know the source of the 95% (am told by various brokers its even higher), I have to agree with at least the first part of the statement. Second part is questionable given that there is so much of Survivor bias in the data we have and one never knows which fund will have lost money regardless of how long one held the same.

A google search provided me with what could be the Worst Mutual Fund “Ameritor Security Trust” which lost money despite being in the market for 50 years. If you think India is different, think again. CRB Mutual Fund was closed after 20 years with investors getting back 64% of what they invested.

Given the evidence, the question that naturally comes is whether a retail investor should ideally dip his toes into the world of derivatives. While I have been a trader for the last many years, if there is something I agree with the naysayers, it would be that most of them have no business to take part in that trade.

But human greed is tough to conquer. When one thinks there is a opportunity in a certain stock, would you just buy what you can afford (Cash Segment) or try to leverage it (using either Futures, Options or Margin Trading – provided by a lot many brokers) to make the best of the situation?

While I trade in Derivatives, I trade only in Nifty and not Individual Stock Futures. But Stock Futures are the more famous cousin in India where it out-trades Index Futures (measured in Turnover) by nearly 3 times. In fact, Stock Futures turnover is higher than even Stock Options turnover showcasing the bias that has meant that liquidity begets liquidity and there is hardly any trades in majority of the stock contracts.

Stock Futures has had a interesting history in the United States. From Investopedia I learn that Stock futures were in fact banned from 1982 until 2000 and though it trades today, the volumes are way lower than what you see in Individual Stock Options.

In India though, Individual Stock Futures has been the rage. Then again, where else on earth would you see a retail trader having access to a contract worth 5.7 Million (MRF, near its peak) without there being a iota of necessity with regard to whether he is even financially fit to buy such a contract.  If you thought, that was excessive, you should have seen the contract value of Gaur Gum hit the roof when it climbed an astonishing 2000% in just around 18 months. Since contract is for specific quantity, there is no revision.

For instance, when MCX started offering Gold contracts, the value of 1 Kilo (its normal contract) was around 8 Lakhs. Today, the same contract has a value of 31 Lakhs. With SEBI revising the minimum lot value from 2 Lakhs to 5, a lot of stocks have so absurd a quantity that its enticing to the retail investor to try his luck and see whether he can make it big.

Unlike delivery based investments where you can lose only what you invest, when you deal in futures you can lose a lot more. While risk is limited when you buy options, that is theoretically not comparable since you cannot really bet big on options without taking the risk of having a large part of your capital wiped out. For instance, while there is high risk in stocks, you can bet 10 / 20 or even 40% on a single stock,the probability of you being wiped out (especially if you are buying Index Stocks) is pretty low, in Options, you can get wiped out pretty easily.

Trading attracts the best of the minds since its a constant challenge and winning means that you are literally the member of a high class club with very few long term members. But trading is not even comparable to other endeavors since the risk is asymmetric.

Just as I was about to write this post, I came across this very view by Eric Peters

Trading is tougher than most realize, the odds of success are fairly small and when that window of opportunity opens, very few have any stamina (financial or otherwise) left to take the big calls that would lead to the big gains.

If you were to count the number of advisors who offer you the recipe for success in markets, you quickly realize that this is a market for selling shovels to gold diggers. Brokerage houses survive thanks to Sepculators, more so those who do it in Stock Futures as they have very small holding periods are liable to churn excessively.

While I have no clue as to what might be the optimal number of trades, for me it comes to (based on my system history), 1 trade in a fortnight. As Adam Grimes blogged and I quote,

“On some level, professional trading is boring, and it should be. What we need is structure, routine, and a methodology that points toward repetitive elements of market behavior. What we don’t need is excitement. Be a bricklayer.”

Trading is not for the fainthearted, nor for those looking to make some quick bucks, not for those who cannot afford to spend the time required (its a full time job regardless of how little amount you trade) and definitely not for those who think its a path to glory and riches.

People love the story of Jesse Livermore but forget the fact that he went bankrupt not once but twice. Having had a close encounter myself, its amazing that people think that bounce back is easy. Its not and generally ends with the trader abandoning the markets rather than come back in force.

To conclude, in my opinion, its not Leverage that kills but the inability to understand and handle the risk that finally kills the trader. Leverage in the hands of a able trader is a opportunity, in the hands of a speculator, its a self-destruct button.

If you aren’t a full time trader, stay away from derivatives and at the very least you can enjoy the up’s and down’s of the market for a long time to come (regardless of whether you actually make money or not). There is no such thing as hand-holding out here.