Wednesday, May 24, 2006

There is peril as well as profit in riding the leverage tiger

DNA, 24th May 2006

It has happened before, and it's happening again. Futures markets were widely blamed for the Black Monday crash in the US in October 1987 - even though research has shown that futures cannot be blamed for the unfortunate turn of events then. Similarly, futures are being blamed now for the falling indices in India. Let us examine how trading in futures has an impact on the cash markets.
Let us take, for example, the Reliance Industries share for the past one month.On April 24, 2006, the share closed at Rs 977 in the spot market and Rs 988 in the futures market. Buoyed by the positive market sentiment, investors bought into the Reliance stock futures in the hope that its price will rise in the future, and then they can offset or close their positions in the futures market by selling.
People prefer to take a long position in the futures market as they have to pay only a small margin for the contracts rather than the entire amount. For example, an investor can buy one lot of Reliance futures consisting of 600 units by paying a margin of around 28% on the total contract value. The total contract value would amount to Rs 5,92,800 (Rs 988 x 600 = Rs 5,92,800). The investor, though, needs to pay only Rs 1,65,984 (5,92,800 x 0.28). To buy the same number of shares in the spot market, the investor would have had to pay Rs 5,86,200 (977 x 600) on the same day.
Now, say, an investor has bought in one lot of Reliance futures contracts by paying a margin of Rs 1,65,984. He is of the view that the price of the futures contracts will keep rising. And indeed they do, till May 12, 2006, after which they start falling. The investor thinks that it is just a temporary downward move and does not square off his position.But the markets continue to fall. On May 22, 2006, all hell broke lose and the Sensex lost more than 1,000 points during intra-day trading. The Reliance futures price also took a heavy beating and closed the day at Rs 928. On account of the daily mark-to-market system in the derivatives segment, the investor receives margin calls as the value of his investment falls.

Mark-to-market essentially is a term used for adjusting the value of an investor's investment on a daily basis. Here, the difference between the settlement price (the closing price of the futures contract) of the previous day and the settlement price of today is settled in cash daily. So if the price of the futures is falling, the investor needs to deposit cash with his broker, who, in turn, needs to deposit it with the clearing house.
Now, the investor has three choices. If he has the cash to meet the margin call, he pays the money to the broker who will then deposit it with the clearing house. Second, he can square off his position by selling one lot of futures contracts and can book a loss on his position (loss of (Rs 988-Rs 928) x 600=Rs 36,000). Thirdly, if he holds Reliance shares or any other shares in the spot market, he can sell them and raise the money to meet the margin call. Most of the investors fall in the second and the third category. They either square off their positions on their own or the brokers do it compulsorily if the investor fails to deposit the margin call or they sell shares in the spot market to meet the margin call in the futures market.

In both the circumstances, there is selling pressure on the spot market. When an investor squares off his futures position by selling futures contracts, there is a drop in the futures price due to selling pressure on the futures contracts. If the futures prices drop, and they start selling at a price which is lower than the cash market, the market players will start buying in the futures market and selling in the spot market. This will create a selling pressure on the cash market, sending the prices down.

Similarly, there is selling pressure on the cash market if investors start selling their shares in the spot market to raise cash in order to meet the margin calls in the futures market. And so, futures market influence the spot market.

Note: Stock and futures prices have been rounded of.
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