Wednesday, June 27, 2012

Riding the Leverage Tiger

Co-Author: Amulya Chirala

This article was originally published in Postnoon on June 15th, 2012

I had a strange dream last night. I saw a young lad sitting in front of a computer and it’s raining thousand rupee notes. He is soaked in those notes, enjoying every bit of it. I look closer to see what is on the computer screen. I wake up with a start as soon as I realised that the screen was nothing but a derivatives trading platform and the young lad was Srikanth.

I had explained futures to him a few days back. What has been bothering me is that I did not explain the downside risks of investing in futures as profoundly as I should have. Futures are extremely leveraged contracts. And if not used wisely, they can wipe out fortunes. Often people mistake them as magic wands due to this very property of leverage. Let me explain.

Leverage in finance is very much like the leverage we learn about in physics. It amplifies effort, or in this case, the impact of our investment. When one buys a futures contract, she does not need to pay the full amount. For example, if you were to buy 100 shares of Reliance Industries Limited (RIL), you would need to pay a total of Rs72,700 (Rs727 per share times 100).

On the other hand, in the case of Reliance Futures, one contract of 100 shares costs only a small percentage. This amount is known as the initial margin and is calculated based on a system known as Standard Portf¬olio Analysis of Risk (SPAN).This system takes into account the volatility of the underlying stock.

Let us say that according to SPAN, the initial margin should be 10% of the contract value (Rs72,700). This would mean that you end up paying only Rs7,270 to control 100 shares of RIL. That means you are highly leveraged. Now if the stock price goes up, you gain as the price of RIL futures also go up and you can sell them at a profit.

Let’s say you sell them at Rs750 — your profit will be a total of Rs2,300 (750-727 times 100 shares). Hence your profit in percentage is 2,300/7,270 times 100, that is 31% on an investment of Rs7,270 Here is where we need to remember that leverage doesn’t always mean more profits, it merely amplifies things, so in case of a loss, the amount lost is also multiplied by the same factor.

Let’s assume that the stock price goes down by the same Rs23. That is you sell RIL futures at a loss. Once again, your losses are much higher than they would be if you had invested in the stock instead of the futures.

Unfortunately, people forget that the prices can go down. They feel that they can make huge profits with little investment in the case of futures. And I must explain this to Srikanth before he starts dr-eaming of big money and invests recklessly in the futures market. The exchanges do take measures to ensure that the risks are taken care of by adjusting the initial margin on a daily basis.

The investors get margin calls to top up their initial margin accounts in the case of a falling market. This keeps the investors informed of how much they are losing or gaining on a daily basis. The investors can close their positions or take offsetting positions before they end up losing a lot.

But this system of marking to market everyday also means that in addition to profit or loss at the end of your contract, you have to keep track of cash flows needed to stay invested. Otherwise, a sharp move can cause your position to be closed out prematurely when the contract would have been profitable at expiration.
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