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For the equity riches, try derivatives Saturday,August 9th 2008

Listening to Saigal sing his favourite song on the radio transports Kishorilal to his long-cherished vision of this huge house, with grills of silver, etc, where he lives happily with his entire family. Alas, he is nowhere close to realising this dream yet.

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Having retired last year, Kishorilal gets a pension of Rs 15,000 per month. During his working life, while he was never in an uncomfortable position financially, he could not chase his own dreams in the race to fulfill the needs of his family. And today, he just isn’t earning enough to realise any dream.

With an income of Rs 15,000 per month, he is left with only about Rs 6,000 by the end of the month. The bank assures him that if he opens a recurring account with them, depositing Rs 6,000 per month, he will have Rs 12 lakh in 10 years. That translates into a return of approximately 9% per year, Kishorilal calculates. “That’s far too low a return and the Rs 12 lakh he gets at the end of 10 years won’t be enough for the bungalow of my dreams.”

The other alternative is to invest in the stock market. His neighbour Ravi recently made a lot of money by buying the shares of Reliance at Rs 1,960 apiece in September last year and selling them at around Rs 3,000 per share in January this year, getting over 100% annualised returns.

However, Kishorilal feels the market is too volatile. Besides, it isn’t exactly booming right now. He also remembers this former colleague who was forced to commit suicide after losing lakhs in the stock market in 1994.

Kishorilal turns on the TV and switches channels nonchalantly. Images blur in front of his eyes, but suddenly, a few words catch his attention. A young lady (the banner at the bottom of the screen identifies her as Nicky, professor in finance at a renowned business school) is talking about making big bucks with small investments on CNBC. Take to derivatives trading, she says.

Kishorilal always thought these contracts were for the likes of Warren Buffett and J P Morgan. But, Nicky says anyone can invest in derivatives. How come?

Nicky is giving an example. To cash in on the rising share prices, one can invest in stocks that he thinks are going to rise in value in the coming days. However, investing in stocks can be a very expensive affair. Instead, one can buy the futures of that stock. Let’s say one now invests in Reliance futures, which expire on September 25 (last Thursday of the month). Say the price of one Reliance futures is Rs 2,300 currently.

A good point about futures is that one only needs to pay a small percentage of the total contract value as margin initially. Let us say that the initial margin that the investor needs to pay is approximately 10%. Each contract has a lot size; for Reliance, the lot size is 75. Thus, the initial investment is only 10% of the value of contract (which is 75 times Rs 2,300 = Rs 1,72,500). This equals an investment of only Rs 17,250 per contract. Kishorilal’s face lights up. His savings last year totalled more than Rs 70,000. Going by Nicky’s calculations, he could invest in 4 Reliance futures contracts, which would cost him only Rs 69,000.

But what will happen on September 25, when the contract expires? Nicky goes on to explain that upon expiry, the investor will receive his initial investment and the profit or loss on the futures contract. Suppose the shares of Reliance are trading at Rs 3,000 at that time. The gain will be (Rs 3,000-Rs 2,300)*75, i.e. Rs 52,500 per contract, or Rs 2,10,000 for four contracts. This is a gain of 304% in just two months.

Kishorilal runs some mental calculation and concludes that if he keeps reinvesting his profits and the initial investment after every three months, he will have enough money to buy his dream house in just two years.

This is too good to be true, he thinks. There has to be a catch. There is, he remembers from experience. Haven’t experts always advised investors to be careful in judging where the stock prices are headed? Imagine Ravi’s plight had the prices of Reliance shares had fallen instead of rising.

Ben Golub’s famous words come to mind, “Risk management is akin to a dialysis machine. If it doesn’t work, you might have a noble obituary, but you’re dead.”

Nicky’s not finished yet, though. According to her, if you are convinced that the share price of Reliance will go up in the next three months, you must take advantage of the Reliance futures. However, if there is any chance of the share prices falling, a different strategy may be adopted.

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Kishorilal sees a glimmer of hope. He switches off the TV and puts on the radio. Luckily for him, the music isn’t over yet.

The writer is a member of ACCA, UK and a faculty member at ICFAI Business School, Hyderabad and can be reached at Views are personal.

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