Why is ‘derivative trading’ a form of high gain – high loss trading with minimum investment?
For the sake of understanding, you may replace “futures” with price of share.
So, one must take a bet on the movement of the share price at the end of the period.
Since one is looking at price movements, one may presume that the share price would perhaps go up or down by a maximum of 10% in this period.
The margin money required to take a bet on price movements would be 10%.
Let’s say the price of the share is Rs.100/-.
Hence, if you want to take a bet on the price movement at the end of say 20 days, you will need to deposit margin money of Rs.10/- for a share of Rs.100/-.
Let’s say after 20 days, the share value goes up to Rs.120/-.
(For the sake of understanding, we are ignoring the mark to market impact where daily debit / credit entries are made)
The buyer of the future makes Rs.10/-
(Rs.120/- (–) margin Rs.10/- (–) original price of Rs.100/- = Rs.10/-) as net profit per share.
He thus makes a profit of Rs.10/- on an investment of Rs.10/- which means that the return on investment is 100%.
However, please bear in mind that while you can invest in a single share of a company in the spot or cash market, the requirement in the derivative markets is to invest in a diverse basket or lots of the same shares . For example, a basket (which is generally termed used lot size) of say stock “A” would contain 10 stocks per lot.
Let’s say the cost of “A” in the spot market is Rs.100/-; your investment too would be Rs.100/- in the spot market whereas in the derivatives market, you would have to invest in a group of say 10 shares which would be valued at Rs.1000/- but since you only need to invest the margin money of say 10,% your investment would be the same Rs.100/-.
However, in this case, you get the opportunity to take a bet on the price movement of 10 shares valued at Rs.100/-.
Thus…
Investment of single share in spot market
Spot / Cash Market
Future lot of Shares A
Investment in a group of shares in derivative market
Futures or Derivative Market
Now…
Cost of investment is equal to market price of share in spot market.
Cost of investment in spot or cash market = margin money for the lot size in derivative market.
Rs.100/- for one share.
Hence for a Rs.100/- stock the cost of investment is Rs.100/- in spot market.
At Rs.100/- per share the cost of the group would be Rs.1000/- but since cost of investment is equal to margin money, which are assuming to be 10%, then cost of investment is Rs.100/- in derivatives market.
Rs.100/- as margin for 10 shares.
So…
In spot market if price rises by 10% you make 10% profit (Rs.10/- on an investment of Rs.100/-)
In derivative market if price rises by 10% you make a profit of Rs.100/- on the entire group for your investment of Rs.100/-. Thus, you make a 100% profit.
However, in case of a loss, you get badly hit in derivative trading as seen below…
In spot market if price falls by 10% to Rs.90/-, you make 10% loss ( Rs.10/- on an investment of Rs.100/-)
But in derivative market if price falls by 10% to Rs.90/- per share you make a loss of Rs.100/- on the entire group of shares for your investment of Rs.100/-. Thus, you make a 100% loss as you lose your entire investment in this example.
Hence, derivative trading is a high gain and high loss trading as compared to trading in a spot market.
Also, in derivative trading you do not deal with a single stock, but in a group of shares. In derivatives trading, you do not take ownership of the group of shares. You only get the rights to bet on price movements of the entire group of shares.
