Tuesday, May 24, 2005

Hedging using derivatives - Can we really do it?

In india, the derivatives market is relatively new and some of the quirks are yet to be ironed out. This is especially tough for the individual investor who is looking to operate in the market with a smaller capital base (say < 1 lakh). Let me attempt to explain the problem - The contract size is different for each stock: Unlike the US, the where one options contract represents 100 shares, the contract size in the Indian market is dependant on the underlying stock. I am not aware of the logic behind the sizes but here is a sample 1 Infosys contract = 100 shares, 1 Wipro contract = 300 shares. Also, the margin amounts that need to be provided for taking a short position in any of the options requires the investor to put in a certain percentage (around 20%) of the money as margin. This has the following disadvantage - I can hedge at a minimum of 100 Infosys or 300 Wipro shares - not less than that volume. The cost of such volumes of Infosys/Wipro at today's price represents about 2 lakhs. Further to buy one contract, the margin is 20% of 2 Lakhs which is another 40K. Thus the total cost of maintaining a position with fixed return (100 shares of Infosys and sell 1 call option) is about 2.4Lakhs.

As a side note, the whole concept of options and options strategy is a fascinating concept and one of my favourites. Do spend some time to understand the mechanics of it. If you like complex problems with elegant solutions, this is probably an area that will offer hours of fun. There is very good book on options - considered one of the best books written about various derivative instruments. The book is Options, Futures, and Other Derivatives - John C Hull

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