Derivatives play a crucial role by providing investors with tools to hedge risks, speculate and even enhance returns. But not all derivatives are created equal. A nuanced understanding of stock derivatives versus index derivatives is essential for any serious trader. This article delves into these differences and offers guidance on the optimal approach for various trading scenarios.
The primary distinction between stock derivatives and index derivatives is the underlying asset. Stock derivatives are linked to individual stocks, while index derivatives are tied to a stock market index, such as the Nifty 50 or the Sensex.
Key differences
Risk: Stock derivatives inherently carry higher risk. This is due to the comparatively more volatility associated with individual stocks. A single stock can experience a 10 per cent price swing in a day, a phenomenon less likely in a broader index. Thus, index derivatives, reflecting the performance of a diversified basket of stocks, tend to be more stable.
Moreover, stock derivatives are traded in larger lot sizes. It typically ranges from 100 to 5,000 shares, whereas index derivatives have smaller lot sizes, often between 15 and 25 shares. So, relatively lower volatility and lesser lot size means lower risk in index derivatives.
Capital and Margin: The higher risk in stock derivatives translates to higher margin requirements. Typically, margins range from ₹1.5 lakh to ₹2.5 lakh. Conversely, index derivatives require lower margins, usually between ₹60,000 and ₹1 lakh, making it more accessible. For instance, Nifty futures would require a margin of ₹60,000-75,000, whereas for stock futures, say SBI futures, would require approximately ₹1.5 lakh.
Liquidity: Liquidity is a critical factor in trading. Index derivatives generally offer higher liquidity compared with stock derivatives. This enhanced liquidity ensures tighter bid-ask spreads, facilitating smoother and more efficient trade executions. In contrast, illiquid stock derivatives can trap traders, making it difficult to exit positions without incurring substantial losses. In fact, out of the 180-odd stocks in the F&O segment, one wouldn’t find liquidity even for ₹1 crore in more than 60 stocks.
Weekly contracts: For options traders, index derivatives provide the advantage of weekly expiries. These weekly contracts have lesser premiums and are more volatile, allowing traders to implement dynamic strategies and adapt to market conditions quickly. Stock derivatives, lacking weekly expiries, compel traders to hold positions until month-end, limiting strategic flexibility.
Hedging: Hedging is more straightforward with index derivatives due to the abundant liquidity in far out-of-money (OTM) strikes. Stock derivatives often face liquidity challenges, even for strikes that are 5-8 per cent away from the current price, making hedging difficult.
An optimal approach
Choosing between stock and index derivatives depends on various factors such as capital, risk-appetite etc. Novice traders and participants with limited capital should lean towards index derivatives, given their lower margin requirements. The higher margins required for stock derivatives can quickly deplete an individual trader’s account after a few bad trades. Therefore, risk management becomes more critical.
Broadly, smaller lot sizes and relatively stable index movements offer a comparatively safer trading environment. But one should understand that derivatives per se carries higher risk compared to the equity segment.