Derivatives are looked upon suspiciously by many. Mr Warren Buffett, with his comment comparing derivatives with weapons of mass destruction, has warded off the typical long-term investor from this segment. But is it necessary to give derivatives a wide berth?

The answer is no and here are a few reasons why. Derivatives help investors to hedge the risk of loss in their portfolios.

If you own stocks worth Rs 5 lakh and are worried about an imminent fall in stock prices, you could purchase Nifty put options. If the value of your portfolio declines, the profit in the Nifty put contracts will compensate for these losses.

These instruments let you leverage your capital. That is, you can take a position that is several times your outlay. For instance, with Rs 20,000, you can purchase Nifty future worth Rs 2 lakh. The leverage is much greater in options.

Regulators look askance at derivatives due to the speculative excesses that occur in this segment. But these instruments are needed for discovering the future price of an underlying.

They also help in transferring risk, from the risk-averse to the ones with more gumption. That said, the leverage in these instruments makes them risky and those who belong to the play-it-safe camp are better off staying away.

Given below are a few facets of Indian derivatives that retail investors can benefit from.

Go for Nifty

If you wish to start playing the derivative market, the best place to do so would be Nifty or mini-Nifty options. This is the most traded contract on both the National Stock Exchange and the Bombay Stock Exchange. It accounts for more than 75 per cent of daily derivative turnover on NSE and about 60 per cent of BSE's derivative turnover.

It is, therefore, no surprise that most traders spend the entire trading day just making bets on the Nifty movement. Having only one underlying to track adds to the ease of trading. Hedging portfolios is also best done through Nifty options.

The contract with the second highest volumes on NSE is the Bank Nifty. Other large-cap stocks such as Reliance Industries, SBI, Infosys, Tata Motors and so on are also fairly liquid.

But if you have this sudden urge to trade in futures or option of Videocon or Ruchi Soya, it is possible that yours could be the only order in the order book. The top 5 contracts account for over 85 per cent of daily volumes while some contracts are scarcely traded. Since stocks in the derivative segment do not have circuit filters, trading in such low-liquidity stocks in the cash segment is also fraught with risk.

On global indices

Those who believe that stocks in the US offer greater growth prospects compared with their Indian counterparts can bet on futures or options on Dow or S&P 500 listed on NSE. These contracts are denominated in rupees. That is, each unit will have the same value as the index at any point. For instance, if the Dow is trading at 12,000, the value of each contract would be Rs 12,000 multiplied by 25 (the contract size).There is thus no currency risk in these contracts.

Currently, futures and options on Dow, S&P 500 and FTSE 100 are available for trading.

If you hold the view that the contraction in European economies can derail Indian stock prices, you can hedge your portfolio by buying put options in FTSE 100.

Gaining currency

While MCX-SX, NSE and USE offer trading in futures of dollar-rupee, euro-rupee, pound-rupee and yen-rupee, only NSE is currently allowed to offer trading in options on dollar-rupee pair. This segment witnesses trades worth Rs 20,000 crore to Rs 30,000 crore every day.

Investors who think that the stocks that they hold could decline due to rupee depreciation can go long on USD-INR future (falling rupee will make this contract move higher). Traders wishing to play on currency volatility can also use these instruments.

While exchange traded currency futures are more transparent than over-the-counter (OTC) market, the small size of contracts (one contract represents just 1,000 USD) and the fact that they are settled in rupee wards off big companies wishing to hedge their forex exposure.

Again, the customisation and bargaining power that large importers or exporters enjoy in OTC market is not possible with exchange traded products.

Commodities pick up

You might have often read about the strong run in crude oil prices or the healthy growth prospects of silver. If you wanted an exposure to such commodities, commodity futures are the easiest route.

While earlier, lack of research was a deterrent to commodity investment, now many prominent brokerages provide daily, weekly or monthly reports on the commodity market.

This segment currently clocks about Rs 57,000 crore turnover every day. That makes it half the size of equity market.

MCX is the largest exchange in commodities with over 85 per cent share in volumes. NCDEX is a distant second with 10 per cent share.

Bullion (gold and silver) accounts for half the volumes. Other metals enjoy 15 per cent share, energy about 18 per cent and agricultural products make up the rest of the turnover.

Tighter regulatory oversight and the resultant volatility of agri-products make traders wary of these products.

lokeswarri_sk@thehindu.co.in

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