OPEN APP
Home >Money >Personal Finance >Dabbling in derivatives: Smart or reckless?

A common lament among investors sitting on the sidelines of India’s turbocharged bull market is that they are comfortable investing in the market, but not at current levels. For such individuals, Harish Menon, founder and chief executive officer, H Zone Capital, has an unorthodox solution. Menon, who is also a Sebi- registered financial adviser (Sebi-RIA), suggests investing in debt mutual funds, and simultaneously selling puts for his sophisticated clients.

Using derivatives to enhance portfolio returns is highly risky, but a small segment of advisers believes it adds value, albeit for only investors with a high risk appetite and high net-worth. They advocate derivatives as an ancillary strategy to contain risk or to moderately enhance return in the core portfolio. They do not generally recommend using derivatives as a leveraged instrument to earn outsized returns.

Menon typically recommends two strategies to his clients. For those who are heavily in the market and don’t see much further upside, he suggests a covered call strategy. A call option is the right to buy a stock or index at a particular price. Selling this option means giving someone else that right and thus involves capping your upside in return for a premium. “This works best during the current market situation where Nifty is largely range-bound. This strategy is not a hedge. If an investor wants to hedge the portfolio, then the premium received on selling calls can be used to buy Nifty puts, thereby reducing losses when the market has a fall," he said. For investors who are comfortable entering at particular levels that are lower than the current market levels, Menon suggests a combination of debt funds and selling put options. “This strategy is suitable for investors who are waiting for a correction before entering equity. The objective of selling Nifty put is to earn premium income while waiting for the correction," he explained. “The key point here is that the investor would have shifted from debt to equity anyway on such corrections. The Nifty put adds extra income to the portfolio."

Mint
View Full Image
Mint


This is a high-risk strategy. For instance, an investor selling a 15,000 put when the Nifty is at 15,800 levels would pocket a small premium but expose himself to severe losses if the market were to crash below 15,000. To accept this loss as equivalent to what would have happened if the investor had actually entered the index at the 15,000 level not only requires sophisticated financial understanding but also cast-iron discipline.

Roopali Prabhu, chief investment officer at Sanctum Wealth, takes a more conservative approach while recommending derivatives to her clients. She limits their use to buying put options when there is a major event risk in the market. “We hedge the portfolios of sophisticated clients using put options. Normally, we only hedge 30-40% of the equity portfolios and we do it when there is a high-risk event coming up. We are cautious with this. Only next month index puts are sufficiently liquid in India and they aren’t good for the mid- and small-cap parts of a client’s portfolio. The hedging cost varies enormously, but is usually 0.5-75% of the portfolio value," she said.

Approaches such as Menon’s or Prabhu’s remain a minority, with most advisers preferring to stay away from derivatives altogether. “I have not recommended derivatives to my clients, nor do I personally invest in them. Even mutual fund managers have been unable to use them effectively and that’s why I stay away from arbitrage funds. But if at all you are keen on hedging through derivatives, use the mutual fund route and leave the decisions to a professional fund manager. I don’t even suggest derivatives to my high net-worth (HNI) clients," said Kalpesh Ashar, founder, Full Circle Financial Planners and Advisors, a Sebi-RIA.

While derivatives used well can hedge a portfolio’s downside or add to overall returns for a sophisticated HNI, investors should be mindful of the risk they contain. A call or put option only pays off if the market movement is greater than the option premium you have paid for it. Selling a call or put is even more risky because your loss is not limited to the premium you have paid. Trading in derivatives requires you to place a margin (a certain sum of money) with a broker and sharp movements in stock prices can lead to the broker suddenly asking for a greater margin (called a margin call). The gains from derivative trading are also taxed as business income, which is as per slab rate. This can be less favourable than the 15% short-term capital gains tax applied to gains in stocks or mutual funds and 10% long-term capital gains tax on gains above 1 lakh per annum.

Subscribe to Mint Newsletters
* Enter a valid email
* Thank you for subscribing to our newsletter.

Never miss a story! Stay connected and informed with Mint. Download our App Now!!

Close
×
Edit Profile
My ReadsRedeem a Gift CardLogout