0:35

I'll talk about this financial instruments part first and

Â remember in all these papers that you studied.

Â This is in the US, I think.

Â Most of them use US economics, I think.

Â And as you know, the markets in the US are well developed.

Â You have all kinds of financial instruments.

Â And more importantly, you are allowed to short in the spot market in the US.

Â Of course, there are restrictions imposed from time to time.

Â But by and large, you're allowed to short and that market works well.

Â But in many countries, the shorting is now allowed.

Â You are not allowed to short in the sport market.

Â So, what do you do in that case?

Â The answer is you can use derivative instruments.

Â So, futures and options.

Â I've covered a bit in one of the previous modules.

Â Again, we have a specialization on investment management.

Â There we go in detail about derivatives, what are these instruments?

Â So, you can use derivatives and derivative instruments you can always short.

Â A few charts you can always short or you can buy your production.

Â So, that is a lot.

Â But when used derivative instruments, one has to be really, really, careful.

Â Because what you do in derivative instruments is that you trade on margin.

Â 1:49

Let me give an example.

Â Let's say, you're taking a position on some 400,000 what a particular stock.

Â Remember derivative instruments, you cannot buy one or two stocks.

Â There is always a minimum lot size.

Â You have to buy a lot and that lot will have a value.

Â So, lot will be number of units.

Â 100 units of a stock, 50 units of a stock.

Â It could be 500 units of a stock, so on and so forth.

Â Let's say, a minimum value of a lo of a stock A is

Â 400,000 in whichever currency it is.

Â 2:36

I told you about this when I was talking about how do you decide a benchmark for

Â future.

Â So, you need to deposit a margin.

Â So you need to be, so that margin will be around 15%.

Â Sometimes, it can go up to 20% also.

Â Usually, most countries it's around 10 to 15%.

Â Technically, it's based on something on its value interest.

Â Let's not get into that right now, but imagine it's like 15% of 400,000.

Â That comes to what?

Â 60,000.

Â Now on the positive side, if the market goes up,

Â if the stock goes up, let's say, by 5%.

Â Say from 400, it becomes 420, you will make like 30% reduct.

Â More than 33% reduct.

Â That's huge.

Â But on the negative, it also works the same way.

Â If the stock, let's say, it also falls by 10% from 40,000.

Â 10% is 40,000.

Â You have put in, let's say, you assume 15% to 50,000.

Â You lose two-thirds of your money.

Â So one has to be really, really careful when dealing in derivative instruments.

Â 3:39

So just because the market, a lot use to leverage, you should be careful.

Â So if you have say, 400,000 rupees with you or dollars, rupees, whatever.

Â So what I suggest is that even though the margin required is 60,000,

Â 80,000 or 100,000, whatever.

Â You keep the remaining amount in risk-free instruments or government securities.

Â Do not all leverage.

Â Do not think that the 60,000 is your principle.

Â So whenever you are dealing in derivatives, my solution is

Â that keep the margin plus remaining part of the gross contract

Â value in risk-free kind of instruments, then what happens?

Â Then now, let's go back to the same example.

Â Let's say, 400,000 is the contract value and the margin required is 60,000.

Â Now if the stock goes up by 10% and you have 400,000, you have two choices.

Â 4:38

One, just to make your life simple.

Â Let's assume that margin required is 40,000, 10%.

Â That makes calculation simple.

Â That's all.

Â So, let me repeat.

Â We are talking about a case where gross contract value is 400,000 and

Â the margin required is 40,000.

Â 4:57

Now, if the stock goes up by 10%.

Â So, and lets talk about think about two scenarios.

Â One is someone who's taken maximum leverage.

Â The other is someone who has taken no leverage.

Â The person who's taken maximum leverage will be buying how many contracts?

Â Think about it.

Â You have 400,000 with you and minimum margin required is 40,000,

Â so you'll be buying ten contracts.

Â That means you'll be taking exposure worth 4 million.

Â Yes, that's correct.

Â So, you'll be taking exposure worth 4 million of that currency.

Â Now, the stock goes up by 10%.

Â So from 400,000,

Â the contract value for it becomes 440.

Â Because you are now have 10 times leverage instead of making 40,000,

Â you'll make 400,000.

Â Very nice, huge.

Â So that's on the positive side, our defensive person.

Â Let's say, this is aggressive strategy, a defensive person.

Â What will a defensive person do?

Â We'll put 40,000 in the stock as margin and

Â put another 360,000 in risk-free securities.

Â [COUGH] This is for the sake of example, assume risk-free security gives nothing.

Â 6:17

In developed countries anywhere these day, risk-free securities do not yield much.

Â In emerging markets, they do.

Â For example, in India where we are located,

Â risk-free rate even today is 6.5%.

Â 6:32

Let's assume 0% for our humans.

Â So on 40 000, you make another 40,000.

Â Because the stock has gone up by 40,000, but the remaining 360,000 makes nothing.

Â So, your total gain is 40,000.

Â Actually, will remain 10%.

Â Whereas in the aggressive case, your gain is 100%.

Â Why?

Â Because you're taking ten contracts.

Â The stock went up by 10%, but your investment went up by 100%.

Â All good.

Â In a positive state of the world, it's all great.

Â Now imagine the other way around, what if the stock falls by 10%?

Â Now again, same situation.

Â You have 400,000 with you.

Â Gross contact value is 400,000 and the margin require is 40,000.

Â Now, the stock tanks by 10%.

Â The aggressive strategy.

Â The aggressive guy will lose, how much?

Â Yes, you will lose the entire 400,000.

Â Because for each contract, you will lose 40,000.

Â Are you ready?

Â What does the aggressive person done?

Â He's invested the 400,000 with him in 10 lots by depositing and

Â that 400,000 is margin.

Â That's what the aggressive person has done.

Â Now if the stock falls by 10%,

Â that means your gross contract value falls from 400,000 to 360,000.

Â On each of those 10 contracts, this person loses 40,000.

Â So effectively, you are left with nothing.

Â 8:26

So the upside is also limited if you follow the strategy that

Â defensive strategy, but downside is also limited.

Â Now think of I guess, what if the stock goes up by 15%?

Â The aggressive guy will do beyond 50%.

Â Defensive guy will make only 15%.

Â But what if the stock goes down by 50%, 15%?

Â And the aggressive person will lose, how much?

Â [COUGH] 600,000.

Â Yes, margin.

Â It's not that your margin is gone and then you are free of responsibility.

Â No, you're liable to pay the full loses on futures.

Â So it is not limited up to your margin.

Â In case value at risk,

Â all these calculations are based on normal circumstances.

Â But in case, if the loss is more than the total margin that you deposited,

Â you'll have to make good that loss.

Â That means if the stock falls 15% and you have ten lots.

Â On each lot, you lose 60,000.

Â So, total your loss becomes 600,000.

Â So not only you'll lose all that you have, 400,000.

Â You will have to pay 200,000 from your pocket.

Â Realize in the defensive case, you lose your 40,000.

Â Pay another 20,000.

Â 340,000 is safe.

Â Also, futures is a double-edged sword that way.

Â It works both ways.

Â When things are good, it'll help you.

Â When things are bad, it can harm you.

Â So my suggestion is when you use the strategies, if you're forced to use

Â derivatives instrument, futures or options or any of these instruments.

Â Do not use all leverage using these strategies.

Â So, my suggestion is keep the rest of the money

Â in a risk-free investment and then trade.

Â