[MUSIC] >> Learning outcomes. After watching this video, you will be able to understand how derivative financial instruments work. [MUSIC] >> Hi, in this module, I will talk about some tips about back testing and also I'll talk about the kind of financial instruments that one can use for these strategies. I'll talk about this financial instruments part first and remember in all these papers that you studied. This is in the US, I think. Most of them use US economics, I think. And as you know, the markets in the US are well developed. You have all kinds of financial instruments. And more importantly, you are allowed to short in the spot market in the US. Of course, there are restrictions imposed from time to time. But by and large, you're allowed to short and that market works well. But in many countries, the shorting is now allowed. You are not allowed to short in the sport market. So, what do you do in that case? The answer is you can use derivative instruments. So, futures and options. I've covered a bit in one of the previous modules. Again, we have a specialization on investment management. There we go in detail about derivatives, what are these instruments? So, you can use derivatives and derivative instruments you can always short. A few charts you can always short or you can buy your production. So, that is a lot. But when used derivative instruments, one has to be really, really, careful. Because what you do in derivative instruments is that you trade on margin. Let me give an example. Let's say, you're taking a position on some 400,000 what a particular stock. Remember derivative instruments, you cannot buy one or two stocks. There is always a minimum lot size. You have to buy a lot and that lot will have a value. So, lot will be number of units. 100 units of a stock, 50 units of a stock. It could be 500 units of a stock, so on and so forth. Let's say, a minimum value of a lo of a stock A is 400,000 in whichever currency it is. Now in futures, you do not have to pay 400,000 at the beginning itself. All you need to do is deposit a margin. I told you about this when I was talking about how do you decide a benchmark for future. So, you need to deposit a margin. So you need to be, so that margin will be around 15%. Sometimes, it can go up to 20% also. Usually, most countries it's around 10 to 15%. Technically, it's based on something on its value interest. Let's not get into that right now, but imagine it's like 15% of 400,000. That comes to what? 60,000. Now on the positive side, if the market goes up, if the stock goes up, let's say, by 5%. Say from 400, it becomes 420, you will make like 30% reduct. More than 33% reduct. That's huge. But on the negative, it also works the same way. If the stock, let's say, it also falls by 10% from 40,000. 10% is 40,000. You have put in, let's say, you assume 15% to 50,000. You lose two-thirds of your money. So one has to be really, really careful when dealing in derivative instruments. So just because the market, a lot use to leverage, you should be careful. So if you have say, 400,000 rupees with you or dollars, rupees, whatever. So what I suggest is that even though the margin required is 60,000, 80,000 or 100,000, whatever. You keep the remaining amount in risk-free instruments or government securities. Do not all leverage. Do not think that the 60,000 is your principle. So whenever you are dealing in derivatives, my solution is that keep the margin plus remaining part of the gross contract value in risk-free kind of instruments, then what happens? Then now, let's go back to the same example. Let's say, 400,000 is the contract value and the margin required is 60,000. Now if the stock goes up by 10% and you have 400,000, you have two choices. One, just to make your life simple. Let's assume that margin required is 40,000, 10%. That makes calculation simple. That's all. So, let me repeat. We are talking about a case where gross contract value is 400,000 and the margin required is 40,000. Now, if the stock goes up by 10%. So, and lets talk about think about two scenarios. One is someone who's taken maximum leverage. The other is someone who has taken no leverage. The person who's taken maximum leverage will be buying how many contracts? Think about it. You have 400,000 with you and minimum margin required is 40,000, so you'll be buying ten contracts. That means you'll be taking exposure worth 4 million. Yes, that's correct. So, you'll be taking exposure worth 4 million of that currency. Now, the stock goes up by 10%. So from 400,000, the contract value for it becomes 440. Because you are now have 10 times leverage instead of making 40,000, you'll make 400,000. Very nice, huge. So that's on the positive side, our defensive person. Let's say, this is aggressive strategy, a defensive person. What will a defensive person do? We'll put 40,000 in the stock as margin and put another 360,000 in risk-free securities. [COUGH] This is for the sake of example, assume risk-free security gives nothing. In developed countries anywhere these day, risk-free securities do not yield much. In emerging markets, they do. For example, in India where we are located, risk-free rate even today is 6.5%. Let's assume 0% for our humans. So on 40 000, you make another 40,000. Because the stock has gone up by 40,000, but the remaining 360,000 makes nothing. So, your total gain is 40,000. Actually, will remain 10%. Whereas in the aggressive case, your gain is 100%. Why? Because you're taking ten contracts. The stock went up by 10%, but your investment went up by 100%. All good. In a positive state of the world, it's all great. Now imagine the other way around, what if the stock falls by 10%? Now again, same situation. You have 400,000 with you. Gross contact value is 400,000 and the margin require is 40,000. Now, the stock tanks by 10%. The aggressive strategy. The aggressive guy will lose, how much? Yes, you will lose the entire 400,000. Because for each contract, you will lose 40,000. Are you ready? What does the aggressive person done? He's invested the 400,000 with him in 10 lots by depositing and that 400,000 is margin. That's what the aggressive person has done. Now if the stock falls by 10%, that means your gross contract value falls from 400,000 to 360,000. On each of those 10 contracts, this person loses 40,000. So effectively, you are left with nothing. Now, come to the defensive one. If the stock falls by 10%, what will the defensive person lose? 40,000. What happens to remaining 360,000? Where is it invested? It is free asset. It will remain as it is. So the upside is also limited if you follow the strategy that defensive strategy, but downside is also limited. Now think of I guess, what if the stock goes up by 15%? The aggressive guy will do beyond 50%. Defensive guy will make only 15%. But what if the stock goes down by 50%, 15%? And the aggressive person will lose, how much? [COUGH] 600,000. Yes, margin. It's not that your margin is gone and then you are free of responsibility. No, you're liable to pay the full loses on futures. So it is not limited up to your margin. In case value at risk, all these calculations are based on normal circumstances. But in case, if the loss is more than the total margin that you deposited, you'll have to make good that loss. That means if the stock falls 15% and you have ten lots. On each lot, you lose 60,000. So, total your loss becomes 600,000. So not only you'll lose all that you have, 400,000. You will have to pay 200,000 from your pocket. Realize in the defensive case, you lose your 40,000. Pay another 20,000. 340,000 is safe. Also, futures is a double-edged sword that way. It works both ways. When things are good, it'll help you. When things are bad, it can harm you. So my suggestion is when you use the strategies, if you're forced to use derivatives instrument, futures or options or any of these instruments. Do not use all leverage using these strategies. So, my suggestion is keep the rest of the money in a risk-free investment and then trade.
