Pre-IPO Investing – Importance of Investing in Pre-IPO Companies

A key factor in the growth of a company is capital. Many of us have business ideas, but we do not have money to convert the idea into a business. Even when we do have enough to start a business, we would find it difficult to raise growth capital. Many small and medium enterprises the world over have remained small because of a lack of capital. 

 

Over the last few years, thanks to excess liquidity in world economies, money is now chasing business ideas. India has become the favourite destination for private equity firms. More graduates in India, especially engineering graduates, are looking at joining a start-up company or starting a company of their own rather than an established one.  

Private equity funds are not only providing capital to these companies but also providing strategic guidance. Many companies go through multiple rounds of funding or even mergers and acquisitions before they reach the stock market.

When some of these companies reached the stock market, investors who subscribed to the IPO and made money on its listing are now yearning for more. There were some IPOs that did not do well, nonetheless the search for investing even before the companies reach the market is increasing.

Enthused by short term gains and news of investors making bumper profits on their listing, there is increasing interest in going one step back, that is investing in these companies at a pre-IPO stage.

While the idea is good, it is not without risk. We are only looking at the success stories. Less than one company in ten ever reaches the IPO stage, despite the funding. 

Despite the low success rate, private equity funds are making money because they invest in numerous companies. The few companies that reach the IPO stage generate enough money to take care of the losses in the others and still leave enough on the table. 

Let’s have a closer look at pre-IPO funding.

What is pre-IPO funding and how does it work

  • As the name suggesting pre-IPO funding involves funding a company before it approaches the primary market to get listed. 
  • This can be just a few years before the IPO or many years. 
  • Even if an investor invests after being told that the company is planning to get listed in a short time, there is no guarantee and such decisions have many variables including market condition, investor appetite and the company’s financials. 

For an individual investor, especially a retail investor, direct investing in a company at a pre-IPO level is difficult. This is mainly because companies look for the big-ticket and limited number of investors to fund them. They are ideally on the lookout for investors who understand their business and can add value if possible. Private equity firms or business houses that can add value or help their business grow are normally preferred. 

Should one invest in pre-IPOs

Unless one has excess money, investing in pre-IPOs is risky. 

  • As these companies are not listed, there is little public information that can help in monitoring them. 
  • Further, these are not transparent companies and are not obliged to part with financial information as the listed ones are. 
  • They are not bound by the laws that listed companies are in terms of disclosing information. 
  • No research reports are available on them. 
  • More often than not, chances are that these companies may not make it to the IPO level. 
  • Furthermore, one does not know the value of their investment, unlike a listed company where the share price is available. 
  • Also, the investor cannot exit his position if he needs the money or is not happy with the company’s performance. 

How do you invest in pre-IPO companies?

In case an individual managed to invest in a pre-IPO company, the one way he can make money is when the stock is listed. He will need to check whether his investment is in the lock-in period. If it is, he will have to wait for the lock-in period to be over before he can offload his shares. 

However, there are avenues open for retail investors now. Some asset management companies (AMCs) have announced funds that will invest in companies requiring pre-IPO funding. This is a safer route for retail investors, as the fund manager and his team of analysts will be in a better position to understand the business and monitor the business. 

Investing in pre-IPO is not for the fainthearted. Unlike an investment in an IPO or the secondary market, where the exit is easy, pre-IPO investments do not have an exit route unless they are listed. 

Investment is like buying a partnership stake in a business. To do so, one needs to understand the business closely. Further, most companies in the pre-IPO stage that need investments are generally the new-age ones. These companies mostly work on a cash-burn model, that is, they are not profitable and need a steady and heavy dose of funds inflow till they achieve some size before gaining some market share. 

Investing in pre-IPO companies requires patience. Returns from such companies, if at all, will take some time. Even when these companies are listed, one cannot be sure that the market would be as generous in giving them the valuation that a pre-IPO investor did. 

Having said that, if one manages to get their bet right and invest in a company that turns out to be a strong performer, it is nothing short of winning a lottery.

Income Tax on Demat Account

Stock markets offer immense opportunities for wealth creation. It gives the maximum returns amongst the various asset classes. Trading and investments in stock markets can be done only through a stockbroker. A trading account needs to be opened with a stockbroker through which one can buy and sell shares. One also needs a demat account where one can receive or take delivery of the shares bought and also give delivery when one sells. Earlier way of holding physical shares is done away with. One can only hold shares in electronic form and that is why a demat account is a must.

A demat account can be opened with the same broker with who you have a broking account. It can also be opened with any other depository participant known as DP. However, the demat will have to have to be mapped with the broker through whom the shares are bought and sold.

Taxation of investments held in demat account

Any gains made out of selling shares or bonds or mutual funds held in the demat account is subject to tax. Income tax charges gains from stock market trading and investment depending upon the holding period. If the stocks are held in demat for more than 12 months before it is sold it amounts to long term capital gains (LTCG) and if it is sold before the end of 12 months then it is treated as short term capital gains (LTCG)

Tax on long term capital gains (LTCG)

Sale of any capital assets mentioned below are sold after holding it for a period of 12 months then the gains arising out of these are long term in nature and are subject to long term capital gains tax. The gains or profits are charged at 10% over and above Rs.1 lakh.

  • Equity shares, preference shares listed in a stock exchange, 
  • Debentures, bonds, government securities listed in a stock exchange, 
  • Units of UTI and units of equity-oriented mutual funds whether quoted or not
  • Zero-coupon bonds whether quoted or not quoted.

However, one may also incur a loss in long term assets. Such a loss is known as long term capital loss (LTCL).  LTCL on selling assets mentioned above after 31.3.2018 can set them off against any LTCG as profits/gains on long term shares or equity funds are now taxable more than Rs.1 lakh. The unabsorbed LTCL can be carried forward and set off against LTCG in the subsequent years up to a maximum of 8 years.

Tax on short term capital gains (STCG)

Gains arising out of the sale of assets like equity shares, preference shares, debentures, bonds government securities, units, mutual funds, zero-coupon bonds mentioned above after holding it for less than 12 months will be considered as short-term capital gains and will attract tax on such gains.

Gains or profits arising out of STCG is taxed at 15% where securities transaction tax (STT) is applicable. In other cases, the gains are added to the total income and taxed as per the slab rate applicable.

Loss on sale of the above-mentioned assets is known as Short-term capital loss (STCL). STCL can be set off in the same year against LTCG or STCG and can be carried forward to be set off against STCG or LTCG arising in subsequent years.

However, one needs to appreciate that any carry forward losses will not be allowed if the returns are not filed on or before the due date.

Tax saving investments in demat

One can use the demat account to bring down the tax liability if they invest in investments that give significant tax exemptions like the unit-linked equity schemes (ULIPS) or the equity link saving schemes (ELSS).

ULIPS offer double benefits of both insurance and investment. The investment is divided in such a way that one part is used for giving life cover and the other part is used for investing. The units of the investing part are credited to your demat account and are locked in for 5 years. The maturity amount received at the end of the lock-in period is exempt from tax. Investments up to Rs.1.5 lakh annually qualify for a deduction under section 80C of the Income-tax act.

The ELSS on the other hand is a saving scheme that offers better returns and a comparatively lower lock-in period of 3 years. At the end of 3 years, the maturity amount is taxed as long-term capital gains and is taxed over and above Rs.1 lakh. ELSS investment also qualifies as a deduction under section 80C of the Income-tax Act. 

Advantages of having a demat account

  • Easy to open a demat account
  • Easy to operate and less cumbersome unlike physical holdings as assets are held in electronic form
  • Quick transfers into and out of demat account
  • Elimination of bad deliveries
  • No risk of loss due to theft fire misplacement etc and therefore safe
  • No transfer fees and stamp duties unlike physical transfers
  • Easy and quick settlement of corporate actions like dividends, bonuses, rights etc.
  • Nomination facilities available
  • Easy record keeping as periodic statements are sent to customers

What is Face Value in IPO?

In order for a business to grow, capital is needed. There are two ways in which money can be raised–equity or debt. Equity is the capital that the entrepreneur or the promoter or group of promoters bring in a proprietary partnership or a private limited company. Debt is the component that lenders loan to the business, which is to be repaid over a fixed tenure. 

When a private limited company intends to raise more capital through the primary market, it has to go through the IPO route or the Initial Public Offering route. Here, the company seeks funds through a process where the general public can invest in the company. 

By investing in the company, the public is essentially becoming a partner in it. In order to seek such partners, a company has offered a price at which it is willing to take them. This offer price at the time of an IPO has two components–Face Value and premium. 

In order to understand these terms, let’s first dive deep into understanding the IPO process. 

What is the IPO process?

  • IPO is the process through which a private limited company raises money from retail individuals and institutions and gets listed on the bourses. 
  • The company, in this case, known as the issuer, approaches a merchant banker to help raise funds. 
  • The merchant banker handholds the company through the process of raising funds by meeting all the requirements set down by the market regulator, the Securities Exchange Board of India (SEBI), and the stock exchanges. 

It is the merchant banker, who through their experience and market study, informs the issuer on the pricing that the company can charge. Looking at the mood of the market, the company’s fundamentals and the relative valuation of its peers, the merchant banker suggests the issue price. 

Face Value of an IPO

  • The price at which a company raises money from the market has two components–face value and a premium. 
  • It is the premium at which the company should price its issue is what the merchant banker advises the company. 
  • The face value is normally fixed by the company. 
  • A Face Value is the par value or the nominal value of one share. 

A company can have a face value of as low as Re 1 and any number above that. Most companies in India have a face value between Re 1 and Rs 100. The most common numbers apart from these two are Rs 2, Rs 5, and Rs 10.

Face value is also the minimum price at which a company can raise money. If a company having a face value of Rs 10 decides to raise funds at the face value or at Rs 10, it is said that the company is raising money at par. 

Most companies have raised money at a face value of Rs 10 and a premium above it. If the share price of the company increases in higher four digits or five digits, it is observed that the trading volume in the company reduces in the secondary market. In order to attract more investors to the company and have a wider investor base, face value is reduced. 

A change in face value impacts the earning per share (EPS) of the company, which in turn impacts the price to earnings or PE ratio, one that is among the most important valuation ratio monitored. 

The dividend announced by the company is also based on the face value. If a company has a face value of Rs 10 and announces a dividend of 30 percent, it means that the dividend payout will be Rs 10 * 30% = Rs 3 per share. 

Conclusion

Understanding of face value is very important both at the time of IPO when the company is raising funds and also at the time when it is being actively traded in the secondary market. A number of corporate actions like dividends, rights, and splits of shares are announced on the basis of face value. Important ratios and valuation parameters use face value as an important component.

How to Calculate Turnover for Futures and Options (F&O) Trading?

Income from stock markets is perhaps the most confusing topic concerning taxation. This is because it touches upon two different tax heads namely; Income Capital Gains (long-term or short-term) and Income from Businesses or Profession.

There are two ways income from trading is treated  under the income tax act

  • Speculative business- Intraday trading is treated as speculative
  • Non-speculative business- Trading in futures & options is treated as non-speculative business income

Business of F&O trading

Any business comes with a lot of obligations. Maintenance of books of accounts and getting them audited, advance tax payments and filing returns on time are but a few of them. Let us examine some relevant rules laid down by the income tax act concerning business.

  • Maintenance of books of account- Any business entity has to maintain books of account. However, in the case of stock market trading, the stockbroker maintains the ledger and contract notes and bills. Therefore, it is less cumbersome for the F &O trader to maintain them.
  • Audit- Like any other business F&O trading also attracts audits. Audit applies to a business if its turnover exceeds Rs 5 crore. This limit has been increased to Rs.10 crore from FY 20021-22
  • Filing of returns- Any taxpayer is obliged to pay tax on the due date prescribed by the income-tax act. Failure to file returns attract penalties.Non-audit taxpayers are supposed to file their returns by 31st July, while those taxpayers who are subject to audit have to file by 30th September.
  • Payment of advance taxes- Every person whose estimated tax liability is more than Rs.10,000 is liable to pay advance tax on the dates mentioned on the estimated income. Not paying would attract interest for the delayed period.

There are some advantages as well

  • Claiming of expenses and exemptions- expenses directly attributable to the business can be claimed. There are some exemptions as well allowed by the income tax act.
  • Carry forward of losses- losses can be carried forward to be set off against future incomes provided the return is filed on time. 

Turnover for audit applicability for F&O trading

Trading in F&O is slightly different to other businesses. Other businesses are pretty straightforward in arriving at their turnover and profits, however, in F&O trading turnover and profits have to be computed.

Computation of turnover for F&O trading involves aggregation and arriving at the absolute value of the following

  1. The sum of favourable outcomes (Profits)
  2. The sum of the absolute value of unfavourable outcomes (absolute value of losses)
  3. Premium received on selling options
  4. The difference on any reverse trade 

The aggregate of the above will be the turnover from F&O trading.

Table 1

Particulars Amount Absolute value
Profit on options transactions 55000 55000
Loss on Futures Transactions -50000 50000
Premium received on the selling of options 25000 25000
Loss on reversal of the sold options -10000 10000
Turnover   140000

Tax audit

Section 44AB read along with section 44AD of the income tax act says an account need to be audited u/s 44AB under the following circumstances

  • if gross receipts/turnover exceeds the threshold limit of Rs.5 Crin a financial year
  • if he claims that his actual net profit is less than 6% of the turnover as calculated in table 1 above and 
  • the taxable income should be above the threshold level of Rs.2,50,000.

The table below contains the income details of a trader. Let us understand the concept of a tax audit.

Particulars Amount
Income from salaries 10,00,000
Rental Income 40,000
Income from interest 20,000
Loss on F&O business -75,000
F&O turnover  1,75,000
6% of F&O turnover 10,500
F&O loss to be carried forward  -15,000

The trader declares an F&O trading loss of Rs.15,000 and wantsto file his return without a tax audit report. However, in this case, he will not be able to as the conditions mentioned in Section 44AB is not met. His actual net profit (in this case loss) of Rs.15,000 is less than Rs.10,500 which is 6% of the F&O turnover and due to his salary and other income his threshold level of taxation is more than Rs.2,50,000.He will have to get his accounts audited under section 44AB. The only alternative is he has to pay tax on Rs.10,500 and file the return without a tax audit report.

Taking the same example if the trader has no other income apart from F&O business, the question of tax audit nor tax. 

What is Call and Trade Charges? Auto Square Off Charges

The rapid technological change has significantly changed the way businesses are done. This is especially true for stock broking companies. Online stockbroking companies and technology-enabled trading is the norm. Gone are the days when one used to visit broking office for executing trades or dial the phone continuously till someone answered and place your order.

Today everything or rather anything can be done with a laptop, desktop or mobile phone. Trading and investing are no exception. However, there are times when due to various reasons the access to your laptop or internet is not available. Opportunities have an uncanny way of surfacing during such times. This is the time where call and trade facilities come in handy.

A call and trade phone number is provided to the client to execute his trades during such inaccessible times to execute his trades. The clients’ credentials are verified over the phone to the dealer assigned so that no unauthorised trades are done on behalf of the client before the trades are executed. Brokerages offer this facility for a fee that may range from Rs.10 to Rs.50 per executed call +GST.

Many brokers provide auto square off facilities as well. This is mainly for intraday traders. In case the intraday trader fails to square off his positions this facility enables the intraday position to be closed automatically at a specific time set by the broker before the market closes. This is to make sure that the intraday trade doesn’t result in a delivery risk due to failure to close positions for any reason. 

Advantages of call and trade facility

  • Just a phone call away
  • Available across all market segments
  • Transactions are secured through proper verification
  • Dedicated desk
  • Auto square of facility mitigates the risk of delivery

What Is Portfolio? Different Types of Portfolio

From an early age, we are taught not to keep all eggs in one basket. Not realizing it then, but this was one of our first lessons in portfolio management and diversification. 

As the saying goes, concentrating your assets may make you rich but diversifying your assets keeps you rich. 

Diversification helps divide risk in the portfolio. However, too much diversification will hamper returns on the portfolio.  

Expert investors do not prefer a too diversified portfolio. Legendary investor Warren Buffett says ‘Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing.’ 

His partner and long time friend Charlie Munger is of the opinion that ‘The idea of excessive diversification is madness. Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results.’

Their point is that if you know how to pick and monitor your investment, you can keep a concentrated portfolio. But for most of us who are not as savvy as these investors, we need to diversify our portfolios. 

But portfolio diversification cannot be random. There is a science behind creating a portfolio, depending on various factors like risk taking capacity, age of the investor, financial goals, among other factors. 

Let’s first define a portfolio

  • A portfolio is created by investing in different kinds of financial assets to achieve a financial goal. These assets can range from bonds, equities to real estate and paintings. There can be further diversification within each asset segment that will depend on the goal of the investor. 
  • The return expectation of a portfolio depends on the selection of assets under it, which in turn is dependent on the risk and return the investor is willing to take. 
  • An investor doesn’t have to stick to one kind of portfolio throughout their life. As they achieve knowledge about the financial market they can graduate from selecting a very conservative portfolio approach to a more aggressive one. 

We shall now look at various kinds of portfolios.

Aggressive Portfolio 

  • As the name suggests, this portfolio seeks a high return but at the cost of high risk. An investor builds an aggressive portfolio with stocks that move faster than the benchmark indices. Such stocks, also called high beta stocks, while giving higher returns, have a tendency to fall even faster than the index. 
  • Fund managers who have a good understanding of the market and risk generally build this type of portfolio. They shuffle their portfolio based on various technical and fundamental factors. 
  • Various strategies like investing in growth companies, turnaround companies are adopted to build this portfolio. A higher number of small and medium sized companies may see themselves in this portfolio. 

It is not advisable to build an aggressive portfolio at the start of one investment journey. One needs to have a good knowledge of both fundamental and technical parameters to build an aggressive portfolio. Such a portfolio needs active management and can be built by professionals or people who have more time and knowledge to spend in the market. 

Defensive Portfolio

  • A defensive portfolio generally moves at a slower pace than the market, both on the upside as well as a downside. 
  • The companies in this category are mature and pay high dividends. They have a dominant position in their industry, with products that are brand leaders. These companies are generally debt free and have sound and professional management. Such companies are the first to bounce back from an economic downturn or a recession. 
  • Blue chip companies are normally found in this portfolio.

A Defensive portfolio is a good entry level portfolio, where the chance of going wrong is less. Even if one is wrong in timing an entry, blue chip stocks, in the long run, have always given money. 

Income Portfolio

  • The creation of this portfolio can be through more than one asset class. As the name suggests, the portfolio is created to generate an income stream from its assets. 
  • Likely constituents of this portfolio are bonds or debt instruments that pay interests, or equity shares that pay a handsome dividend, real estate assets that yield rental incomes, steady returns from investments trusts like Infrastructure Investment Trusts (InvIT), or Real Estate Investment Trusts (REITs). 

If one needs to stick to investment in equities, then there is a high chance that an Income Portfolio may look like a Defensive Portfolio. 

The ideal time to build an income portfolio of stocks is when markets are depressed and we are able to get companies at a good dividend yield. 

Speculative Portfolio

  • This type of portfolio is more like a trader’s portfolio rather than an investor’s folio. 
  • Stocks are picked up either based on technical parameters, certain telltale signs of a fast move like insider buying, buybacks, news based, or on external developments. 
  • Special purpose investments, like an arbitrage trade based on a merger or a demerger, a bonus or rights issue announcement, a corporate development, all make up a speculative portfolio. 

The portfolio investor needs to have a good understanding of the market and a general idea of how stocks will react to news or development. Such an investor has a nose for smelling opportunities in the market and is in the game only until the opportunity is there. 

The Hybrid Portfolio

  • A hybrid portfolio, as the name suggests, is a mix of all asset classes. 
  • They may have been accumulated over the years with excess cash flow from the investor. 
  • Normally, such a portfolio is held by High Net Worth (HNI) individuals and is managed by wealth managers. 
  • Fund allocations are done based on a macro scenario on a medium to long term basis. Like in the case of rising inflation, an investor would prefer to be out of equity and into bonds, while when interest rates are falling, an investor would prefer equities and real estate. 

Conclusion

Building a portfolio is a journey. One can change from the type of portfolio one wants to build based on various factors like returns, age, excess capital in hand, knowledge of the financial markets, and risk taking ability.

How to Apply for IPO Using UPI?

Unified Payments Interface (UPI) has now become one of the most preferred electronic payment modes in our country. The adaptation has been remarkably quick and across segments.

UPI is designed by the National Payments Corporation (NPCL) an entity regulated by the Reserve Bank of India (RBI). It is a system built on the architecture of Immediate Payment Service (IMPS) system that allows the transfer of money between two bank accounts instantaneously i.e., in real-time. UPI finds its application not only in merchant payments but also peer to peer transfers.

Investing through the digital medium

Since UPI is a real-time system that allows a bank-to-bank transfer and a mobile phone is enough to do any transactions including investing in shares and stocks. The Securities Exchange Board of India (SEBI) has made it mandatory for retail investors who apply for an Initial Public Offer (IPO) through an intermediary to use the UPI mechanism. 

IPO and its various forms

IPO is a new stock issuance by a private company to the public. IPO has many forms or sub-components namely

  • Offer for sale wherein an existing shareholder offers his stake in the company
  • Follow on offer (FPO) is the additional issuance for raising of funds for an already listed company
  • Rights issue also is done by an existing company to raise additional funds

All the above can now be applied through the UPI mechanism.

How to get a UPI Identification (UPI ID)

Step-1 Download any UPI-enabled bank app or any third-party UPI app from the google play store like Gpay, PhonePay or PayTM, etc.

Step-2 Thereafter select the preferred language, mobile number, and the bank in which you hold an account 

Step-3 Create your unique UPI ID 

Step-4 Link the unique UPI ID to your bank account (this mobile number must be the same one registered with the bank as the bank will verify it through an SMS)

Step-5 Create an MPIN (mobile banking personal identification number) for authorising transactions made through the UPI

Step-6 After this you would have successfully created the UPI ID

Applying for an IPO through a UPI

Now, let us understand how to apply for an IPO with the UPI.

Needless to say one needs a demat account and a broking account to apply for an IPO. 

Step-1 An IPO applicant has to login through a broker website or broker app to subscribe to an ongoing IPO

Step-2 Select the IPO for application and read Draft Red Herring Prospectus (DRHP) and the details of the IPO carefully before applying. One needs to take note of the following details

  • Offer start date— This is the date when the IPO application bidding starts
  • Offer end date— This is the date when the IPO bidding ends
  • Finalisation of allotment date—This is the date by when the allotment is finalised
  • Refund initiation date—This is the date by when your mandate will be revoked and the funds will be unblocked
  • Demat transfer—The date by when the shares will be transferred into the demat account
  • Date of listing—The date on which the shares will be listed on the exchanges
  • End of mandate—The date on which the mandate will be revoked and the funds in your bank will be unblocked

Step-3 Fill the IPO application with

  • UPI ID
  • Select your investor type-Individual investor
  • Number of lots
  • Fill in your bid rate or tick mark the cut-off rate if you want to subscribe at the cut-off rate. After this, the total amount that will be blocked will be displayed.

Step-4 Hit the submit button. Once the application is submitted the UPI mechanism will begin. 

  • The subscriber will receive a block mandate request in his mobile app
  • The subscriber needs to accept the mandate received on his mobile and enter the UPI PIN 
  • After this, the amount payable for the IPO is blocked
  • On full allotment, the amount is debited and the shares are transferred demat
  • On partial allotment, the partial fund is unblocked and the partial shares are transferred to the demat
  • On no allotment, the whole amount is unblocked. The funds will be unblocked after the date of expiry or the end of the mandate date.

UPI-based IPO application is hassle-free. Gone are the days of physical submission, writing a cheque for an IPO application by using ASBA (Application supported Blocked Amount) forms and their related issues. Now IPO application is an instant, real-time and seamless application. Happy investing.

What is Margin Trading and Short Selling?

Margin trading and short selling both are leverage products offered to day traders.  Both these have an element of borrowing in them. Leverage helps in magnifying profits. However, one must not be over-leveraged as it may cause magnified losses too. Leveraging is a great tool to improve the return on investment (RoI)

In margin trading, the trader borrows money for increased exposure to maximise profitswhile on the other hand in short selling the trader borrows specific stocks to short sell to capitalize on short-term opportunities. In both cases opening a margin trading account with a broker is necessary.

Let’s understand how margin trading and short selling works.

In margin trading, one can invest or take an exposure more than what you can otherwise invest or trade with your own money. In simple words, the broker finances your trade partly for a fee known as interest on margin financing. This helps in taking advantage of any favourable movement expected by the trader and maximising the profit on it.

Let us understand what is margin trading with an example. A trader expects the State Bank of India (SBI) to go up in the next few days based on his information and study and wants to buy 500 quantities of SBI which is trading at Rs.450. The total cost of this trade would be Rs.2,25,000 (excluding brokerage and charges). Generally, the trader must bring in at least 20 per cent from his side. In our example, he has Rs.75,000 credit in his margin trading account and doesn’t want to lose the opportunity. The trader can use his margin trading account to buy the entire 500 quantity of SBI as the balance of Rs.1,50,000 (Rs.2,25,000-Rs.75,000) will be funded or borrowed from the broker on which interest will be charged.On the T+2 day, if SBI moves up to Rs.470 as expected by the trader, he will make a quick profit. The brokerage and other charges along with interest and the funding will be deducted and the balance will be credited to the account. 

Let us understand the calculations:

Buying side    
Purchase price of SBI (500 x Rs.450) 2,25,000 (Rs.75,000 is own fund)
Brokerage and charges (0.5%) 1,125  
The total cost of purchase 2,26,125  
     
Selling side     
Sale proceeds of SBI (500 x Rs.470) 2,35,000  
Brokerage and charges (0.5%) 1,175  
Margin funding 1,50,000 (Rs2,25,000-75000)
Interest on margin funding for 2 days (15% annualised) 1,23 ((1,50,000*15/100) *2/365)
Net sale proceeds 2,33,702  
Profit on the whole transaction 7,577  
ROI 3 %  

Short selling is a method where a trader sells first and buys later. Markets throw immense opportunities when it goes down. Those are the times one can short sell and make quick profits. The catch however here is shares should be available in your demat account that can be sold. Indian equity markets do not allow short selling in the cash market. Therefore, short selling can be done only through borrowing shares. In short selling, the trader borrows shares unlike in margin trading.

The working of short selling is similar to margin trading the only difference is that the trader borrows shares instead of money. Let us understand the process of short selling. For ease and understanding, we will take the same example of SBI. The trader wants to short sell SBI and SBI is not available in his demat. The trader uses the same margin funding account and borrows SBI shares for selling. As the stock goes down the trader buys SBI with these proceeds and makes a quick profit. On T+2 the trader gets delivery and it is credited back to the broker account.

Both margin trading and short selling have their advantages and disadvantages. The advantages are improvement in ROI due to enhanced profit with minimum own funds and the disadvantages being quick loss as well. For margin funding, one can use stocks or other liquid assets or mutual funds as collateral like fixed deposits as a pledge. Since the collaterals are pledged the cost on this is zero and only the funding from the broker will be charged for interest. Apart from this, the pledged stocks can be sold regardless of the pledge.  Short selling on the other hand can be used as a tool for hedging your existing position and is also tax efficient as it will be treated as short-term capital gains.

Both margin trading and short selling are risky and active risk management is paramount. As a word of caution only experienced traders should indulge in these transactions as the loss could be too big for a novice trader.

Stop Loss Orders – What is Stop Loss?

When it comes to trading, one of the oldest adages is to cut your losses and let the winners run. Though it sounds simple, ask any trader and he will tell you how difficult it is to cut the losses and allow winners to run.

Most traders, especially during their formative years, end up doing the opposite–cut the position as soon as it is in a winning position for fear of losing and holding on to their losses, hoping to recover the losses. Trading is considered a mental game rather than one of strategy for this reason.

A professional trader would cut his position if he feels the premise for taking the trade had gone wrong. But a rookie trader does not have the discipline to cut his losses. 

Thankfully, electronic trading now has a provision to allow traders to come out of a losing position mechanically. The process is called putting a Stop Loss order.

What is a Stop Loss?

  • As the name suggests, it is an order which is used to prevent losses from going out of hand. 
  • Stop loss orders can be put on both long and short trades. 
  • It is a risk and money management tool.

Take, for example, a trader who has bought a share for Rs 500 with the hope of the price moving higher to say, Rs 550. On the downside, he feels that if the price goes below Rs 490, then the chart pattern based on which he had taken the trade does not hold.

To prevent his trade from incurring unlimited losses, he will place an order in the trading system which will help exit his position if the price touches Rs 490.  

Similarly, in case the trader has taken a short trade (where he sells a share or a derivative instrument without owning it) based on a chart pattern, he can prevent his position by placing a stop loss.

Assuming the trader feels the market is looking weak and sells Nifty at, say, 17,000 with an expectation of the price touching 16,800. However, the pattern will not hold if the price crosses above 17,050. In this case, the stop loss order will be placed around 17,050 and the trader will be out of the trade if the price moves higher.

Some traders place their stop loss order based on their risk profile. If the maximum risk a trader is willing to take is say, Rs 1,000, then, in that case, he would keep his stop loss at a point where the loss will not exceed Rs 1,000 if the trade goes against him.

In the short sell example of Nifty mentioned, if the maximum loss a trader can afford is Rs 1,000 then he will place his stop loss at 17,020. Since Nifty has a contract size of 50 units of Nifty, a 20 point stop loss would result in a loss of Rs 1,000. (50 units of Nifty X 20 points = Rs 1,000).

Advantages of a Stop Loss order

  • Stop loss order is a risk management tool where the maximum risk per trade is known as soon as the trade is initiated.
  • A stop loss order is not only used to reduce losses but also to achieve maximum profit by following what is called the trailing stop loss. 
  • A stop loss order can be used for money management.

In the example mentioned above, if the stock bought at Rs 500 starts moving higher and touches Rs 515, the trader can move his stop loss from Rs 490 to the recent low or based on any other indicator, say, at Rs 505. As the share price continues to move higher, he can trail the stop loss until his target is achieved or the stock breaks through his stop loss level.

A stop loss order can be used for money management. Continuing with the same example of the share bought at Rs 500, suppose a trader has designed a trading system that allows him to take a maximum risk of Rs 2,000 per trade. Now in the example, if the trader has taken an entry and kept his stop loss at Rs 490, he will risk a maximum of Rs 10 per share. To risk Rs 2,000 on the trade, he can buy 200 shares (maximum risk of Rs 2000 divided by maximum risk of Rs 10 per share) of the stock. Rather than trading with a fixed amount, the trader can use the stop loss to optimize his position size. This approach of trading is called position sizing.

Disadvantages of a stop loss order

  • Chances of stop loss being hit too often and price moving in the original direction
  • If placed too close can result in many trades 
  • If placed too far, it can result in big losses

The one reason why rookie traders avoid putting a stop loss order is that they feel the market comes down to their stop loss level only to take them out and then move in the direction in which they intended to move. This is because most traders keep their stop loss at the most obvious points, which professional traders generally exploit.

In a range-bound market, stop losses are regularly hit, which will test the patience of a rookie trader and make him shift his trading strategy. A professional trader knows that there will be times when his strategy will face drawdowns because of repeated stop loss, a phenomenon that is commonly known as whip-saw n trading parlance.

There are times, especially during a fast move, that the stop loss order will not get executed as the market will jump above or below the order, resulting in higher losses to the trader. Such slippages are the worst enemy of a trader and require the trader to continuously monitor his trade despite placing the order.

Stop loss orders, in most cases, have to be put every day as they are in the system only till the end of the day.

How to set up a Stop Loss order

Earlier, there were two ways of placing a stop loss order–a Stop Loss limit order (SL order) and a Stop Loss Market order or an SL-M order. However, the stop loss markets order has been discontinued by the Securities Exchange Board of India (SEBI) as it resulted in sharp swings in prices of illiquid instruments, especially illiquid option contracts.

We shall therefore consider how to place a stop loss limit order in case of a buy trade and a short sell trade.

A stop loss limit order means that the trader has defined the price limit beyond which he would not like to be in the trade.

Let’s consider a buy example first where shares are bought at Rs 500 and the trader wants to put a stop loss at Rs 490.

Since the trader has bought the shares, a stop loss order should be of a sell position that if hit will take him out of the trade.

To place a stop loss order, two sets of prices have to be placed–an SL limit price and a trigger price. If the market price reaches the trigger price, the stop loss order of the trader will get activated and the trade may get executed if the price is around the same stop loss level or between the limit and trigger price.

A trigger price is always above the limit price. In the present example, a trigger price will be at Rs 490 and the limit price can be Rs 489.50. This gives a range for the order to get executed.

With a sell trade, as mentioned in the example above, a short position is created at 17,000 and the stop loss is at 17,020. Here, the trigger price will be below the limit price.

The trader will put the trigger price as 17,020 and the limit price as 17,021, giving a range of 1 point for the trader to exit from the position.

The bottom line

Trading without a stop loss is considered as going to war without armour or driving without a helmet. Stop loss is the cost of trading successfully. The earlier a trader appreciates the value of stop loss, the faster will he become successful.

Futures and Options (F&O) – What is F&O Trading?

When it comes to markets, the cash market is where the transactions of tangibles actually take place. Even in equity markets, the cash segment is where shares are bought and sold. 

There is always risk associated with one’s investment and the cash market offers no solution to manage risk apart from exiting the investment. 

Globally, any cash market is supported by other markets, which help in managing price risk through hedging. These markets are called derivatives markets or futures and options (F&O) markets. Since the instruments – futures and options derive their value from the cash market, they are called derivatives. 

Let’s now look at this market closely. 

What are futures and options?

Both the instruments are different and derive their price for the underlying stock or index. Both these instruments are bound by a contractual agreement between a buyer and a seller. 

Futures Contract

  • A futures contract is the obligation to buy and sell an asset (called the underlying) at a later date (expiry date) at an agreed upon price. 
  • Derives its value from the underlying stock or index
  • Futures contracts were meant to be used as a hedging tool but have become more popular with speculators and arbitrageurs. 
  • Most actively traded commodities have future contracts.
  • A futures contract has a standardised size (number of shares) and may differ from one company to another.
  • For the same contract, multiple contracts, expiring on various dates, are traded.
  • A trader can take a long or a short position in the futures contract, unlike in the cash market, where only long positions are possible.
  • There are many arbitrage opportunities that a trader exploits using a futures contract between two different months or between futures and the cash market.

Let’s understand the definition with the help of an example. 

Suppose a trader is holding shares of Asian Paints. At Rs 3,400 he feels that there is limited upside to the stock and may hover around these levels or come down in the short to medium term. 

For various reasons, including tax management, he does not want to sell his shares of Asian Paints but at the same time would like to protect himself from any fall in its share price. 

In such a case, he will sell a futures contract of Asian Paints (creating a short position) at Rs 3,400. By doing this, he has locked his profit at Rs 3,400 irrespective of where the stock goes. 

Suppose if the price comes down to Rs 3,200, in that case, his shares would have a notional loss of Rs 200, but the short position would result in a profit of Rs 200 (3400-3200). Even if the price keeps on falling, his future position will compensate for the loss in the spot position. 

However, since he has sold a futures contract, the trader will not enjoy the benefit of any rise in stock price. 

If Asian Paints rise to Rs 3,500 the cash position will sit on a notional profit of Rs 100 but the futures contract will give him a loss of Rs 100 (3400-3500).

Big fund houses use index futures to hedge their portfolios by selling index contracts like Nifty or Bank Nifty to protect their portfolio. 

Options

  • The textbook definition of an options contract is that it gives an investor the right, but not the obligation, to buy or sell shares (underlying) at a specific price (strike price) within a specified period. 
  • They derive their value from the underlying stock or index. 
  • They have the same number of shares or lot size as the futures contract. 
  • They give the trader the flexibility to trade in either direction of the market
  • It is a cheaper way to hedge your position 
  • Unlike cash and futures markets, options can be profitable even when markets are flat and going nowhere. 
  • Traders use simple and complex option strategies based on their view of the market.
  • Since buying an option is the cheapest form of acquiring the ‘right’ to own a share, it has gained immense popularity among traders, retail and institutional. 
  • Designed as a hedging instrument, traders are using options for speculating and arbitrage trades.
  • There are two types of options – Call and Put
  • A Call option is bought when the trader feels that the stock or index will move higher and a Put option is bought when the stock or index is likely to move lower. 
  • A seller of a Call option feels that the underlying will fall or stay stagnant.
  • A seller of Put options initiates the trade if he feels the underlying will rise or remain flat.

An example to help understand the instrument. 

Unlike a futures contract, an option contract is slightly complex. 

Continuing with the same example of Asian Paints, supposed the trader wants to hedge his position as he feels that the stock may not rise beyond Rs 3,400. 

Here, the trader can hedge his cash portfolio by buying a 3400 strike price Put option expiring in the current month. To buy the Put option, he pays a premium of, say, Rs 50. 

Now if the share price of Asian Paints falls to Rs 3200, the value of the premium at the time of the expiry will be Rs 200. Thus, the trader will gain from the purchase of the put option, even though there is a notional loss in his cash position. The profit from the Put will be Rs 200 minus the Rs 50 paid for buying the option. 

Now if the price of Asian Paints rises to Rs 3,500, the maximum loss to the trader will be the Rs 50 he paid for buying the Put option. He can enjoy the benefit from a further rise in price. 

One key difference between Futures and Options in the above example is though both the derivative instruments are protected to a large extent, the futures contract locks the price while the option contracts allow the trader to get the benefit of rising prices to some extent. 

What is the difference between Futures and Options?

Trading in futures and options differs in terms of its obligations on the traders. The futures contracts are a liability for the investor, mandating them to buy or sell the contract on or before a predetermined date, and the options contract gives the investor the right to do it.

In other words, the futures contract holder has to buy or sell underlying security following the predetermined date at the decided price. In contrast, the options contract gives the buyer a choice to buy or sell if they profit from the trade.

Types of Futures and Options:

Generally, futures contracts have the same conditions for both sellers and buyers of the contract, and the derivative of the option is divided into two types. Traders can enter into an options contract to sell a type of asset at a certain price on a specific date and can do this by availing of a put options contract. In the same way, traders who want to buy a type of asset on a particular date can do so through a call option to fix the price for future exercising of the contract.

Who Can Invest in Futures and Options?

Traders or investors participating in future and option trading are classified into the following types:

  • Hedge Players:

Hedgers opt for futures and options contracts in the stock market to minimise market volatility impact on their investments. Setting a price for a transaction at a predetermined date helps these players to experience the difference in gains if at all the prices move vaguely adverse to the trading position made by the buyer. But, in case of favourable changes, traders buying a futures contract can face significant losses. This risk is rationalised by an options contract, as here, the investor can cut out of the deal if at all price swings are favourable.

Hedgers plan to safeguard their profits or losses in the future by trading a specific derivative contract. Such players can be found more in the commodities market, where the traders try to safeguard an estimated price of certain products from the respective exchange. Let us understand this with a future and option contract example. A peasant can trade a futures contract with some wholesaler to sell 60 kilograms of onions for Rs. 30 per kilogram two months from now. On the contract expiry day, if the price of onions falls below those levels, the farmer has now hedged his stake to minimise the underlying risk linked with trading in the future.

But, in case the prices rise in the onion market, the farmer will lose out on some profits. These losses can be balanced with the help of a put options contract, which provides the farmer a right but not the obligation to match the conditions of the contract. If there is a fall in the market prices of onions, the farmer can exercise their right on the options contract to minimise their losses. Prices rising, on the contrary, will allow the farmer not to exercise any of the contracts and sell the onions in the market at the current market prices.

Hedgers usually go for physical trade settlement in which the asset is exchanged after the expiry of the contract. It is much more prevalent in the commodities market, as here, producers and firms carry out the physical trade of goods to maintain the costs of raw materials at a certain fixed level. This allows stability in the price levels to prevail in the economy.

  • Speculators:

Speculators predict the trend or the price movement in the market according to the assets’ intrinsic valuation and the economic condition and decide to build a reverse position in the existing markets to profit from any such price movements. Let’s take a futures and options scenario; if the trader bets on the price of any stock to rise in the future, they can take a long position in derivatives or the F&O market. This showcases buying a stock or its derivative in the present to sell it off on a future date at a higher price.

Also, traders or investors can take a short position who expect the prices of an underlying to fall in the coming future according to their market outlook. Here, traders or investors would want to buy the securities in the future at a comparatively lower price via any of the contracts, to relatively make a profit.

A majority of the speculators participating in derivatives or F&O trading would want to make cash settlements, where the physical movement of an asset does not take place. On the other hand, the difference in the spot price, i.e., the current market price and the value mentioned in the derivatives, is settled between two buyers and the seller, thus minimising the problems in these trades.

  • Arbitrage Players:

Arbitrageurs would want to profit from price variance in the market, which occurs because of the market inefficiencies in the first place. A price quotation in the futures and options market includes the contract’s current price and the cost of carrying that contract. It also has a predetermined understanding that the strike price or the present value of the contract will become in sync with the spot price. The price differences incurred for carrying the underlying security to a future date are called carrying costs.

Arbitraging resultantly takes out all the price variations due to inefficient market conditions, as these players vary the demand and supply outlooks to create a price equilibrium.

Futures and options trades are usually leveraged, in which the overall cost of trading must not have to be incurred upfront. On the contrary, a broker finances a specific percentage of the entire contract for its client. The investor maintains a minimum amount called the mark to the market amount in their trading account. This propels the investor’s profit margin significantly if their bet is right.

But, as addressed above, futures and options have seemingly high risks, as efficient and highly accurate predictions about the price movement or trend and market directions are to be made. The complete know-how of the stock markets, the underlying security, and related organisations, etc., have to be known to profit from derivatives trading.

More about F&O trading in the stock market:

A majority of the people today still are unaware of futures and options trading in the share market. But, the trend for this has seen a growth in the recent years, so it can be of great advantage to learn more about this market.

The National Stock Exchange (NSE) implemented trading on index derivatives on its Nifty 50 2000. So, one can invest in futures and options in nine major indices, including more than 100 securities today. Traders can also trade in futures and options through the indices and securities listed on the Bombay Stock Exchange (BSE)

As discussed, options consist of lesser risk as the trader has the right to choose not to exercise the contract on maturity when the prices aren’t in the way they want. The only loss they would bear will be the premium paid for the security. Thus, once a person understands what the F&O is in the stock market, it is possible to make money and hedge your investment risks.

More about futures and options trading in the commodities market:

Futures and options trading in commodities is another chance for investors to make money. But, Commodities markets are very volatile, so it is suggested to trade in them only when one is aware of its risk and can take such a risk. Also, the margin for commodities is lower, so there is a chance of taking significant leverage. Leverage can provide more options for profit, but the risks involved are much higher then.

One can trade commodity futures and options via commodities exchanges such as the Multi Commodity Exchange or MCX and the National Commodity & Derivatives Exchange Limited or NCDEX in India.

Understanding what critical future and options can play an essential financial role in the industry. It also helps traders hedge their positions against any unwanted price movements and ensures liquid markets remain.

Conclusion

Warren Buffett calls derivatives a weapon of mass destruction. But just like nuclear energy, if one learns how to handle the instruments with proper risk and money management, they can result in returns that are much higher than compared to the cash market. 

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