How securities are traded

The involvement of retail investors in capital market has increased significantly. While many of them invest in market passively through mutual funds, there are quite a few who either invest using demat account or get help of the broker for investment. Many might wonder how shares come to their account and money is deducted online? Why the exchange trading in India is termed as T+2? And what do clearing and settlement means?

The whole trading starts with decision to trade, when the investor looks for some script and place order for that. If the order matches with the counter order placed by some other investor, it gets executed. Once the order gets executed, on the next day it goes to the clearing house where all trades are confirmed. Which is shown in the diagram at T+1 days. Then these cleared trades get settled, where pay-in & pay-out of all the securities and funds takes place. This settlement takes place on T+2 days. Such settlement is called rolling settlement.

In India, rolling settlement was first introduced by Over the counter exchange of India (OTCEI). In the year 2000, SEBI made rolling settlement compulsory for 10 selected securities which had volume more than Rs 1 crore. With time by December 2001, other stocks were also included for rolling settlement. SEBI introduced T+5 rolling settlement in equity market from July 2001, which was subsequently shortened to T+3 from April, 2002. To reduce the risks in settlement like counterparty risk and system risk, SEBI mandated rolling settlement of T+2 days for all the scripts from April 1, 2003.

Derivative Market - Financial weapons of mass destruction!!

Yesterday I made a decent 40% profit on the CALL option which I had bought a couple of days back. I started getting interest in option trading last year and followed market religiously. Index option of NIFTY has got decent volume and a volatile market like this could get fair return in the derivative side. The foray in derivative market was a good learning for me. Option market is good for those who have fair idea of economics, who do not get tempted and most important who trades in a market which follows logic.

In case of Indian derivative market, the volume is really thin as compared to equity market. The inflation reported to 42 month’s high at 7.61 on May 9th 2008, but the market did not move down for “some time”. Analysts came with opinion that the current inflation figure was expected and already accounted for. The market started falling after that and the opinion changed that the high inflation was causing the mayhem... On May 12th, the Index of industrial Production (IIP) number came, which was lowest in the last 6 years. Markets fell initially, but regained its loss in the second half with no positive trigger. Not only this, it closed surprisingly in green. Next day market fell by around 2% and the IIP number was blamed for such movement... The inflation on May 16th was reported as 7.83, the highest in last 44 months but market went up in spite of low IIP number and such high inflation. Same story gets repeated and market closes in green - about 0.50-1.0% higher than the previous day close. There are many such instances, which indicate that Indian market is rigged, does not follow logic and is well manipulated for the benefit of a few.

In such a scenario, whether derivative trading is sensible investment alternative or not is an issue to be debated. As per the report from Chicago & New York, between 80-95 % of the amateur players lose in the Futures & Option market. And these odds are worse than the worst odds at casino or at the racetrack. The large potential return in this market is attractive to many small investors who are not satisfied with getting rich slowly by investing in stocks for long term. They venture into the derivative market to get rich faster and eventually lose all their saving in a very short span of time. Options are only for certain period and get expired at the end of the period. One has invested in stock and his research suggests that price will come down soon, so he buys PUT option to hedge his losses. But price does not come down in this month. The option expires worthless and he loses all the money he had paid as the premium. To be protected continually, he has to keep buying PUT option every month which he can not afford to do. The worst thing happens when the sure thing proves to be true and the price of the stock comes down the next month. Not only he has lost his money, he has done it while being right about the stock. Instead of being rewarded he is wiped out from the market with very thin saving at hand.

Another sad part of the story is that these options are very expensive. The more volatile the market is and the more time-horizon the option has got, the higher the premium is. The Black-Scholes formula for calculating the premium of option suggests that NIFTY has got roughly 20-35% of volatility (Volatility index), which results in quite higher premium.

Options are zero-sum game, for every Rupee won in the market there is someone who lost a Rupee, and interestingly, minority does all the winning. Buying option has nothing to do with owning a share and it does not make one owner of the dividend paid by the company. One contributes to the growth of the economy of the country when he buys the share of stock even in the secondary market. But in options market, not a bit of money is put to any constructive use.

To sum up, trading in derivative is one of the riskiest investments. While stock itself is highly priced, the derivative trading could lead to major disaster. Warren Buffet referred these volatile, dangerous options as “financial weapons of mass destruction”. Small investors should be cautious of making investment in such financial instruments and should be rationale than being tempted.

Where to get the FII and Mutual Fund investment activity in Indian stock/equity & debt markets?

FII (Foreign Institutional Investors) and Mutual funds activities are very important for short term traders to speculate the trend. Being major players most of the time their actions moves the market up or down. Fortunately SEBI (Securities and Exchange Board of India) publishes the total amount of buying and selling done by FIIs and Mutual Funds in the Indian equity and debt market.

The data are made available to the public through SEBI's website in the "FII / Mutual Funds Trends" column. The webpage gives the last trading day's activities by FIIs and MFs and has archives for each day of current month. To visit the archieves for periods earlier than one month another archive section for both FIIs and Mutual Funds is available. To access any historical data enter the closing date of that month and click 'go'.

According to a note on SEBI's website:

"Note: The data pertains to all the activities undertaken by FIIs in Indian Securities Market, including trades done in secondary market, primary market and activities involoved in right/bonus issues, private placement, merger & acquisition etc."

SEBI has a 'investors awareness campaign' and provides the investors with the latest data/information to help them make informed choices.

Nick Leeson and late Barings bank :)

The Britain’s oldest merchant bank, Barings bank, had financed the Napoleonic wars, the Louisiana purchase, and the Eire Canal and Queen Elizabeth’s personal bank. Once one of the biggest banks, it grabbed attention of the world in 1995 for the action of a single trader from the small office in Singapore.

Nick Leeson joined Barings bank after working with Morgan Stanley for short period. His work on clearing the mess in Jakarta was highly appreciated and he was made General Manager with authority to hire traders and back office staff in Barings Securities (Singapore) Limited (BSS). After joining BSS in 1992, Leeson soon took necessary exam to trade in SIMEX (Present Singapore Exchange) along with his team of traders. Leeson and his traders got authority for two types of trading –

1. Transacting futures and options orders for clients or for other firms within the Barings organization, and
2. Arbitraging price differences between Nikkei futures traded on the SIMEX and Japan’s Osaka exchange.

As a trader, Leeson had extremely hard luck. He started losing money since very beginning and increasing his bets made his position worse. By the end of 1992, he was losing GBP 2MM which increased to GBP 23MM in a year. By 1994 he had lost total of GBP 208MM and surprisingly Barings management was till unaware of this. For all such furtive trading Leeson used account number 88888. Generally neither trader, nor employer prefers to publicize the loss. But by the time the unauthorized speculative trading of Leeson was discovered, Barings bank was bankrupted after such a huge loss.

Such a staggering loss caused by Leeson speculation went unnoticed in the Barings management because of ongoing merger of two parts of Barings organisation. Barings had started forming risk management function, but Singapore went without having any risk controller. There was no single person within Baring responsible for supervision of Leeson’s activity. Baring had adopted Matrix structure in 1993 and lines of reporting were not clear most of the time.

Leeson tried every possible act to keep the management unaware of such mismanagement of funds. He falsified records, fabricated letters and concocted stories to deflect management attention, auditors and even SIMEX. A few concerns from other employee couldn’t attract attention of management and Leeson remained celebrity within Barings. He secretly kept making loss in 88888 account, but publicly recorded profit in three arbitrage accounts.

By February 1995, when the management discovered the fraud, the total loss of Barings had reached $1.4 billion. Barings was unable to meet SIMEX’s margin call and was declared bankrupt. On 3’rd March 1995, the Dutch bank, ING, purchased it for £1 and assumed all its liabilities.