How to Handle Leverage, Liquidity Risk, and Systemic Risks When Trading Derivatives in India
Beginning
In India, derivatives trading includes futures, options, currency, and commodity contracts. These markets are great for hedging, speculating, and arbitrage. But these benefits come with a lot of risks, especially because of high leverage, liquidity issues, and systemic exposures. To keep participating in the market in a way that lasts, it's important to understand and manage these risks.
This article goes into great detail about the main risks of trading derivatives in India and gives good advice on how to deal with leverage risk, liquidity risk, and systemic risk.
1. The risk of leverage in derivatives trading
What does leverage mean in derivatives?
Traders can take positions much bigger than their capital by posting a small amount of the total contract value as margin. SEBI controls this margin in the Indian market, and it changes based on the type of asset, how volatile it is, and the state of the market.
Leverage Example
A trader puts down ₹50,000 as margin to control a futures position worth ₹5,00,000.
The ratio of leverage is 10x.
How Leverage Increases Risk
Amplified Losses: A small change in price causes big losses compared to the amount of money invested.
Example from real life
In March 2023, a trader who was short on Nifty futures at 17,000 saw the price suddenly jump to 17,500 because of unexpected news about the economy.
Loss = (17,500 – 17,000) × Lot Size (75) = ₹37,500.
This was a big loss for a margin of ₹50,000.
Ways to Reduce Risk
Keep Enough Margins
Keep more than the minimum initial and maintenance margins to avoid over-leverage.
Use stop-loss orders
Set exit levels ahead of time to keep losses to a minimum.
Sizing Up Your Position
Keep the amount of money you risk in each trade to a small percentage of your total capital.
2. Risk of liquidity
What does liquidity risk mean?
Liquidity risk is the chance that you won't be able to buy or sell derivatives at a fair price because the market isn't very liquid. This risk can be worse in the Indian market when contracts are thinly traded or when orders are large.
For example
A single stock future for a small-cap company might not have a lot of open interest or volume.
Trying to get out of a big position could change the market price in a bad way.
Effects of Liquidity Risk
Wider Bid-Ask Spread: More expensive to execute.
Price Slippage: When you place big orders, the prices can change a lot.
This is a case study.
A trader tried to get out of a big position in a low-volume Reliance Future during off-peak hours in June 2023.
Impact on the Market: ₹5 per share slippage.
Higher costs for transactions.
Ways to Mitigate
Concentrate on contracts that are very liquid
Choose index futures (like Nifty and Bank Nifty) or large-cap stock futures (like Reliance and HDFC Bank) that have a lot of volume and open interest.
Do business during market hours
Stay away from times when there isn't much going on or when there aren't many people.
Place Limit Orders
Set prices ahead of time to stop execution at bad prices.
3. Risk to the whole system
What is the risk to the system?
Systemic risk is the chance that the whole financial system will fall apart because of interconnectedness and defaults that spread. The derivatives market is especially weak because of leverage, daily MTM settlements, and large open positions.
A historical example is the global financial crisis of 2008.
The 2008 crisis showed how derivatives exposure in illiquid markets can cause systemic failures, like the collapse of Lehman Brothers. This is not just true in India.
In India
To lower systemic risk, SEBI and exchanges have put in place strong margining systems and position limits.
Daily MTM settlements make sure that losses are recorded on a regular basis and that liquidity is kept up.
A real-life systemic risk event
A sudden change in the geopolitical landscape in February 2023 caused huge swings in global markets.
India VIX went up a lot in the Indian derivatives market.
A lot of people didn't meet their margin calls, which led to forced liquidations.
How It's Handled
System for Collecting Margins
Mandatory upfront margins stop positions from building up without control.
Position Limits: These are the most open positions that each participant can have.
Exchange's Clearinghouse: It acts as a central counterparty to guarantee the trade and lower the risk of default.
4. Risk of Volatility
What it means
Volatility risk is the risk of prices changing in ways that are hard to predict, which affects the prices of options and futures.
For example
Before RBI policy announcements or budget speeches, implied volatility often goes up a lot.
Effect on Traders
Higher premiums for options.
Futures have unpredictable mark-to-market changes.
Ways to lessen the damage
Strategies Based on Volatility
Instead of making directional bets, use straddles or strangles to take advantage of volatility.
Keep an eye on India VIX
Use it as a sign to stay out of new positions during times of extreme volatility unless you are trading volatility.
5. Risk of the other party
Definition
In India, counterparty risk is mostly gone in exchange-traded derivatives because the exchange is the main counterparty.
Why SEBI Rules Are Important
Makes sure that brokers and participants have enough money.
Regular checks for compliance and audits.
Makes sure that market participants follow the right ways to manage risk.
6. Risk of Basis
What it means
When the futures price and the spot price don't meet as expected at expiration, that's called basis risk.
For example
A trader who uses index futures to hedge a portfolio of stocks might run into basis risk if the correlation isn't perfect.
How to Manage
Use instruments that are more related
Pick futures contracts that closely follow the underlying portfolio.
Rebalancing every once in a while
Change the hedge ratios to reflect changes in correlations.
7. Risk of Regulation
What it means
Changes in government policies or SEBI rules can change how people trade and how the market works.
For example
In April 2023, SEBI raised the margin requirements on stocks with a lot of price movement to stop people from trading on speculation.
Effect
More money is needed for the same job.
Some traders sold their positions, which caused short-term price swings.
8. Risk of Settlement
Meaning
Settlement risk is the chance that one party won't follow through on their end of the deal.
How India Handles It
Daily Mark-to-Market settlement stops big unpaid positions from building up.
Required margin deposits and the sale of positions that aren't paid for.
End
The Indian derivatives market has a lot of potential, but it also has a lot of risks because of leverage, low liquidity, and interconnectedness. For trading to be sustainable, you need to have the right risk management strategies in place. These include keeping enough margins, focusing on liquid contracts, using volatility strategies, and relying on exchange-clearing mechanisms.
SEBI's regulatory oversight has put in place strict margining systems, position limits, and mandatory reporting to keep the market honest. Still, both individual traders and institutions need to stay on their toes, especially when the economy is very uncertain or the world is very volatile.
Market participants in India can effectively and responsibly navigate the complicated world of derivatives by choosing strategies carefully and managing risk wisely.
