Few best kept secrets, you may not know about Stock Market, Currency market and Commodity Market

What is the most profitable place to invest? Stock Market or currency market or commodity market…? Confused about which market to invest…?

Understanding the fine distinctions between these markets, often spells the difference between failure and success in investing.

Being a regular reader of personal finance columns, you must be knowing about what stock market is, what currency market is and what commodity market is. I would like to highlight a key difference between stock market and the two other markets.

A Key Difference:

Stock exchange has got both the spot market as well as the derivatives market. Whereas the commodity exchange or currency exchange have only the derivatives market.

Let us quickly recall what is spot market and derivative market.

In a spot market, as an investor you can buy shares and hold it perpetually. You can sell it whenever you decide to. You can hold the shares for long term – say 5 years or 10 years. For Example, you can buy Infosys shares and keep it for 5 years or 10 years.

In the derivatives market, you will do advance booking to buy or sell a particular quantity of shares or commodities or currencies on a pre-determined settlement date for a pre-fixed price. As you are doing only advance booking you need not pay the complete price; you need to pay only the margin money.

You can’t hold these contracts perpetually. You need to either buy or sell the shares or commodities or currencies on the pre-determined settlement date.

Let me illustrate. In the commodities market you would like to trade in crude oil. Minimum size of a crude oil contract is 100 barrels. The price of the contract as of 18th june 2014 is Rs. 632100. This contact will expire on 19th Nov 2014. You need to pay 5% of the contract value as the margin money.

If you expect the crude prices to go up, then you can buy this contract. If you expect the share prices to go down, you can sell this contract.

Say you expect the prices to go up. So you buy this contract by paying the margin money of Rs.31605. On 19th Nov, if the crude moves up to Rs. 6,39,900, then you will gain Rs. 7800.

On 19th Nov, if the crude moves down to Rs. 6,24,300, then you will loose Rs.7300.

Let me reiterate the key difference. Currency and commodity exchange have only the derivatives market. Stock exchange has got both the spot market and the derivatives market.

Derivatives as a tool for hedging:

The original purpose behind derivatives is hedging. You can hedge yourself against the future fall or rise in the price of a particular asset.

Why do you need to hedge? Let me explain you with an example.

Say you are an importer. You have placed an order with the exporter. You need to pay the exporter at the end of 3 months in dollars. You are not sure how the exchange rates will move. If the rupee value falls at the end of 3 months, then you may end up paying more in rupee terms to settle the exporter. This will cut your bottom line badly.

So you do advance booking for dollars which you will take delivery at the end of 3 months by paying a small margin. By doing this you have removed the downside. You have hedged yourself against the rupee fall.

Similarly an agriculturalist that is producing wheat can book the sale price for his produce now-itself, however he can do the delivery after 3 months. He has hedged himself against the fall in the prices of wheat.

Somehow, the fall or rise in the price of a particular asset is going to affect you. So you protect your position by hedging with derivatives.

Derivatives as a tool for Speculation:

Though the original purpose of derivatives is hedging, it is often used as a tool for speculation. Though, the fall or rise in the price of a particular asset is not going to affect you, you trade in derivatives to profit from the price movements of an underlying asset.

Say you are not an importer. However you expect that the rupee value will fall and want to gain out of that. Therefore you do advance booking for dollars. This is pure speculation.

Stop Speculating and Start Investing:

Stop speculating in the derivatives market and Start investing in the spot market. Speculating in derivatives market is a zero sum game. Either buyer or seller of the contract can make money. Both can’t make money. Whatever the loss of one person will be the gain of another person. Money is not generating more money. Money is not put into productive use. Money is rotated. Money moves from one pocket to another pocket.

As you need to pay only the margin money, you may take over exposure which will increase the overall risk. Either you will make huge profit or huge loss. This leads to greed and emotional imbalance. Therefore you will loose control at some point in time.

A person who gains in ALL the speculative transactions is only the broker. That’s why Benjamin Graham says, “The investors make money for themselves and the traders make money for their broker”.

When you are investing in shares through the spot market, both the buyer and seller can make money. For Example, Mr.A can buy a share for 100 Rs and keep it for 5 years. At the end of 5 years, he may sell it to Mr.B for 200 Rs. Mr.B can hold the shares for another 5 years and sell it to Mr.C for 400 Rs.

Both the buyer and seller can make money. Here money is not rotated; money is generated.

As you are investing in shares of a company, the company does its business with your money as capital. The company generates more money by way of profit in its business. Because of the profit the share prices go up.

As our money is put into productive use, it breeds more money. As a result, both the buyer and seller can make money by investing in the shares for long term. If you patiently accept the short term volatility you will have long term gain. As you are patient enough and investing only long term money in the stock market, you will be emotionally balanced.

In the spot market, as you are investing for long term, you need to buy the shares by paying its full value and not paying just the margin money. So you will take risk only to the extent you can afford to. Hence, you will not loose control over your investments.

Tell me why:

I have asked this question frequently with the investors. Tell me why you would like to invest in the stock market or commodity market or currency market. Most of the times, their reply will be very vague. They will say, ‘I would like to make more money’.

When you just say you want t make more money, it is not very clear that, you would like to make more money in the short term or long term…? What is your return expectation…? Is it 15% or 50%…?

As you are not very clear about your purpose of investing, it is easy for the broker to confuse you and give you a sugar-coated sales talk about making quick money by trading in the derivatives market.

Why brokers recommend trading in derivatives market over investing for long term in the spot market? In the derivatives market, though you are asked to pay only the margin money, the broker charges his commission as a percentage of the total contract price.

In addition to that, in derivatives market, you can’t invest for long term, so you need to frequently trade. For every trade broker makes money. Also he can feed your greed easily.

In the spot market, if you invest for long term say 5 years or 10 years, broker makes less commission, that too once in a while.

If you are very clear about why you want to invest in the stock market or commodities market or currency market, then the sugar coated sales talks of the broker will not affect you. The very clear answer for the question ‘why you want to invest in the stock market…?’ is ‘I want to meet my long term financial goals with inflation adjusted returns by taking calculated risk’.

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