Learn With ETMarkets: Understanding investment options; trading instruments

Dev has been Tara's unwavering guide on the exhilarating journey of technical analysis since she reached out to him to learn about financial investing.

"Hey Tara, welcome to my office," greeted Dev with a warm smile. "I am so glad you could make it.”

Tara smiled back, her eyes shining with anticipation. "I've been looking forward to this," she replied. "I can't wait to learn more and meet your teammates."

As Dev walked Tara to the conference room, he thought it would be useful to give her an introduction to trading instruments.

"When it comes to investing, there are many trading instruments available for traders to choose from. Let me give you a brief overview of the two main segments: the cash segment and the derivatives or F&O segment", he said.

Tara nodded, curious to learn more. "What's in the cash segment?" she asked.

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Cash Segment:
1. Stocks and Bonds

Dev explained, "It's a type of trading segment in the stock market where investors buy and sell stocks on a delivery basis. The investor needs to have sufficient funds in their trading account to buy the stocks, as the transaction is settled in cash. The cash segment is suitable for long-term investors who want to hold stocks for a longer duration."

Tara acknowledged that she understood buying stocks with cash but on the other hand was curious about F&O. "So, we don't need to have sufficient funds to trade in the F&O segment?" she asked.

Dev clarified, "Investors only need to pay a margin amount to buy or sell derivative contracts as they are leveraged products. But remember that these contracts have a time limit or expiry during which they need to be settled."

Continuing their discussion, Tara asked, "Apart from stocks, what other asset classes can investors trade in the cash segment?"

Dev replied, "Other asset classes available for trading in the cash segment include bonds like the 10-year benchmark bond issued by the Reserve Bank of India and bonds issued by corporates such as Tata Motors."

Tara nodded and asked, "I remember what you explained about bonds and yields in our previous discussion. So, can we purchase these bonds from exchanges like stocks?"

Dev confirmed, "Yes.These bonds can be bought and sold on the NSE and the BSE exchanges, as well as on the Wholesale Debt Market segment of the NSE. Also, there are a few other investment options within the cash segment, like Mutual funds."

2. Mutual Funds
"Well, a very popular alternative is to invest in Mutual funds. These are professionally managed investment vehicles that pool money from multiple investors and invest in a diversified portfolio of stocks, bonds, and other financial instruments. They aim to provide investors with long-term returns that mirror the performance of the broader market." explained Dev.

" Do they charge a fee for managing the funds? " asked Tara.

"Yes, Mutual funds typically charge a management fee that is a percentage of the assets under management, as well as transaction costs and other fees. They're suitable for investors who lack the time or expertise to select individual stocks and prefer to have a professional fund manager manage their investments.” Dev replied.

Highlighting their features, Dev continued “Mutual funds can be actively managed or can be passive. However, I would like to point out that Mutual funds are heavily regulated by the regulators, and must follow specific rules regarding diversification, disclosure, and other aspects of their operations. This makes them relatively safer for investors who prefer a more traditional and hands-off approach to investing.”

"That makes sense. So how and where can we buy mutual funds in India?" inquired Tara.

" Mutual funds are bought and sold at the end of the trading day at the NAV (Net Asset Value) price, which is calculated based on the closing prices of the securities in the fund's portfolio. One can purchase these funds directly from the Asset Management Company (AMC), through a Certified Financial Planner. They are also tradable on stock exchanges such as NSE and BSE," replied Dev.

Tara was curious to know how to pick the best mutual funds for investment. 'So Dev, how do we determine which funds to invest in?' she asked eagerly.

"Hey Tara, when it comes to investing in mutual funds, it's important to choose a diversified fund rather than a sector or theme specific fund," explained Dev.

"Remember how the infrastructure fund didn't perform for over ten years? That's why diversification is key - it ensures that even if one sector doesn't perform, your investment remains stable as there's always another sector that's doing well."

"Here's my pro-tip - instead of investing a lump sum, it's better to go for Systematic Investment Plans or SIPs," shared Dev. "Why? Because the market is unpredictable and it never stays at the top or the bottom for too long. SIPs provide time-based diversification, ensuring that your investment is spread out over time and is not affected by short term market volatility."

"Interesting! Is there something where we can have more control over our investments with a lower cost structure?" Tara asked.

3. Exchange-traded funds (ETF)
"Absolutely!”. Dev replied. “ETFs are investment funds that trade on stock exchanges and hold a basket of underlying assets such as stocks, bonds, or commodities. While Mutual Funds are bought and sold at the end of the trading day based on NAV, in contrast, ETFs can be bought and sold on the exchanges like NSE and BSE, throughout the trading day, similar to stocks. Their price is determined by the market demand and supply.”

Being reminded about the cost comparison, Dev explained “Since they are typically passive investments that track a market index, ETFs typically have lower expense ratios than actively managed mutual funds which require more resources and research. For example, the Nifty 50 ETF tracks the performance of the Nifty 50 Index, which represents the top 50 companies listed on the NSE”.

"Cool! Is there an instrument that is more actively managed by experts? Tara inquired.

“Yes, there is” Dev replied with a smile. “But these are usually only available to accredited investors, who have higher income and net worth requirements”.

4. Hedge funds/Alternate Investment funds (AIF)
"Hedge funds and Alternative Investment Funds (AIFs) offer greater investment opportunities to those looking for higher returns than the market. Unlike mutual funds, these investment options have more flexibility in their investment strategies, which means they can trade on both long and short positions and use different asset classes without any restrictions," clarified Dev.

“However, this flexibility comes at a cost,” Dev added and continued further. “Hedge funds typically charge a higher management fee and also take a percentage of any profits generated, which is known as a performance fee. They may have lock-up periods during which investors cannot redeem their investment, and may have other restrictions on when and how shares can be bought or sold.”

“What are Alternate Investment funds (AIF)?”, asked Tara.

Dev replied “In India, hedge funds are classified under the category known as Alternative Investment Funds (AIFs). This term was introduced by the Securities and Exchange Board of India (SEBI) in 2012 when they issued guidelines for the regulation of AIFs. AIFs encompass a broader range of funds beyond traditional hedge funds, including private equity funds, real estate funds, and infrastructure funds.”

"Great! Is there anything else in the cash segment that we can trade on exchanges?" Tara inquired.

5. Real estate investment trusts (REITs)
"Real estate investment trusts or REITs are another option. These are investment funds that invest in income-generating real-estate properties such as office buildings, malls, and hotels. In the cash segment, investors can buy and sell REIT units on a delivery basis. Introduced in India in 2019, these can be traded on the NSE and the BSE, where Investors can buy and sell REIT units on a delivery basis,” Dev explained.

"Since most people don't have the resources to invest in high-value property, REIT units offer an accessible and practical alternative for investing in real estate. Some popular REITs in India include the Embassy Office Parks REIT and the Mindspace Business Parks REIT," pointed out Dev.

"This is fascinating! I had no idea there were so many different options available in the cash segment. Thanks for explaining everything, Dev," Tara said, impressed.

"You're welcome, it’s always good to explore different investment options to find what works best for you," Dev replied with a smile.

Derivates (F&O) Segment:
"Let's dive into the exciting world of futures and options trading!" exclaimed Dev. "With futures, you can buy or sell a contract for something like a stock or index that will be delivered in the future. Options, on the other hand, give you the right to buy or sell that same asset at a set price before a specific date. It's like betting on the future price of something!”

"I'm intrigued, but I need a deeper understanding of this concept," said Tara. "Also, I'm not entirely clear on which assets can be traded as derivatives. Can you explain that to me?"

"Absolutely," said Dev. "My colleagues will explain everything in detail, but for now, let's talk about the assets that can be traded as derivatives."

1. Stocks and Indices:
"In the F&O segment, investors can trade in futures and options contracts based on individual stocks or stock market indices like Nifty 50 or Sensex. These contracts derive their value from the underlying stock price or index level and allow investors to take positions on the price movement of the stock market. Both can be traded on the NSE and BSE." Dev explained and continued.

2. Commodities:
“Commodities such as gold, silver, crude oil, natural gas, and agricultural products are also popular assets for derivatives trading. Similar to stocks, these contracts derive their value from the price of the underlying commodity and allow investors to take positions on the price movement of the commodity. You can trade commodity contracts on the Multi Commodity Exchange of India (MCX) and the National Commodity and Derivatives Exchange (NCDEX)."

3. Currencies (Forex):
"Currencies are also a popular asset class for derivatives trading," Dev added. "Investors can trade in futures contracts based on different currencies like the US dollar, euro, British pound, and Japanese yen, which allow them to take positions on the exchange rate movement between two currencies. In India, forex trading is regulated by the Reserve Bank of India (RBI), and there are restrictions on the amount of foreign currency that can be traded. The NSE, BSE, and Metropolitan Stock Exchange (MSE) offer currency derivatives trading in the form of futures and options contracts for various currency pairs such as USD/INR, EUR/INR, GBP/INR, JPY/INR, among others."

4. Interest rates:
"Lastly, investors can trade in futures contracts based on interest rates, such as the 10-year government bond yield, which allow them to take positions on the direction of interest rates. Interest rate derivatives trading in India is primarily conducted on two major exchanges, the NSE and the BSE, which offer a wide range of interest rate derivative products such as Interest Rate Futures (IRF), Interest Rate Swaps (IRS), and Forward Rate Agreements (FRA)." Dev concluded.

Tara looked impressed by Dev's knowledge of derivatives trading. "That's a lot to take in, but I appreciate you breaking it down for me. It seems like there are many options available for investors in the derivatives market."

"Definitely," Dev agreed. "And my colleagues will be able to explain futures and options in even more detail, so you'll have a good understanding of this segment in no time."

Suddenly, a gentle knock on the door interrupted their lively discussion, signaling the arrival of an expected visitor.

To Be Continued...

(The author is CEO TradingHeads.com, Yubha.com)