Derivatives are “time bombs” and “WMDs”: Warren Buffett
“I view derivatives as time bombs, both for the parties that deal in them and the economic system,” Warren Buffett said with his characteristic clarity of thinking even as he proceeded to provide a masterful explanation for his opinion.
“The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal,” Warren concluded in a chilling tone.
Rome was not built in a day but Hiroshima was destroyed in a day
"Rome was not built in a day but Hiroshima and Nagasaki were destroyed in a day." Do read my article: https://t.co/suwTWmn2Q6
— Vijay Kedia (@VijayKedia1) March 6, 2017
When Vijay Kedia uttered the golden words of advice of how it takes patience to build a fortune (Rome was not built in a day) but impatience can cause loss of a fortune (Hiroshima was destroyed in a day), novice investors and traders stared at him goggle-eyed and nodded their heads sagely in agreement.
However, nodding heads in agreement in one thing and having the sense to follow the advice is another thing.
Rs. 24 lakh lost in just five minutes
This day trader lost Rs.24 Lakhs in 5 minutes. (Fwd).https://t.co/wT93xBwhaK
— Vijay Kedia (@VijayKedia1) April 20, 2017
Chirag Gupta, a bright-eyed youngster, learnt the perils of dabbling in futures and options the hard way.
When the markets were about to close for the day, he noticed that Nifty call options were available at a throwaway price of 5 paise per unit and that he could make a quick profit of Rs 2.75 on each.
In a flash, Chirag mopped up all the Nifty 8,600 lots that were available. He could snare 3,000 lots for which he paid a pittance of Rs. 11,250.
As the Nifty closed at 8,602.75, he laid back expecting to cash in on a hefty gain of Rs. 6.08 lakh.
Unfortunately, Chirag lost sight of a cardinal principle of law governing Nifty options.
Apparently, the law is that if a trader squares off his long position before the market closes, he is liable to pay STT of only 0.05 per cent on the premium paid when contract is sold. However, if the contract expires, the STT rate jumps to 0.125 per cent and is charged on the entire settlement value of the contract, including the value (or price) of the asset.
Because, Chirag’s Nifty options expired worthless, he became liable to pay a massive amount of Rs. 24 lakh by way of STT on his contracts.
Always square off Nifty contracts before expiry
The big takeaway from Chirag’s tragic story is that all trades, whether a put option or a call option, must be settled before the expiry of contract. Even if the trade is in a loss, the settlement is mandatory if one wants to avoid getting ruined by the levy of STT.
It appears that most brokerages have a mechanism in place to track such trades and prevent mishaps. If the trader fails to square off his position, the system automatically does it on his behalf.
However, in Chirag’s case, the system did not trigger an alert probably because he put the buy order in the last five minutes of trade.
Silver lining: Saved from loss of Rs. 4.8 crore
Chirag has to count his blessings because though he went on a rampage to mop up all the Nifty options that were available in the market, he could only find 3,000 lots.
Given his margin limits, he could have easily bought 20x that amount and if he had done so, his loss would have been – hold your breath – a staggering Rs. 4.80 crore by way of STT!
Anomaly in the law?
Chirag has addressed a petition to Arun Jaitley and other top brass of the Finance Ministry and SEBI in which he has claimed that there is an anomaly in the law.
“I cannot understand how STT can be over 10000 times higher just because I decided to hold onto the trade for a few minutes extra,” he says, tears welling in his eyes.
He has also made relevant points of how the law poses a systemic risk because huge liabilities for STT can be raked up by novice traders which will ultimately have to be discharged by the brokers if the traders do not have the means to do so. This can amount to a catastrophic loss for the entire capital market, he warns in a grim tone.
Other novice traders have sworn off futures and options
Vijay Kedia’s followers confessed that they too had lost heavily by dabbling in futures and options and that they have now sworn to stay away from it.
@VijayKedia1 I also lost 80k in 5 mins on a day trade. From then on I have stopped day trading. Buy and hold strategy is best Already gained by 30%
— gourav panda (@monutweet) April 20, 2017
@VijayKedia1 i also lost 1.70 lcks 3 years back
— chirag haria (@chirag210684) April 20, 2017
@VijayKedia1 Thts y i never do day trade… safe to do swing on quality stocks👍
— Prem (@pdprem91) April 20, 2017
Some thanked Vijay Kedia for his timely caution and vowed to heed his advice to stay away from derivatives:
@VijayKedia1 Thanks for cautioning.
— Rajeev (@RaajeevIndia) April 20, 2017
@VijayKedia1 As you have rightly said in one of your interviews this is not trading or investing.. This is pure Gambling !
— Scrips Reader (@ScripsReader) April 20, 2017
It is obvious that complicated derivative products like futures and options are way beyond the comprehension of novice investors like you and me. We are better off doing our daily punting of buying and selling stocks and should be careful never to get ensnared by get-rich-quickly schemes!