Choose between stocks, indices, and derivatives

Understanding the three instrument types

Individual stocks

WHY stocks?

• Direct exposure to company performance
• Voting rights (usually negligible for retail investors)
• Potential for outsized gains if you pick winners

HOW they work: You buy through a broker → ownership recorded in demat account → you can sell anytime during market hours at prevailing market price

Capital requirement: Full stock price × quantity. To buy 100 shares at ₹2,500 = ₹2,50,000 (plus brokerage, ST, GST ~0.5% total).

Index funds/ETFs

WHY indices?

• Diversification: One purchase = exposure to 50+ companies
• Market returns: You capture broad market movement, not individual company risk
• Lower volatility: If TCS crashes 10%, NIFTY might drop only 0.5% (TCS is ~4% of NIFTY)

HOW they work (ETF example): NIFTY 50 ETF holds all 50 NIFTY stocks in exact proportion → ETF price tracks NIFTY level × scaling factor → you buy ETF units like buying a stock

Capital requirement: Much lower. NIFTY 50 ETF trades at ~₹200/unit. With₹10,000 you get diversified exposure.

Step 1: Calculate each stock's adjusted market cap $\text{Adj. Market Cap}_i = \text{Price}_i \times \text{Free-float shares}_i$ Free-float = shares available for public trading (excludes promoter holdings)

Step 2: Sum all adjusted market caps $\text{Total Market Cap} = \sum_{i=1}^{50} \text{Adj. Market Cap}_i$

Step 3: Apply base period normalization $\text{Index Value} = \frac{\text{Total Market Cap}}{\text{Base Market Cap}} \times \text{Base Value}$

For NIFTY 50: Base date = Nov 3, 1995; Base value = 1000

WHY this formula?

• Larger companies (higher market cap) have bigger impact on index → reflects economic reality
• Free-float adjustment prevents distortion from illiquid promoter holdings
• Base normalization makes current value interpretable (NIFTY at 22,000 = 22× growth since 1995)

Total Market Cap = ₹15,000 million

If base market cap = ₹10,000million and base value = 1000: $\text{Index} = \frac{15,000}{10,000} \times 1000 = 1500$

Next day: Stock B rises to ₹550(10% gain)

• New Adj. Market Cap for B = ₹550 × 10M = ₹5,500M
• New Total = ₹4,000M + ₹5,500M + ₹6,000M = ₹15,500M
• New Index = (15,500/10,000) × 1000 = 1550

Why this step? Shows that a10% move in mid-sized stock B causes only 3.3% index move because B is 1/3 of total market cap.

Derivatives

Main types: Futures (obligation to buy/sell) and Options (right but not obligation)

WHY derivatives?

• Leverage: Control large positions with small capital (margin = 10-20% of contract value)
• Hedging: Protect existing holdings from downside
• Speculation: Profit from price movements without owning underlying

HOW they work: You trade contracts, not actual stocks. On expiry, either:

• Cash settlement: Pay/receive difference between contract price and market price
• Physical delivery: Rare; actual shares transferred (mostly in stock futures)

Stock approach:

• Buy NIFTY ETF: ₹200/unit × 500 units = ₹1,000 invested
• NIFTY rises4.5% → ETF rises to ₹209
• Profit = (₹209 - ₹200) × 500 = ₹4,500
• Return = 4.5%

Futures approach:

• Buy 1 NIFTY futures lot (size = 25units of NIFTY)
• Contract value = 22,000 × 25 = ₹5,50,000
• Margin required = ₹60,000 (broker sets this, ~11% of contract value)
• NIFTY rises to 23,000 → Profit = (23,000 - 22,000) × 25 = ₹25,000
• Return on margin = ₹25,000 / ₹60,000 = 41.7%

Why this step? Shows leverage effect: Same market move (4.5%) yields 9× higher return in futures because you control₹5.5L with ₹60K.

BUT: If NIFTY drops 4.5% to 21,000:

• Futures loss = (21,000 - 22,000) × 25 = ₹-25,000
• You lose41.7% of your margin

Leverage magnifies both gains AND losses.

You own 100 shares of Infosys at ₹1,500 (total = ₹1,50,000). Worried about earnings report next week.

Buy Put Option:

• Strike price = ₹1,500
• Premium = ₹30/share
• Cost = ₹30× 100 = ₹3,000
• Expiry = 1 week

Scenario 1: Stock crashes to ₹1,300(bad earnings)

• Stock loss = (₹1,300 - ₹1,500) × 100 = ₹-20,000
• Option gain = (₹1,500 - ,300) × 100 = ₹20,000 (you can sell at ₹1,500 via option)
• Net loss = ₹-20,000 + ₹20,000 - ₹3,000 (premium) = ₹-3,000

Why this step? The put option capped your maximum loss at the premium paid. Without it, you'd lose ₹20,000.

Scenario 2: Stock rises to ₹1,600 (good earnings)

• Stock gain = ₹10,000
• Option expires worthless (no reason to sell at ₹1,500 when market price is ₹1,600)
• Net gain = ₹10,000 - ₹3,000 (premium) = ₹7,000

Options are asymetric bets: Limited downside (premium), unlimited upside (for call options).

Comparison framework

| Criterion | Stocks | Indices (ETF) | Derivatives | |--------|---------------|-------------| | Capital needed | High (full price) | Medium (₹5K-₹50K) | Low (margin 10-20%) | | Risk level | High (single company) | Medium (diversified) | Very High (leverage) | | Profit potential | Unlimited | Market returns (~12% CAGR) | Unlimited (but time decay for options) | | Loss potential | 100% (company bankrupt) | Limited (market won't go to zero) | >100% (margin calls) | | Time horizon | Any (days to decades) | Long-term (1+ years) | Short (days to months, expiry-bound) | | Complexity | Simple | Complex (greks, strikes, expiry) | | Ideal for | Stock pickers | Passive investors | Hedgers, speculators |

The Steel-man: Derivatives DO have legitimate uses:

• Exporters hedge currency risk: A company expecting $1M in 6 months locks USD/INR rate via currency futures to avoid rupee appreciation eating profits
• Portfolio managers protect downside: During uncertain times, buying index puts is cheaper than selling and re-buying stocks (tax implications, transaction costs)

The fix: Derivatives become gambling when used purely for leveraged speculation without:

1. Position sizing (risking >5% of capital per trade)
2. Stop-losses (no exit plan)
3. Understanding of instrument mechanics (selling naked options without knowing unlimited loss potential)

Used for hedging with defined risk = tool. Used for 50× leverage gambling = casino.

The nuance: Indices eliminate unsystematic risk (company-specific events like fraud, bad management) but fully expose you to systematic risk (market-wide crashes, recessions).

Example: March 2020 COVID crash

• NIFTY fell 38% in 1 month
• Your NIFTY ETF portfolio: -38%
• If you held IT stocks (benefited from work-from-home): Some dropped only 15%, some were flat

The fix: Indices are safer for stock-selection risk but not immune to market risk. For short-term goals (<5 years), even index funds can be risky. For 10+ years, indices converge to positive returns (India: ~11% CAGR historically).

Decision tree for choosing instrument

START: What's your goal?

1. Are you investing for long-term wealth (5+ years)?
   YES → Do you have time to research companies?
         YES → Individual stocks (10-15 stocks across sectors)
         NO → Index funds/ETFs (NIFTY, SENSEX, or sector ETFs)
   NO → Go to2

2. Are you speculating on short-term price moves?
   YES → Do you understand derivatives deeply?
         YES → Futures/Options with strict risk management
         NO → Don't trade derivatives; use stocks or swing trade ETFs
   NO → Go to 3

3. Are you hedging an existing position?
   YES → Use options or futures to protect downside
         (e.g., Put options on stocks you own)

Buying stocks is like buying a piece of your favorite company (say, the company that makes your phone). If the company does well, your piece becomes more valuable. But if that ONE company messes up, you lose money. It's risky because you're betting on one company.

Buying an index fund is like buying a tiny piece of the top 50 companies all at once! If one company fails, you still have 49 others. It's like having a cricket team instead of betting on one player. Much safer, but you won't get super-rich quick.

Derivatives are like making a bet on where the price will go WITHOUT buying the actual thing. It's like betting your friend₹100 that your team will win next week. If you're right, you win ₹100 (or more!). If you're wrong, you lose your₹100 (or more!). It's exciting but super risky because the bet has a time limit—if the match is over, the bet is done.

Most people starting out should go with index funds because it's like letting the whole market work for you, not just one company.

Connections

• 4.1.01-Risk-and-reward-relationship - Risk tolerance determines instrument choice
• 4.2.02-Lot-sizesand-margin-requirements - Derivatives mechanics details
• 4.3.01-Market-and-limit-orders - Execution applies to all instruments
• 5.1.01-Diversification-strategies - Index funds provide instant diversification
• 6.2.01-Hedging-with-options - Derivative use for risk management

#flashcards/stock-market

What are the three main financial instruments available for trading? :: Stocks (individual equities), Indices (via ETFs/mutual funds), and Derivatives (futures and options)

Concept Map

Hinglish (regional understanding)