At the time of filling the KYC (Know Your Customer) documents (when joining), do not sign wherever you are asked to. In particular, look closely at the power of attorney (PoA) section, experts tell Sanjay Kumar Singh.
A recent Sebi circular makes it compulsory for brokers to maintain evidence of orders placed by clients
Losing money in a stock market trade isn't uncommon for retail investors. Many get greedy and end up making significant losses. But, there are also many instances when unauthorised trading by brokers on behalf of clients has caused them severe loss.
A large proportion of the complaints the markets regulator, Securities and Exchange Board of India (Sebi), receives relate to this issue. Recently, it issued a circular aimed at curbing this.
Maintain proof of order
Sebi's circular of September 26 requires all brokers in the equity, equity derivative and currency derivative markets to execute trades on behalf of clients only after keeping evidence of the client placing such an order.
So far, only brokers in the commodity derivative market were required to do so. The record could be in the form of a written document, telephone recording, e-mail from an authorised e-mail ID, log for internet transactions or record of SMS messages.
A key point in the circular is when a dispute arises, the burden of proof will be on the broker. He will have to produce the record for the disputed trade.
While this is a welcome step, investors also need to be watchful in their dealings with stockbrokers, as the recent example below demonstrates.
Rogue trader, negligent investor
Sameer Singh (name changed on request), a Mumbai-based finance professional, allowed his broker to trade on his behalf in March this year. Within a few months, his portfolio of Rs 85 lakh was almost completely wiped out.
Singh had been investing in equities on his own for eight years, earning about 1-1.5 per cent return per month (12-18 per cent annually). His broker promised to generate a return of 3 to 4 per cent per month (36-48 per cent annually) by trading in derivatives, using his equity portfolio as margin.
He promised not to touch the shares in the portfolio. After opening a derivative trading account with the broker, Singh transferred the shares in his portfolio into the new account between March and May.
The broker started trading on Singh's behalf. He would inform Singh verbally of the trades done and returns made. He did not give Singh regular statements of his position.
On July 4, the broker informed Singh that he had incurred losses. Singh asked the broker for a statement. The losses stood at Rs 76 lakh. On July 11, his portfolio was liquidated.
Understand the risks in derivatives
Among the many mistakes Singh made, the first was to enter a segment whose risks he did not understand.
When an investor does a delivery-based purchase in shares, he has to pay the entire amount. Derivatives are leveraged products. Here, the investor only has to pay the margin money.
He can, for instance, create a position worth Rs 5 lakh by depositing only Rs 75,000. If the share moves up by 10 per cent, a profit of Rs 50,000 is generated.
On an investment of Rs 75,000, this amounts to a return of 66 per cent. The losses in such leveraged trades are equally high.
"Investors only think of the profits in derivatives, not the risks. They need to understand that if they are taking leveraged positions, they must have the capacity to bear high losses," says Vikas Singhania, executive director, Trade Smart Online.
In derivative trading, the investor must also have additional cash at his disposal. Suppose he pays Rs 1 lakh to create a position worth Rs 5 lakh and sustains a loss of Rs 5,000. He has to pay Rs 5,000 to the broker right away.
In delivery-based trades in equities, investors have holding power. Even if the share price falls, they can wait until the price recovers.
In futures, any loss has to be made up by the evening. The broker gives a margin call, asking the client to pay up.
If the client fails to do so, he squares off the trade, thereby causing the investor to register a loss.
"It is very difficult to hold on to your position in the futures segment when the market moves against you," says Shrey Jain, founder, SAS Online, a Delhi-based discount broking firm.
The Rs 1 lakh (in the above example) paid is the margin money.
Many people don't give that amount as margin and instead give shares worth the same amount. If the market falls, the investor first has to make good the losses he has incurred.
The value of the shares given as collateral also falls. He then has to also make up for the value of the collateral. Thus, a double whammy.
Don't sign on the dotted line
At the time of filling the KYC (Know Your Customer) documents (when joining), do not sign wherever you are asked to.
In particular, look closely at the power of attorney (PoA) section.
Insiders say it's all right to give a limited PoA to the broker for two purposes. One, when you sell stocks, the broker has to pay them to the exchange.
You will have to give PoA for this purpose, or else you will have difficulty in transacting.
Another thing for which a PoA has to be given is that if you don't pay up for losses (in derivatives), the broker can liquidate your holdings.
Don't sign a PoA for any purpose other than these, especially not to trade on your behalf.
Experts say that PoAs for trading are not even legally valid. Usually, they are informal arrangements between the client and the broker that are best avoided.
A cardinal mistake that Singh made was to allow the broker to trade on his behalf.
"You have to take responsibility for your trades and can't entrust this to someone else," says Singhania. Also, obtain and study statements of your position regularly.
Finally, don't risk your entire portfolio just to save a few basis points on brokerage.
"Operate only with well-known national brokers who are financially strong and have robust systems and processes in place," says Jatin Khemani, founder and chief executive officer, Stalwart Advisors, a Sebi-registered independent equity research firm.
Photograph: Punit Paranjpe/Reuters.