Every bull run culminates in a peak and is followed by a correction. Bear this in mind, with the stock market close to its all time highs. That final peak may come tomorrow or a year later.

When it arrives, you should be braced for the end of the party. In a market trading close to its historic peak, volatility is high. As and when the trend reverses, momentary panic will lead to additional volatility.

Especially for traders, using borrowed capital and leverage, a trend change may be disastrous. Margin is inevitably raised and most traders are over-exposed and unable to meet margin calls. The broker gets spooked and cuts losing positions off.

Volatility in itself is not dangerous. If you've read the trend right, you make more money in a high-volatility market. Leverage is also neutral � it amplifies both gains and losses. But a combination of high volatility and high leverage is disastrous to the trader on the wrong side of the trend.

Traders avail of leverage in both spot and F&O segments. In spot, leverage comes through funding and day-traders are sometimes offered leverage of up to 10:1. F&Os are naturally leveraged and the leverage on a long option is theoretically infinite.

A note of caution is struck by Manish Bandi, Vice President, Wealth Advisory Services, India Infoline [Get Quote], who says "Global concern over inflation and the expected hike in interest rates globally may result in extremely high volatility in the market. In the present scenario, we do not advise retail investors to leverage in cash markets."

Other market analysts concur that a degree of overheating is visible. "There has been an excessive build up of positions. Investors are, therefore, advised to cut down positions according to their capacity to handle repercussions in the event of a fall-out." Dinesh Thakkar, CMD, Angel Broking.

The trader must be disciplined. Don't get greedy, set stop losses, and don't commit more than say, 5 per cent of capital to a given trade. According to Nihar Oza, vice-president, Brics Securities, you should not leverage more than 50 per cent of your own capital.

For example, if your trading capital is Rs 100, then Rs 40 should be assigned for completely-owned positions and Rs 40 for leveraged positions. The remaining Rs 20 should be held in cash as a cushion against mark-to-market differentials.

Here is a description of how margin works in spot and F&O segments. Margin trading and leverage are perhaps easiest explained through an example.

"We allow intra-day margin trading in a large basket of liquid shares and normally allow an exposure of five times (20 per cent margin)," claims Sudip Bandyopadhyay, CEO Reliance Money.

This 5:1 leverage ratio allows disproportionate profits and losses. Take Reliance Industries [Get Quote] at its current price of Rs 1728. You buy 500 shares of Reliance (value Rs 864,000) by paying only Rs 172,800 or 20 per cent of contract value.

If the stock price rises 2 per cent, the return is Rs 17,280 or 10 per cent appreciation on Rs 1,72,800. But leverage is double-edged. If the above position sees a 2 per cent price depreciation, that translates into a 10 per cent loss of capital.

Borrowing for delivery, brokers may fund anywhere between 50-80 per cent of a delivery position through affiliate financiers. The cost ranges between 18-22 per cent per annum. At 50 per cent funding, a 1 per cent rise translates into 2 per cent profit, less interest.

When there's a big trend reversal like in the crashes of May 2006 and March 2007, traders with highly leveraged long positions get wiped out. The graph shows, that an investment of Rs 100 in the Sensex in January 2007 would have dropped to Rs 85 during the crash of March 2007. But if you had 4:1 leverage, your losses would have been magnified to Rs 60.

Another important thing to remember is that small stocks mean big risk. Risks are usually higher in mid-caps and small-caps. When two stocks have the same average volatility, the variance of the smaller stock's returns is usually higher.

Smaller stocks fall more than the market index during crashes - they have high betas.

During the crash of May 2006, the BSE Midcap and BSE Smallcap were down 38 and 42 per cent respectively, much more than the Sensex fall of 29 per cent. Importantly, small counters also become illiquid and investors are often left without an exit option.

Apart from trading in the secondary markets, investors borrow money to apply for IPO, intending to sell allotments on listing. Finance companies charge about 18-20 per cent for IPO finance.

IPOs such as Mindtree Consulting [Get Quote], Nitin Fire and MIC Electronics have given massive gains on listing. And a holding period of 3-4 weeks means that an absolute gain of 10 per cent annualises to 120 per cent.

This is tempting but you need a clear understanding of IPO mechanics, over-subscription ratios, etc. Ambreesh Baliga, VP private client group, Karvy Stock Broking opines "I do not think leveraging in primary markets is a good idea when cost of funds is high".

If there isn't a gain on listing, you're left with a capital loss and an interest payment to service. Higher the subscription to an issue, lower are the allotments. This can mean a high per share cost (after accounting for interest charges) and hence higher is your break-even point. Take two contrasting examples. Nitin Fire offered 75 per cent gain on listing. Mudra Lifestyle [Get Quote] lost 30 per cent.

F&O margins: The NSE's F&O margin system relies on the SPAN model. It is like a black box: you plug in contract details and it spits out the required margin.

SPAN margin changes continuously and in addition, there's an exposure margin. SPAN adjusts for spreads and other combined F&O positions. The required margin is usually between 8-25 per cent on a futures position. It's a minimum 7.1 per cent for index futures and 10.5 per cent for stock futures.

On long options, there is no margin since the premium covers maximum loss. Option premiums are generally 1-2 per cent of contract value for close-to-money positions. Out-of-money short options require margins of between 7-15 per cent of contract value. Thus, margin on a short option is often 5 times as high as the premium.

Option leverage is much more variable than futures leverage. Suppose you have paid 1 percent of contract value to buy an option that is struck. The premium may double - even while the position is at break-even.

Futures offer symmetrical gain and loss. Suppose you commit Rs 200,000 to buy a stock and pay Rs 40,000 margin (@ 20 per cent) to take the corresponding short futures hedge. Whether the stock rises or drops, your total portfolio value stays the same. If you take an incomplete hedge (buy Rs 400,000 stock and pay Rs 40,000 @ 20% margin to take a single lot) your loss is halved but so is your profit.

Options offer more versatile hedges because loss-gain is asymmetric. For example, assume a Rs 200,000 stock position and buy a long put 1 per cent from money at 1.5 per cent premium.

Your maximum loss is 2.5 per cent if the stock drops 1 per cent and the premium doesn't rise. If the stock drops over 1 per cent, the option kicks in. On the upside, gains are unlimited once price has moved more than 2.5 per cent up.

Stock options, especially puts are illiquid. To hedge a stock position, in practice you will have to use index options.

This requires 1) computing beta and correlation for the given stock with the Nifty 2) using regression analysis to judge the "fit" of beta 3) taking an appropriate index option position that protects against an adverse move. This is cumbersome and never produces a complete hedge.

Conclusion: While margin and leverage are tempting, they are two-edged swords. Don't go overboard trying to maximise gains because you could end up with larger losses.

Reading F&O warnings

There are several volatility-related signals across F&O and spot markets that can offer advance warning when a market peak is round the corner.

IV signals Implied volatility always spikes when the market is close to a peak and it usually stays high until the crash is over. IV is usually low in a rising market.

In May 2004, as the market crashed, IV jumped from 25 per cent to 70 per cent. From September 2004 to March 2006 as the Nifty smoothly gained 105 per cent, IV stayed between 15-30 per cent. In May 2006, it spiked above 60 per cent as another crash occurred. On historical evidence, any Nifty IV reading of over 30 per cent is a danger signal.

Divergence in HV-IV: During an uptrend, the IV tends to be lower than the HV. Discount to HV is a good sign and a premium to HV appears to be a danger signal.

Stock futures OI: Another useful signal is the open interest in stock futures. A very high stock futures OI is a danger signal. Especially so if it comes in a market with falling volumes.  This combination of high OI and low spot volumes is a classic sign of a market top. A stock OI of around Rs 30,000 crore (Rs 300 billion) seems to be a danger signal.

Spot volumes A rising price should always be backed by high volumes that signify there is no easing in demand as price rises. Near a market peak, spot volumes usually decline and start thinning out - this signals that demand is dropping.

Breadth: A market where breadth is strong is a healthy bull market. Near a market peak, trading interest tends to narrow and declining shares start to outnumber advances.