Today, the equity market has been discounted by almost 50% from its peak. Investors are bearish to enter in this market. In the current scenario Indian equity markets are reacting with global cues. So, any positive cue of stabilization in global markets will start showing uptrend in our markets too. To take the advantage of this uptrend with minimum risk exposure in these scenario investors should follow the 90/10 strategy which will keep them in the loop. Now, there might be few questions rising in the mind of investors such as, what is 90/10 strategy? How they will be benefiting with this strategy?
Basically, the 90/10 strategy involves purchasing calls on the same number of shares of stock that would have been purchased outright, then investing the difference in a fixed income security such as government bonds. The name of the strategy is derived from the most common proportion in which the investments are allocated: 90 percent in government bonds and 10 percent in index or stock call options. This strategy is particularly appropriate for an investor who is not interested to risk his/her capital by investing in the stock market but wishes to participate in the growth of the stock market with limited risk exposure. Interest on the government bonds covers part of the possible loss on the calls. This strategy permits the investor to benefit from favorable stock price movements while limiting the downside risk to the call premium less any interest earned. It is particularly effective approach in periods of high interest rates because of greater interest income.
Example:
The common stock of ABC sells at Rs. 2000 per share. The purchase of 100 shares will cost Rs. 200,000. Let’s also assume that this investor’s upper limit on investment is Rs. 200,000.
Now, let’s assume that the stock call option’s strike price is fixed at Rs. 2000 per share, with a premium of Rs 200 per share. Therefore, if the investor wants to buy the hundred shares it would cost him/her just Rs. 20000. This, in turn, would leave him/her Rs. 180,000 to be invested in something safer, such as government bonds.
Suppose the government bonds mature in six months and earn 6 percent interest. The Rs. 180,000 would earn interest of Rs. 5400 (Rs. 1,80,000 x 0.06 x 6/12). This interest reduces the investor’s cost of the call to Rs. 14600 (Rs. 20000 - Rs. 5400). The Rs. 14600 also represents the investors maximum risk exposure compared to the Rs. 200,000 cost if the 100 shares were purchased outright.
The beauty of this strategy is that although the risk is limited, the potential capital appreciation is not. Once the market price of ABC increases beyond the strike price, the call buyer could realize the same rupee appreciation at expiration as that of an investor who owns 100 shares of the common stock. Therefore, this strategy limits risk to the net cost of the call while still enabling investors to realize capital appreciation.
October 22nd, 2008 at 7:03 pm
Well, the article looks good on paper…. but potential loss on buying Calls if one considers Time Value should not be ruled out.
If you say market has fallen 50% from peak and stocks are cheap then why buy calls?
Moreover, if stocks are cheap than 6% Govt bonds does not make sense at all!
The way the market has fallen, from here with few hiccups….most good companies would give superb returns.!
So. buy in cash market & be 100% in equity …. avoid business channels.!
October 22nd, 2008 at 11:56 pm
Hi,
I liked this article as this is very good and gives such an excellent idea in this type of market condition.
Thanks a lot
Jethanand Kamra
October 24th, 2008 at 2:15 pm
Hi hiral,
Good explanation you had given…. Keep it up and nice to read your article.
Best Regards,
Jugal.
October 29th, 2008 at 11:54 pm
Hi,
Better way of investment.One question arises over here is that on the date of expiry if the call option of that ABC share falls from 2000 to 1000 i.e. 50% of the original value considering the premium falling to Rs.100, then the total loss would be around 10000, if the option have to be exercised on the expiry date.
Also the expiry of the options should have been considered.
It would be a great help from your side if you can explain with taking the expiry of options into accpunt.
Regards,
Prashant.Mishra
November 13th, 2008 at 9:43 am
I’m just glad mortgage rates are dropping here in Australia, after the constant rises under the previous conservative government, it’s nice to be paying a little less at last!
November 20th, 2008 at 1:14 pm
Hi Prashant,
I think the answer lies in your question itself. Consider, the premium has declined to Rs.100 i.e. 50 % drop on the expiry date. The investor could sell the option to partially offset the Rs.20,000 premium, and the loss would be Rs.10,000. If, one did not take action, and the option expired worthless, the loss would be the total amount of the premium paid i.e. Rs.20,000.
I hope I have answered your query. If, you any further question feel free to approach me.
Regards,
Hiral Thanawala
December 18th, 2008 at 12:52 pm
Dear Hiral
I have done this strategy. I am Portfolio manager I have applied stategy but what I feel that Time value of money concept and you know In India option market is not so much active or as much like futures and cash market so this can not be worked out some times but its good. So Isn’t you agree that call market is not so much active here?????????????
Thanks
Dhaval Sheth
09825320373
December 18th, 2008 at 1:31 pm
So does you stand remain the same in today’s environment of the equity market.
December 19th, 2008 at 4:39 pm
Ya Offcourse manisha Equity market you know very long term instrument to make wealth. It depends how you select stock and hold next 2 to 3 years. Buy the stock at darkness and sell tham at euphoria which will create wealth for you. It is long term good buying opportunity.