The equity markets were up with a bang. The bulls had a party and celebrations post Diwali festival. It is considered as a remarkable recovery from the bottom. Well, it seems difficult to talk about whether this bull party will last for a long time. Global economic issues have still not been resolved and how much of that it’s going to affect other emerging markets, including India, is difficult to predict. The markets are facing many negative news and higher volatility in the day-to-day sessions. It’s getting difficult for investors to take a position in these market conditions. This is where the straddle strategy will play a vital role for the investors to hedge the position and profit from it.

This strategy is built on the concept of call and put options. Let’s understand what these mean before going in-depth to understand straddle.

Call Options - A call option gives its holder the right to buy a specified number of shares of the underlying stock at a predetermined price (strike price) between the date of purchase and the option’s expiration date.

Example: An investor who bought an ABC December 1000 call option would have the right, but not the obligation, to buy 100 shares of ABC common stock at a cost of Rs. 1000 per share at any time before the option expires in December.

The right to purchase common stock at a fixed price becomes more valuable as the price of the underlying common stock increases in the bullish trend.

Put Options - A put gives the holder the right to sell a specified number of shares of the underlying common stock at a predetermined price (strike price) on or before the expiration date of the contract.

Example: An investor who bought an ABC December 1000 put option would have the right, but not the obligation, to sell 100 shares of ABC common stock at a cost of Rs. 1000 per share at any time before the option expires in December.

The right to sell common stock at a fixed price becomes more valuable as the price of the underlying common stock decreases in the bearish trend.

Now let’s understand how the straddle strategy operates for investors. Fundamentally, a straddle is the simultaneous purchase of a call and a put on the same stock, with the identical strike price (the price at which the holder can sell or buy from the writer of the option) and expiration month. Typically, the buyer of a straddle anticipates a substantial movement in a stock but is uncertain what the direction will be. Because the investor is betting on an extraordinary stock movement in this the volatile markets. The probability of profiting is good.

A straddle buyer risks losing only the amount of premium (the price that the buyer of an option pays and the writer of the option receives). The maximum loss occurs only if the price of the stock on the expiration date of the options is exactly equal to the strike price. Although it is difficult to lose the entire premium paid for the straddle, it also can be difficult to make a profit. Either the put or the call side of a straddle is almost certain to expire worthless. As, a result, the stock has to move substantially for a profit to be made. Considering the trend of last few trading sessions there were many intense moves for investor. Therefore, it’s considered one of the best strategies to bet on these volatile markets, where the swing in stock prices to different levels in multiple/one trading session gives the opportunity for investors to fill their bag full of profits.

Example:

An investor purchases both a put and a call on a stock, paying Rs. 250 for the call and Rs. 200 for the put. Therefore, the total premium cost would be Rs. 450. Suppose the underlying stock’s price is Rs. 3000 and the strike price of the options is Rs. 3000. If the price of the stock rises above Rs. 3450 or drops below Rs. 2550, the investor will make a profit. Only if the stock expires at a strike price of Rs. 3000 will the investor lose the entire investment. The investor loses only part of the investment at any other price between Rs. 2550 and Rs. 3450.

The investor earns a profit if the stock sells at a price exceeding Rs. 3450 or drops to less than Rs. 2550. If the stock rises to Rs. 3750 per share and the investor exercises the call at Rs. 3000, the investors profit is Rs. 300 (Rs. 750 - Rs. 450 premium). Alternatively, if the stock drops to Rs. 2150 per share and the investor exercises his/her put at Rs. 3000, the profit is Rs. 400 (Rs. 850 - Rs. 450 premium). Thus, the investor is assured of a profit only if the stock moves by more than Rs. 450 in either direction.

The above strategy and example were discussed considering equity markets. This strategy is also useful to hedge a position on commodities in commodity market.

The current scenario of equity, commodity and forex markets is very volatile. It’s extremely difficult for investors to speculate the direction where the market is heading. There are many investors on the global platform trading in the futures market. It is considered to be most risky and speculative of all the markets. Let’s go in little depth to understand the term futures market and its function before actually going to the concept of leverage.
Basically, a futures contract is an agreement between two parties that commits one party to sell a security or commodity to the other at a given price and on a specified future date. This makes it possible to transfer the risk from those who want to avoid it (hedgers) to those who are willing to accept it (speculators). Hedgers can be individuals or firms that make purchases and sales in the futures market solely for the purpose of establishing a price level months in advance for something they later intend to buy or sell in the cash market. Their sole purpose is to protect themselves against the risk of an unfavorable price change in the interim.

Example:
An individual enters into a futures contract to sell 100 shares of ABC Ltd. at Rs.1000 each after one month in the futures exchange. This contract protects the price he/she is intending to get for this stock in the period of one month.
With the basic plot of the futures market clear it will be easier to understand the concept of leverage in the futures market and why it is a double-edged sword. The leverage of futures trading results from the fact that only a relatively small amount of money (known as initial margin) is required to buy or sell a futures contract. For example, a deposit of only Rs.100,000 might enable an investor to buy a futures contract representing Rs.1,500,000 worth of a particular stock/commodity. The initial margin is typically 5 to 15 percent of the value of the underlying contract, although in some cases it is even more or less. The smaller the margin in relationship to the value of the futures contract, the greater will be the leverage and risk.

High leverage can produce large profits when compared to the initial margin if the speculator correctly anticipates the future price change. Alternatively, if prices move in the opposite direction from what was anticipated, the result would be large losses. Thus, the double-edged sword.

Another Example:
An investor anticipates rising stock prices and buys one December Nifty index futures contract (lot size: 100) at a time when the S&P Nifty is trading at 2800. The initial margin required is Rs.28000 (assuming 10% margin cost). The value of the Nifty futures contract is calculated by multiplying the current level of the S&P Nifty by 100 (the lot size) i.e. the contract value is Rs.280,000 (100 x 2800); each point change in the index represents Rs.100 gain or loss.
Therefore, an increase in the index from 2800 to 2850 would increase the investment (50 x Rs.100 per point) Rs.285,000 i.e. a profit of Rs.5,000. A decrease of S&P Nifty from 2800 to 2400 during a contract period in this volatile markets would wipe out the investment to (400 x Rs.100 per point) Rs.240,000 i.e. a loss of Rs.40,000.
Although, a futures contract provides exactly the same actual profit as owning or selling short the actual securities or commodities represented by the contract, the low initial margin magnifies the percentage profit or loss potential. So, it can be concluded that in this market, speculators must be prepared for the possibility of losing their investment in a single day. An investor who is not reconciled to that possibility should avoid this market altogether.

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.

We read it in the papers, see it in the news, hear about it everyday - ABC bank has gone bust; they are waiting for XYZ bank to be taken over etc.

What is happening with these companies and how did it all start?

Let us look at the basics of how this started.

For banks (lenders): About four years ago, banks came up with a new financial product and found that they could package the loans or other assets on their balance sheet and sell them in return for immediate liquidity. This would give them liquid funds which could be lent further to increase business.

Hence, with more funds at their disposal, they started lending more money, even to people who would not have been eligible borrowers otherwise. Loans were made to to people who did not have perfect or good credit history or a steady income stream; these were called sub-prime loans. Slowly various others such products related to loans were created and gained popularity; these products had higher risk but also higher returns for banks.
Meanwhile property prices were soaring. A look at the statistics shows property prices in the US (where this problem is the biggest) rose 53% in the five years ended December 2007. People, on the other hand, had started buying more homes with mortgage loans, now easily available from banks. The rise in property prices was not entirely due to healthy demand and supply factors, but more due to this easily available money. This fueled the construction industry, property markets, etc.

For investing companies (which included banks): The loans that were packaged (securitized) and sold by banks were held as collateral against which securities were issued to investors (which are generally financial companies). These securities, called asset backed securities (ABS), could be traded in the secondary market. The repayments on the loans that were held as the collateral would provide for returns and principal repayment to these investors.

Start of the crisis: As interest rates kept increasing, the monthly installments payable by mortgage loan borrowers started rising. Slowly, borrowers started defaulting on their loan repayments. This raised the level of non-performing assets or problem loans for banks.
These defaults also led to disturbance in the cash flow to ABS investors. The risks related to this type of securities increased and their market value consequently decreased. The investors started incurring losses which decreased the viability of these securities. Soon the market for these securities slackened and losses (both realized and marked to market) started eating into investors’ profits and affected capital negatively.
Besides, banks could no longer easily securitize their assets. This led to lower availability of funds and hence low business volumes. Since loan disbursement was now selective, investment in property was lower and property prices started declining due to lack of demand. This in turn decreased the value of collateral for mortgage loans given by banks and increased the risk attached.

Securitization of loans led to more funds with banks, higher and riskier lending, defaults on repayments, losses for banks and ABS investors which made a large hit on profits and capital. All these things were hence interlinked and one after the other led to weakening of the entire system.

Thanks to the more-than-adequate regulation by the RBI this has not happened in India. However, let’s see how much this affects Indian Banks and the economy indirectly.

Personal loans are gaining popularity among loan seekers in a big way. Be it planning a vacation or getting you daughter married, down payment of your new house or medical obligations, a personal loan may be used for any purpose. A personal loan may be a secured or an unsecured loan where the end use of the money is not supposed to be declared while taking the loan. The rate for unsecured personal loans ranges from about 15 % to 25 % per annum depending up on the credit history and the income of the loan seeker. This type of personal loan is more popular among the public.

The problem begins when people take these kinds of loans for investments into various instruments including equities. Markets have been pretty volatile for last few months and are expected to behave the same for quite some time. So if you planning to take a personal loan and invest in to equities of mutual funds thinking that the markets are at low then think again. The inflation rate has been moving up. The last numbers posted was well above 12%. With the growth in the Gross Domestic Product (GDP) around 8% to 9% the economy may see a negative growth in the current fiscal. The Reserve Bank of India has tried to tighten the liquidity situation by increasing the Cash Reserve Ratio (CRR) by 50 basis points. They may increase it by another 50 to 100 basis points if needed to keep a check on the inflation numbers. The condition worsens if the loan you have taken is on a floating interest rate. You end up losing money in the equity markets and pay more towards the loan at the same time. This is like being the rope in a tug of-war match where both sides are trying to pull you towards themselves to the fullest.

A better way to invest into equity market is by the way of arbitrage. It is buying in the cash market using the loan amount taken and selling it in derivative market by way of futures at a price which is more than the price bought added with the interest amount. On the day of maturity you reverse your position on both the markets and difference of the amount over and above the cash market price added with interest on the loan and the price sold in the futures market is your profit.

To explain arbitrage lets take the following example.

One lot of Reliance Industries Limited (RIL) is of 75 shares. Suppose the price of one RIL share is Rs. 2200 on 1st July, 2008. The maturity is on 31st July, 2008. The total amount of loan of 75 shares is (2200*75) = Rs. 165000. If the interest rate is 18% per annum then for one month the amount of interest is (165000*1.5%) = Rs. 2475 which is (2475/75) = Rs. 33 per share. Thus you need to short one lot of Reliance at any price which is more than (2200+33) = Rs. 2233. If you manage to short at a price say Rs. 2250, then you make a profit of (17*75) = Rs. 1275 on one lot which is almost 9.3% per annum. Now no matter what the price is on the expiry, you will manage to earn the amount stated above as you have already squared off your position.

The main thing over here is to find the right price to buy in the cash market and sell in the futures market. If you manage to hit the right price over the screen, then bingo! You have made money where everyone is losing it.

A covered call is an option strategy in which an investor buys an asset (long position in a stock) from the cash market and writes (sells or takes a short position) call options in the derivatives segment on the same asset. The potential obligation to deliver the stock is covered by the underlying stock in the portfolio; hence it is called a “covered” position. It is also called a “buy-write.” A buyer of a call option has the right, but not an obligation to buy the underlying asset. If one buys (i.e. goes long) a call option one is bullish on the asset, means he/she expecting the market to rise. In case one writes (sells or goes short) a call option, he/she is bearish on the asset, expecting the market to fall.

Let’s understand with an example how a covered call works.
ABC Ltd. shares are being traded at Rs. 38 (cash market price/spot price) and the June 40 call (strike price/exercise price) is being sold at a premium of Rs. 3. As one writes a call option, one receives the premium of Rs. 3. The maximum profit one can receive in this exercise is Rs. 5 i.e. the difference between the prices and the premium one receives writing the call. Now, if the spot price is, say, Rs. 42, the option will not be exercised, and what one receives is the premium amount only. Unlimited risk is not possible as one owes the underlying stock. One needs to buy minimum shares in the cash market equal to the lot size of that particular call option.

One of three situations can occur:

• If the shares trade below the strike price, i.e. Rs.40, the option will expire worthless and what one receives is the premium from the option. In this case, one has outperformed the stock.
• If the share prices fall, the option expires worthless and what one gains is the premium; again one has outperformed the stock.
• If the share prices rise beyond Rs.40, the option is exercised. One loses in the option market, but gains in the cash market.

In options we have two values i.e. Intrinsic Value and the Time Value. If the stock is traded at Rs. 42, the June 40 call will have an intrinsic value of Rs. 2. If the calls are traded at Rs. 5 premium then the difference, i.e. Rs. 3, is the time value for the June 40 call.

The advantages of covered calls are that one can reduce the average cost of a stock in the portfolio and can generate income from the option premium. It is a strategy preferred by risk-averse investors. Normally, investors do it when they plan to sell a stock at a predetermined price. In such cases, the call written by them imposes self-discipline as it ensures that the stock is sold as a planned strategy. They enjoy the premium from the call options and the dividends till the time they hold the stock. The disadvantages are limited profits and the potential gains from the increase in the stock price (cash market) above the exercise prices are foregone. While using this strategy the trading costs should be taken in to account. A covered call strategy can be best used when one does not expect much movement in the stock price.

The author is a Research Analyst working at Apnaloan.com Services (P) Limited

Markets have been choppy for quite sometime now. The gap up and the gap downs have been happening more than often. The bounce back from the day’s low to the correction from the day’s high is a normal phenomenon these days. It is becoming really tough for anyone to predict the movements of the markets as the markets have mastered the art of taking everyone by surprise.

Now what to do in these kind of markets? Quite often I hear people saying that investments in equities should be done with a long term horizon and these short term corrections should not be a thing to worry about. I stand of the same opinion and completely agree to it that one should invest into equities with a long term horizon. But there are times when the markets dip to extremely low levels. The capital gains over more than a year or so is wiped of in less than a week.

The best way to save your money is by keeping your portfolio hedged. The simplest way to hedge your portfolio is by selling index futures. This essentially means that you sell index futures of the amount of the portfolio you have taking into consideration the beta of your portfolio.

Let’s look at an example to understand it better.
Suppose you have a portfolio with a value of Rs. 5 lakhs and the current value of the Nifty is 5000. The lot size for one Nifty future is 50 and the lot size for a mini Nifty is 20. The beta of the portfolio with regards to Nifty Fifty is of 1.2. A beta of 1.2 of your portfolio means that there will be a 1.2% change in the value of your portfolio for every percent change in the value of the Nifty Fifty.

Now you need to sell index futures worth (500000 * 1.2) = Rs. 600000.
The nifty spot is 5000. So you need to sell (600000/5000) = 120 Nifty. Lot size of Nifty Fifty is 50 and lot size of mini Nifty is 20. So you can sell 2 lots of Nifty and one lot of mini nifty.

This will help you to gain in both scenarios - of the market going in either direction. If the markets correct from here and you lose money on your portfolio, you will gain from the index future you have sold. If the markets go up from this point, you gain from the value of increase in your portfolio. And since the beta of your portfolio is 1.2 then you will stand to gain more as the increase in the value of the portfolio will be more than the increase in the value of the Nifty.

So, on expiry, irrespective of the markets moving in any direction you will tend to gain more if you have hedged your portfolio properly than by keeping you portfolio without hedging.

The author is a Research Analyst working at Apnaloan.com Services (P) Limited.