The ‘Strap’ strategy is one that can be beneficial in a bullish market. This is the bullish adaptation of the straddle strategy. It involves buying a number of at-the-money puts and twice that number of calls of the same underlying stock, at the same strike price and expiration date.

This strategy will play a vital role to earn good profits from equity/commodity markets when our GDP numbers are getting stronger, micro and macro economic indicators are stabilizing and improving, profits and sales are increasing, and FII/HNI participation to invest in these markets. In the near term, it seems difficult to implement this strategy since market is in bear mode. But economists expect a clearer picture of economic growth by end of Q2, 2009 for the BRIC (Brazil, Russia, India, China) countries. So, keep the knowledge of this strategy in the mean time and implement it at the right time to gain the advantage - when you are convinced that it is a bull market rally and direction of the market in near term will remain upwards.

Profit Potentiality: This strategy has the potential to create large amounts of profit when the underlying stock price makes a strong move either upwards or downwards at expiration, with greater gains to be made with an upward move.

Risk: The risk is limited in this strategy. The maximum loss for the strap occurs when the underlying stock price on expiration date is trading at the strike price of the call and put options purchased. At this price, all the options expire worthless and the options trader losses the net premium and commissions paid to enter the trade.

Computation of break-even points:

There are 2 break-even points for the strap option strategy. The break-even points can be computed as given below:

• Upper break-even point = Strike price of calls/puts + (Net premium paid/2)
• Lower break-even point = Strike price of calls/puts - Net premium paid

Example:

Consider, ABC stock is trading at Rs. 1000 in December. An options trader implements a strap by buying two January calls for Rs. 60 per share as premium for strike price of Rs. 1000 and a January put for Rs. 50 per share as premium for strike price of Rs. 1000. The net debit taken to enter the trade is Rs. 17000. Assume market lot size as 100 shares.

If ABC stock price reduces to Rs.500 on expiration in January, the January call will expire worthless but the January put expires in-the-money and possesses intrinsic value of Rs. 50,000 (Rs. 500 decline is stock price x 100 lot size). Reducing the initial debit of Rs.17000 the strap’s profit will be Rs.33000.

If ABC stock is trading at Rs.1500 on expiration in January, the January puts will expire worthless but the January two call expires in the money and has an intrinsic value of 1 lakh (i.e. Rs. 50000 x 2 call options). Reducing the initial debit of Rs. 17000 the strap’s profit will be Rs. 83000.

On expiration in January, if ABC stock is still trading at Rs. 1000, both the January puts and the January call will expire worthless and strap will suffer the loss of the Rs.17000 that was paid as premium to enter the trade.

The 2 break-even point in this case will be:

• Upper break-even point = Rs. 1000 (strike price) + Rs. 85 (Net premium paid /2) = Rs. 1085.
• Lower break-even point = Rs. 1000 (strike price) - Rs. 170 (Rs. 60 x 2 call premium + Rs. 50 put premium) = Rs. 830.

In this example the stock has to break the price band of Rs. 830 to Rs. 1085 to be profitable i.e. decline below Rs. 830 or appreciate beyond Rs. 1085. If the stock price fails to break the price band upper and lower BEP investors will end up losing the entire premium paid for executing this strategy.

The strap strategy can be the right option-trading approach for investors who are bullish on the market and expect it to move upwards in the near future.

On vacation earlier this month my wife and I visited a casino during an evening with friends. We were clearly the poorest of our group. We started setting a limit to the amount we would lose that evening. Like all our friends, we lost. The difference in amounts lost was just a matter of decimals.

The losses showed us who paid for plush setting of the casino, good liquor and food, served “free.”

The capital markets are in some ways akin to a casino. Large advertisements by merchant bankers, stockbrokers and mutual funds are paid for - by the person in your mirror.

I have written earlier about methods of analysis. At the risk of repeating them, then: they are fundamental, technical, and logical. Call them the three guides to making money.

Three ways of losing money would be:

1. Gambling on horses, cards or at the casino - the fastest

2. Women - the most pleasant

3. Speculating on the stock market - the most certain and definitely the most boring

Add to these, a fourth - watching too much TV or reading too many expert opinions, mine included. Rewind to the beginning of the last boom and early April 2003 when the jokers on TV suggested a drop to 2,200 for the Sensex from 2,800. Less than a fortnight later, this same bunch was speaking of the Sensex going up to 6,000. There had been no fundamental change during those two weeks.

Fast forward to January 2008: 25,000 was almost the overnight target, 40,000 in the rather near future, for the Sensex (which was then at 21,000). During a meeting with a brilliant fund manager recently, he showed me a clip from a TV channel. It had a number of the most respected names in the capital markets providing sound bites on the Sensex crossing 20,000. Everyone was advocating a buying spree. There was to be no end to the boom.

Now the same purveyors of garbage suggest 6,000 and lower. The difference is that we have a fundamental change in lower earning forecasts, which was obvious even before Diwali 2007 when the index was around 20,000. Will the experts be correct in their bearish forecast? Unlikely for an extended period, would be my guess.

Yes, they will be for a few days, or weeks. Fear and the memory of recent losses will ensure the investor will refrain from committing fresh money to the markets. But the smart money that exited the markets in January, close to their peak PE of 30 on the Sensex will nibble at choice stocks on offer, now at a market PE of about 10. Along the way will be opportunities to grab at the feast table - opportunities such as a payment crisis, the failure of a large institution, announcement of elections or formation of a Government, when shrill loudmouths, only distinguishable by their shrillness, from Mayavathi, Jayalalitha, Mamta Banerjee, Yechury, and the Karats confirm their idiocy on TV. Each occasion such as the ones mentioned above that causes a temporarily sinking Sensex, the smart money will refill its pockets with the crème de la crème of the equity markets.

Start loosening your purse strings in bits and build a quality portfolio. Take a couple of years doing that, for the opportunity cost of money in a stagnant market would mean an erosion of 50% of your money’s risk-adjusted value in 3 or 4 years. At 10%, the current bank FD rates, your money doubles in about 7 years. Expecting double that rate of return on equity investments is fair considering the market risk, thus leading to my above assumption. However, the markets might just surprise and double next year or stay flat till 2015. I am not gambling on the time frame!

Getting into an SIP in mutual funds, or directly in a personal portfolio is a good idea now. This will likely be a good sum in 10 years, if not sooner.

Meanwhile, if you decide to visit that casino carry just as much cash as you believe you’d pay for a nice evening. You will also find that it’s a lot more fun losing it yourself, than on the advise of an expert.

Naveen Fernandes is Vice President - Sales at Orbis Financial Corporation Ltd., a SEBI approved custodian. He is a Certified Financial Planner. On good days, he fancies himself an investment expert.

In my last article I had mentioned that there are several methods, or styles, to investing profitably in the equity markets.

Let me start with suggesting that you, the potential investor, spend some time analysing your investments. If one were to assume that your money is indeed “hard earned”, would it not be unfortunate if is easily lost?

Most professional advisors compare their performance to benchmarks, which are indices. For example, if a fund generated returns of 20%, while its benchmark’s returns were 15%, this “outperformance” of the index by 5% is called an ‘Alpha’. This is a good measure to evaluate fund performance, provided the benchmark is reliable. If reliable, it would be a good measure to evaluate even personal portfolios returns.

The BSE Sensitivity Index of 30 shares is the most popular Indian stock market index. If one were to track this over 5 year periods, starting in 1992 (this is the year of the infamous Harshad Mehta boom, which is a relevant beginning simply because this is the first time there was retail participation in the capital markets), we would find that pre-2003 (the start of the latest boom), the index returned less than bank FDs. Even if we go from 1992 to the current date, the index returns are disappointing. This should indicate that equities are a poor long term investment, but are actually among the best options!

In fact, a well diversified portfolio, built over time and given a few years, at reasonable valuations (PE of close to 10, certainly lower than the Sensex’s long term average of 14 times) will outperform the benchmark or almost any other investment. The great Warren Buffet, however, considers that “wide diversification is only required when investors do not understand what they are doing”. If you know, and you need to know, why you make an investment, you should also have guts to invest plenty in it. Again, quoting Mr. Buffet, “Why not invest your assets in the companies you really like? As Mae West said, “Too much of a good thing can be wonderful.””

Diversification or concentration of portfolios can be achieved through investments in mutual funds. Concentration is through sectoral or thematic funds. Concentration is good only if you are an expert and can time your entry and, more importantly, your exits. Avoid being carried away by the noise. Most fund managers consider themselves to be God’s Greatest Gift to Investments (GGGI) in a bull market. However, when they crash with the markets they are quick to point to outperformance, if any, on the index, i.e. “The index has fallen 30%, but I have been brilliant and have lost only 25% of your money”. I have not met any investor who hands out money to be lost, whatever the market conditions. My advice is to ignore the froth from the fund managers, or brokers. If you are convinced the market is cheap, put in all your money. In an uncertain market do an SIP. But when the market seems overvalued sell. (By the way, have you ever heard a fund manager advice you to sell, or redeem your units in a bull market?) A crash always follows a euphoric bubble. Cash is supreme in bad times. It is a good feeling, and also very profitable to buy when the market is down 70%!!

Is this a good time to invest? Yes and no. An important lesson from Joseph Kennedy, almost a century old, is to sell when the shoe-shine boy gives stock tips. I believe this is true today. When the taxi driver is thrilled to take you to the share bazaar and asks for stock tips en route, the stranger at the party gives you sure shot stock bets and the daily newspaper has headlines of the local housewives club betting their grocery money on stocks – GET OUT. This is the best signal to sell your shares.

And buying? This would be when that party animal with best buys stops partying, the Big Bull has jumped off the 13th Floor and there is a funereal feeling at Dalal Street. Buy when the mention of a good company has people grit their teeth and give you dirty looks. And, of course, the index has a low, mouth watering PE!

One of my own gurus told me never to confuse the market with stocks. “The market is irrelevant”, he said, “buy the right stocks and you will always make money.” If you have his stock picking skills, which I do not, this article is not for you. If you are one of the simple folk, hoping to beat inflation and make a little money on your savings, the market at over 18 PE all this week (18.80 on Nifty on September 4, 2008) remains expensive. Look then for gems that might become multi-baggers.

Otherwise hang on to your precious cash. A better day to buy will dawn, when PEs are closer to 10 than 20. Get into SIP mode then. Market corrections can be both deep and long. Losing opportunity (interest cost of your money) is about as unfortunate as losing capital.

Naveen Fernandes is a Certified Financial Planner and Vice-president, Orbis Financial Corporation Ltd, Mumbai. Orbis Financial is a SEBI-approved custodian.