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.

One strategy that could to benefit in this bearish trend would be the ’strip’ strategy. This strategy is considered the bear market adaptation of the ‘straddle‘ strategy. It’s developed on the concepts of ‘at-the-money’ and ‘in-the-money.’ Let us focus on the terms that require understanding before moving to the actual strategy.

Strike Price: The price at which the option holder can buy or sell the item underlying the option from the writer of that option.

Example
An ABC 50 call option gives the holder the right to purchase 100 shares of ABC stock at a price of Rs. 50 per share. On the other hand, an ABC 40 put option gives the holder the right to sell 100 shares of ABC at a price of Rs. 40 per share.

At-the-money: Options are defined ‘at the money’ when the common stock price is equal to the strike price.

In-the-money: A call option is defined ‘in the money’ when the strike price is less than the market price of the stock. A put option is in the money when the strike price is greater than the market price of the stock.

Ok, that’s clear, then? Let’s move ahead to our main plot.

Strip strategy involves buying a number of at-the-money calls and twice the number of puts of the same underlying stock, strike price, and expiration date.

Investors can take the most benefit from this strategy whenever the market has a bounce back. This could happen due to measures such as CRR rate cuts, Repo rate and Reverse Repo rate cuts, PLR and SLR rate cuts by the RBI to increase the liquidity for banks and investors, the government announcing stimulus packages for certain sectors, or steps taken by the US central bank to make the global financial market stabilize. This would be the right time to execute this strategy if, as an investor, you are convinced that it is a bear market relief rally and direction of the market in the near term is going to remain south.

Profit Potentiality: This strategy has the potential for 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 a downward move.

Risk: The risk is limited in this strategy. The maximum loss for the strip 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 customer losses the net premium and commissions paid.

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

• Upper break-even point (BEP) = Strike price of calls/puts + net premium paid

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

Example: ABC stock is trading at Rs. 2000 in December. An options trader implements a strip strategy buying two January puts for Rs. 120 per share as premium for strike price of Rs. 2000 and a January call for Rs. 100 per share as premium for the same strike price. The net debit taken to enter the trade is Rs. 34,000. The market lot size as 100 shares.

If ABC stock is trading at Rs. 2500 on expiration in January, the January puts will expire worthless but the January call expires in the money and has an intrinsic value of Rs. 50,000 (500 rise in per stock price x 100 lot size). Subtracting the initial debit of Rs. 34,000 the strip’s profit will be Rs. 16,000.

If ABC stock price reduces to Rs.1500 on expiration in January, the January call will expire worthless but the two January puts expires ‘in the money’ and possess intrinsic value of Rs. 1 lakh (i.e. Rs. 50,000 x 2 put options). Reducing the initial debit of Rs. 34,000 the strip’s profit will be Rs. 66,000.

On expiration in January, if ABC stock is still trading at Rs. 2000, both the January puts and the January call will expire worthless and strip will suffer the loss of the Rs. 34,000 paid as premium to enter the trade.
The 2 break-even points in this case will be:

• Upper break-even point = Rs.2000 (strike price) + Rs. 340 (Rs. 120 x 2 put premium + Rs. 100 call premium) = Rs. 2340.

• Lower break-even point = Rs.2000 (strike price) - Rs. 170 (Rs. 340 i.e. net premium/2) = Rs. 1830.

In this example the stock has to break the price band of Rs.1830 to Rs.2340 to be profitable i.e. decline below Rs. 1830 or appreciate beyond Rs. 2340. 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 strip strategy could be the right option-trading approach for investors who are bearish on the market and expect it to correct in 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.

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.

By now it’s a known fact that we are in midst of unprecedented global turmoil. India is surely not insulated from whatever is happening around the globe. To add to that we have our own local problems like high inflation, subdued IIP numbers, which in turn have posed a big threat to our GDP growth. Stock markets are bound to react to whatever is happening around the globe and there is no surprise that our own stock index has shaved off almost 50% from its peak much in line with other indexes around the world. Such is the retail investor psyche that these same buyers who were queuing up to buy at 21,000 odd levels now shudder at even the thought of investing in the market!

The fear is well warranted considering the uncertainty we are facing.

I don’t know where this will end or how much more downside we can eye from here. Not because I am ignorant but only because it should not matter for me as a long-term investor in the equity markets. Notwithstanding all the macro and micro gloomy data points together with the uncertainty hovering around, the fact remains that the current turmoil gives an excellent opportunity for an Investor to build a long-term portfolio in equity markets.

Yes, I do agree a lot will depend on the quality of stocks we pick in the portfolio. But here again, remember that investing is simple. It is only as complicated as you make it. Considering the fact that we are almost trading at 2-year lows on the Index, this is an excellent opportunity for first-time investors to build fresh exposure in the equity market. It surely doesn’t get better than this.

So, where does one start??

The index has shaved off more than 50% from its peak dragging with it all the heavy weight stocks.

In times like these it is always advisable to start building exposure in the markets through the frontline stocks for the following reasons:

1. These are fundamentally good stocks, available at attractive valuations. Typically, during periods of panic, market players tend to over-do the concerns surrounding the stocks pushing the prices much below their intrinsic value.
2. Whenever there is a reversal of trend in the markets, these stocks will be the first to bounce from their lows giving a sharp recovery

How can you take exposure to these stocks?
There are various ways in which you can start building exposure to these front liners:

• Index Funds: Index funds (passively managed funds) from mutual funds could be a good option. These could be funds tracking a particular index (say Nifty or Sensex).

• Diversified Equity Funds: One can have exposure to diversified equity fund schemes of mutual funds, where the exposure could be towards the blend of mid & large-cap funds as per the schemes’ objectives. But please make sure you check the top 20 holdings of the scheme you are planning to invest in, as your objective is to be a part of the frontline stocks.

• Nifty BeES: Nifty BeES is the first ETF (Exchange Traded Fund) in India.

The investment objective of Nifty BeES is to provide investment returns that, closely correspond to the total returns of securities as represented by the S&P CNX Nifty. Typically value of Nifty BeES will be 1/10th value of the prevailing Nifty price (For example, if Nifty is currently trading at 3500, Nifty BeES could be available @ 350) and it can be bought and sold on the National Stock Exchange like a share. In short, you buy/sell the broad Indian market using just 1 scrip.

• Direct Equities: You can even directly buy the stocks form the market in a staggered manner, provided you fully understand the nitty-gritty of investing in equities. If you don’t possess the requisite expertise, simply turn to a professional money manager.

Whatever may be your mode of investing make sure you do some serious investing at these levels. If you feel jittery to invest the entire chunk, start investing at least 30-40% of your investible surplus in equities. And remember always, that best of the investments are always made in the worst of the times.

Kapil Mokashi is an Associate Financial Planner, working with Sharekhan Ltd. as an equity advisor.

Like a drunkard who is wandering alone on the street trying to find a foot hold for his slippery feet, the Indian markets are no less choppy since the first month of the New Year ended the 3 year bull run party. When the 100 year old BSE Sensex hit 21113.13 on January 9th 2008 India was been viewed from Dalal Street to Wall Street as someone who has just driven at 100mph from 17000 to 21000 ,and with 25000 in touching distance. Anticipation seldom turns into reality, come 16th July 2008 BSE Sensex was 12514 a yearly low and 40% down from the top. With IPOs claiming to be multi-billion dollar projects in next five, ten and fifteen years and garnering over Rs 700000 crores, peons, school children, taxi drivers, the what nots, and the who’s who of the Indian economy wanted to apply. The only companies who would have made money would have been paper manufacturers, while Mother Nature was at receiving end for all the paper required to make 200-page red herring prospectuses (RHP).

With equity as an asset class going for a long random walk into oblivion, foreign institutional investors (FIIs), the usual market makers, who had put in close to $17 billion for the FY07, now, in the first six months of the CY08, have pulled out close to $7 billion. Usually bad follows bad but evil follows worse; the American housing bubble woes relentlessly made lives of economists, governors of central banks and heads of states lose sleep over deepening credit crises. The U.S. of A, which prides itself as John Rambo in the Middle East and central banker to the world, has already lost $500 billion in asset write-downs. Simply put, the things that were not affordable were made affordable to people who could not afford them; in other words, the houses for which the loans were taken turned bad value as borrowers defaulted and the subsequent MBSs (mortgage-backed securities) and ABSs (asset-back securities) markets who leverage themselves over these loans also defaulted. Then, with home loan default rising, interest rates rising, and slowing consumer demand, the unfaultable investment banks of Wall Street were getting jittery over their exposure to complex derivates products. Ultimately $500 billion in assets were written down on Wall Street with repercussions felt across the globe.

The regular oil and inflation shock has started to generate fewer tremors as their pace of growth has come off recently. Oil in last couple of weeks has been hovering at sub $110 levels and domestic WPI inflation at sub 13% levels. The booming GDP growth made India hit the $1 trillion economy club, with fiscal year 2007-2008 hitting 9.1% growth. Certainly now with the equity markets off hugely, capital expenditure for India Inc has become a huge question - rising interest costs will make longer-term capital intensive projects in the infrastructure space unviable. The IPO market, also the primary market to raise equity, has also dried up as investors have lost confidence to invest in new unlisted companies.

Estimates of $350-$400 billion have been made for lessening India’s infrastructure woes, and the bill is to be footed via the PPP (public private partnership) route. What remains to be seen is whether the big boys of India Inc ready to participate and does the FDI still hold India in high regard. The nuclear deal has been signed, which comes as a good sign for an energy-hungry country which according to government estimates will require an installed capacity of over 200,000 MW by 2012 to meet its electricity demand, 60 percent more than what the country currently has. India envisages providing electricity to all households including 234 million families living below the poverty line and electrifying around 115,000 villages by 2009.

Certainly all this looks a daunting task to accomplish and only strong jolt of foreign capital flows, relaxed government policies, and wish to take India global with domestic companies a lot of dope is required to put India back on track.

Anurag Sharma is a Research Associate at Padmakshi Financials Services Limited.