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.

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.

I had just started college in 1981. Some saved pocket money and small prizes added up to Rs. 125, which became my first investment in shares. 3 years later I got out of college with some education, a portfolio of about Rs. 10,000 and a lesson in keeping my mouth shut…Knowing my dad also had some investments in shares (from the addresses on the mail) I mentioned a particular stock at home. Dad promptly took me out and warned me never to speak of shares in my grandmother’s hearing. The belief was that investing in shares was as big a sin as gambling – anathema for a small town middle class family.

Stories of legendary wealth created from investments (Warren Buffet, according to an email doing its regular rounds, started at age 11 and used profits to buy a farm at 14, to turning into one of the richest men in the world), to tales of suicides by big losers would suggest that investments in shares is gambling and that the stock market is a huge gambling den. Is it?

Starting at the beginning, what is a share? If I may use examples, a person starting a small business could use his/her money, if a little more money were needed. He/she could rope in friends as partners, or borrow from banks, but would be hard-pressed if the capital required were substantially larger. Such a businessman could split the entire owners’ capital into small units, of normally Rs. 10 and sell it to a large number of ‘investors’, each being a partner in the business to the extent of the money invested (’shares’ bought). The business would be in the form of a ‘Joint Stock Company’ (Company).

The share market? If the investor, from my previous paragraph, had invested in a share of a profitable company, others interested in being a part of the venture would try to buy shares in that company. This would take the prices up. Conversely, if the company were not profitable the holders would try to sell it bringing down the price of the shares. The share market is a forum that facilitates and controls the transactions, to ensure the investors’ transactions are safeguarded.

This does not mean that the stock exchange guarantees profits to all investors. Every transaction of a share bought involves another where a share is sold (shares are not created at will). While the buyer would purchase a share expecting the price to go up, the seller would expect it to drop. One would be right. The Stock Exchange is a place where a seller can find a buyer. The Exchange also ensures that the buyer receives his shares and seller his payment.

Returning to the beginning and my grandmother? How is investing different from gambling? While gambling involves chance (I do not know anything more about gambling in any form), investing involves the science of numbers. All stocks traded (stocks are bundles of shares) are at a price. This price is normally based on measurable factors, including but not limited to the profit of the company (from which is derived the profit per share, also called Earnings per Share or EPS), Book Value (which indicates the amount of profit plowed back in the business), ROE (Return on Equity) and ROCE (Return on Capital Employed, showing how well money has been used to make profits by the Company). Out of these come other ratios relevant to the price, like PE (Price/ Earnings, a fundamental value), PEG (PE/ Growth), P/BV (Price/ Book Value) and others. The market becomes a casino when these values are ignored and shares are bought because it is fashionable to have some!

The guru of investors, Warren Buffet, has said that he considers ROE, followed by PE, the most important values.

Returns are the most important simply because that is the reason for any investment. With a number of options available, the investor would be unwise to use the less profitable. Therefore, knowing that your company earns reasonable returns on the money invested in its business (Return on Equity and Return on Capital Employed) is the basic parameter to value a company and its share.

PE tells us the price we pay for the returns. Simply PE is the number of years it takes to get your investment back as profits, at the present rate of profit. Obviously the investor would like to recover his investment early, so a small PE would normally be better. An example, most small businesses are started with loans from parents or uncles, autorickshaws, fruit juice stalls, vegetable vending and the like, which are numerous successful businesses in India. The loans are taken with a promise to repay (mostly honored) the loan after deducting daily personal expenses. The loans are to be repaid in 2 or 3 years, indicating a PE of 2 or 3. Would the lending ‘uncle’ be as generous if the loan were to be repaid in 30 years? I doubt it. But in shares investors often disregard their ‘pay-back’ period (the BSE Sensex was at a PE of 30 a few months ago), clearly indicating gambling was getting the better of investing. The market fall to a current level of about 18 PE was a natural phenomenon of valuations and better sense descending!

There are several methods to investing and they will be covered in time. The most important is to invest with some knowledge. Data is available today, as easily to the rookie, as a professional. If the money invested is hard earned, the investor has a duty to himself, to see that the money is not lost to stupidity. Three basic types of research are Fundamental, Technical and Logical.

Fundamental research is a study of the Profit & Loss account, as well as the balance sheet of a company to check the financial health and profitability of the business. The ratios mentioned earlier all stem from this.

Technical research is a study of graphs and patterns, best left to experts. This is used to identify the best time to buy, or sell, a stock.

Logical research is simply keeping ones eyes open. The daily news often provides information on opportunities. For example, increases in interest rates hurts companies that borrow, and banks that would see erosion in the value of their bond portfolios. Increased customs duty on steel would benefit the local steel manufacturers.

Till we meet again, a word of advise. Gather some knowledge, or go to experts (through Mutual Funds). Invest so that you keep your losses low (therefore invest cheap – not at low prices, but at cheap valuations). Prefer to lose opportunities, not money (Buffet’s 2 rules to his managers are:

1) Never lose your investors’ money

2) Never forget Rule 1

May your investments be profitable and your days peaceful.

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