Running out of Options and Money
Aircel was recently in the news for being the latest telecom operator to go under as it filed for Bankruptcy with 15,500 Crores of Debt on its books. In its statement, the company said it was forced to file for Bankruptcy owing to intense competition following the disruptive entry of a new player, legal and regulatory challenges, high level of unsustainable debt and increased losses.
“Unsustainable Debt” is another word for Leverage. While the business model may have changed over time, what ultimately caused its demise was that its Leverage ratio was just too high. In stock market parlance, that would be – the broker made the margin call and I had no more money to invest.
Aircel was a Private company and hence we may not know the exact leverage ratio, but we know of Leverage ratios of a host of companies that are either close to or already bankrupt.
As of 31st March 2017, Bhushan Steel where NCLT is preparing to auction the company to the highest bidder had a Negative Equity + Reserves and a Large Debt. Interest pay out was 35% of Sales – Sales. Not of Profits.
JP Associates situation wasn’t so bad, but with Leverage of 10x, there is no way the company could have continued to operate without huge infusion into capital.
There are literally hundreds and thousands of companies that are doomed to survive thanks to their overwhelming debt – most of them being small private companies fly under the public radar and are noticed only as a line item when the Bank decides to write off the debt.
RBI said that total Non Performing Assets hit 7.34 Lakh Crore at the end of September 2017. Lest you get confused with the repetition of Lakh and Crore, the NPA figure RBI put out is Rs.73,39,74,00,00,000
To put that number into context, that number is bigger than the Annual Budget Deficit of the Union government. Yes, Banks have lost more money (or are close to losing since not everything is a 100% loss or has been totally written off) than the additional expenditure government thinks it will spend over its Income.
Traders in many ways are like the companies that raised debt hoping for a glorious future where one can drink a Beer and trade for a living, living off the beaches of Goa.
Trading, like every other business is capital intensive. You need a certain amount of capital to be able to try and live off the earnings. Unfortunately, unlike any other business, a trader doesn’t get bank loans.
This means that a trader has to come up with enough money on his own to be able to trade the position size he wants which in-turn hopefully will like a ATM machine can be used to withdraw money anytime there is a need.
Traders and our Dreams.
Dreaming is one, but how do you find enough capital to make it a worthwhile strategy to execute. I have in the past written about how much a trader should have as his capital before he even places a single trade and that number isn’t small.
Thanks to the Brokerage, Taxes and what not, Trading is a Negative Sum Game. What his means is that not all the losses of the losers go to the Winners. Brokerage and Government fees mean that winners do not get all that is lost by the losing party.
Yet, the appeal of trading using Leverage just doesn’t go away. While in the earlier era, we had Badla system where a financier would finance your positions for a price, now we have Derivatives where with a small margin you can get a large exposure – large enough to either make you or break up depending upon which side you end up when the move happens.
Leverage kills – be you an Industrialist or a small time Trader – longer you are holding the ball, higher the risk that someday will be your last day.
Selling options (with the hope that they will expire worthless) is a strategy followed by many. After all, if a large (60% to 90 %, depending on source of data) of all options expire, the seller is always having a better hand compared to the buyer is a argument I have heard often.
In his latest Annual Report, Warren Buffett makes an interesting point about avoiding leverage or rather over-leverage.
Charlie and I never will operate Berkshire in a manner that depends on the kindness of strangers – or even that of friends – Warren Buffett
I was reminded of the above quote when someone posted a tweet which read
There are two enemies for Option seller:
- Huge Gap up or Gap down.
- Huge two way move.
Both happened today and lost 6 months profit.
End of day to End of day, the day when the above tweet was made, markets didn’t crash by any significant measure. Yes, it was a volatile day, but by the end of the day, markets were slightly lower but not one that was of any unusual concern.
And yet, the person above had lost 6 months of his profits. 6 months for one day’s move. This guy is not an average investor or trader. His Bio reads and I quote “stock market expert with more 25 years’ experience in the industry.”
Long Term Capital Management was a firm founded by those day’s who and who in the finance industry and the results of the first four years showed the level of calibre as they delivered outstanding returns with very little volatility.
And yet, one bad stroke of luck and voila – the Federal Reserve had to step in to bail them out with every investor invested in the fund losing out on 100% of capital.
The attraction of trading options / futures is tough to deny. Where else do you hear about doubling capital in a month, generating good cash flow month after month among other stories.
But not everyone is suited to it and even those who think they are suited, there comes a time when they realize that they weren’t really ready. But then, that realization more often than not is realized after the Horse has bolted the Stable.
It’s one thing to be a rookie and get killed and quite another to think of one as a Ring Master and yet get killed by the very Lion one assumed had been tamed. Markets are wild; there is no taming it one way or the other. If you are exposed to risks that you aren’t prepared for, getting killed is a very real possibility.
Recent Comments