Options | Portfolio Yoga

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 31^st 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.

Defining Risk in Options

Twitter is an interesting way to start conversations, unfortunately the limit of 144 chars means that one cannot explain the thoughts in detail and one can miss the nuances very easily. And the reason for this blog came about from this series of tweets

This is the series of tweet conversations that started with a little innocuous tweet by Deepak 🙂

https://twitter.com/deepakshenoy/status/423756691574779904

So, lets come back to the basic question – How does one define risk?

There are various way to define risk though one that I believe provides the correct meaning is “Risk is the permanent loss of capital, never a number” (Quote borrowed as often it is from the Internet) 😉

In the stock market, it does not matter what we buy, we risk the capital every time (even if there is supposed to be a huge margin of safety). But the problem comes in understanding the amount of risk when we trade options.

Lets assume you have 1 Lakh Rupees as Capital and want to take a trade where you are willing to risk 10K (10% of Capital). These are the ways you can take the trade. For sake of easy calculation, lets assume the price of stock at 100.

You can Buy 1000 Shares of the stock and have a stop at 90. A 10 Rupee move higher will give a return of 10% while one shall end up losing 10% of capital if stop loss gets triggered. A Risk to Reward ratio of 1:1

You can Buy a future (lets assume it has a quantity size of 1000). Now, though you are buying an equal quantity of shares, you are investing only the margin (lets assume the margin is 25%). Keeping another 25% aside for M2M would still leave us with 50% of the capital free.

The stock as usual moves to 110 and instead of a return of equity of 10%, you are actually getting a return of 20% since max capital allocated to it was 50% of the Lakh to start with. Using a small leverage of 1 times the capital, we have actually doubled the returns. Of course, the Risk:Reward remains the same since a 10K loss on 50K of deployed capital is 20% giving us the ratio of 1:1

Lets move to Options. Instead of buying a future, we can buy a option of say the 100 Call Option. The price of the option is based on a lot of factors not least of it would be the amount of time to expiry of the said option (others include how far away the option strike is from the stock price, the risk free rate of interest, the volatility of the stock being the other major factors)

Unlike the stock and futures, options do not have a Linear relationship which makes it harder for assumption of Profit and Loss. Lets assume the stock did nothing for 3 months after which the stock shot up by 10% one fine month. Return on Capital is still 10% for Cash Investment, 20% – Cost of Carry for futures. But the way to calculate would be much harder in case of options. Assuming each option costs 5%, we would have actually lost 15% of the capital before the month of the move. When the actual moves comes and if we still are holding with the same ATM strike (100 CE), we can get a return of approximately 50% on the investment amount. But before you get excited about 50%, here is some small calculation.

As you can see, even though one could get a 50% return on the investment in the option concerned, due to passage of time (& expiry of options in other months), you would have actually lost money trying to buy the same via options (and risking only 5% of the money every month). This despite one being right in terms of the actual move.

Of course, one could have minimized the risk by buying Deep in the Money options which would have had more of Intrinsic value and less of Time premium, but in this world of give and take, the lower amount of time premium comes with a higher amount of Risk on the capital itself.

Other than this, you can build various strategies where you can lower the risk by reducing the maximum reward. But even in the complex of strategies, they key requirement is the direction. Unless you have a strategy to deal with the direction, no amount of strategies can help and if you are sure of the direction, buying in Cash / Futures may be better than trying to leverage through options.

The curious case of cheap options

Doubling / Tripling money in a short time frame is every trader’s wet dream. For many with a great 20-20 (hind)sight, they see such opportunities everywhere. If I had bought X Call yesterday, I could have easily sold it for double today. Hold it for a few more days, it would seem that the option did not stop at just doubling or tripling in price but went on and on and on (like Havells switches I assumeJ ).

Options at the very basic level enables a buyer is to get the right but not the obligation to buy certain shares at a certain price in exchange for a small premium paid to the seller (who takes the risk). The problem with options though starts with this “small premium”.

A 10 Rupee option is not cheaper compared to say a 100 Rupee option though the investment is lower in case of the 10 Rupee option vs. the 100 Rupee option (assuming both of them are of the same stock).

Logical probability thinking makes us believe that a 10 Rupee option has more chances of doubling than say a 100 Rupee option. But the reason an option moves has nothing to do with the price of the option and everything to do with the movement of the underlying stock / index.

Option Price is dependent on

Intrinsic Value (Delta)
Time to Expiration (Theta)
Volatility (Vega)
Interest Rates (Rho)

The aim of any trader / investor doesn’t end with making profits but is about creating wealth. Wealth is created primarily by long term growth of the underlying business (in case of stocks) as well as by the affect of compounding.

Wealth is in-turn created not just by making the right choice of stock but also requires one to allocate the maximum amount of capital so as to maximize the opportunity. One reason why Real Estate is a wealth generator is that the allocation is big (compared to the Individuals Networth).

Assume for instance a person with liquid assets of 1 Crore who buys a site worth 1 Lakh. X years down the lane, the site has given 10X return. But if we assume the persons networth has remained at 1 Crore, the total return generated comes down a piddly 10%.

The same problem confounds the option trader (Buyer in our case) as well. Assuming a trader has a capital of say 1 Lakh, what is the amount of money one should invest in an option is a science in itself. Bet too small and even though you may have a multi bagger in your kitty, your net return will still be small. Bet too large and the option loses value (it’s easy for options to lose 50% of their price (other than deep in the money options) in no time and you end up with a severely eroded capital that restricts the amount you can bet the next time around (unless you are one of those guys who regularly replenish your capital from your Salary).

A friend of mine recently asked me to test a premise which seems to have been advocated by one of the self styled analyst on a Kannada Channel.

The strategy in itself is pretty simple. Buy a strangle (150 to 200 points away from current price) on Nifty on expiry day and sell when either the investment doubles or 10 days (or day 10 of month, whichever is later) passes (reason for selling on day 10 is that as the day to expiry nearly, the pace of the option price fall accelerates).

There are some good months when the returns have been pretty awesome. For example, in the month of March, by day 8, the price of the strange for which one would have paid around 70 bucks would have increased to 118 (a gain of around 68%). Or take the month of August. A strangle bought on the last day of July series and costing Rs.115 would have been worth around Rs.274 on 6^th August giving a return of 138% over the span of 12 days (inclusive of holidays).

But only if life was so simple J

Consider the month of November 2012. A strangle bought using the same logic would have seen a decline 53% in the investment. Same was the case in the next month (December 2012) as well. In just 2 months, any person who started trading the strategy with a capital of X would have seen his capital deteriorate to X / 4 by end of just 2 months. Recovering that would now require the set to Quadruple in price – something that doesn’t happen often

Options are nothing more than Insurance though the ability to trade them makes them one hell of a product to gamble with. Buying cheap options seem like an easy way to make money, but my experience has told me that there is no free money available for anyone to pick up. Both buying and selling options (naked) will for sure result in ruin of capital in the long term though timeline may differ based on the small factor of luck.

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