Risk | Portfolio Yoga

Pitfalls of Momentum – January 2021 Newsletter

When I was younger and more naive than what I am today, I used to argue strongly for Technical Analysis vs Fundamental Analysis. In a way, I thought of myself as a crusader for an art that few seemed to understand much let alone use it.

Today, anyone and everyone has access to a freechart with drawing tools making them experts in patterns and indicators. With a 50% probability of being right (it being binary) and hundreds of charts, it’s easy to look like an expert.

One question that troubled me the whole time though was why if Technical Analysis was so good was not used by any major fund managers. What was inhibiting them from using Technical Analysis when it seemed like it was a great way to not just hedge the risks but pick the winning stocks.

Today, the same questions can be asked about Momentum Investing. For all our claims, there is just one PMS which has a pure price based momentum portfolio. Why is that so? If as some advisors claim, Momentum Investing is the greatest innovation in finance, why aren’t they managing money?

While we do have CTA’s that do use some sort of Technical Analysis, the returns in the last decade and more have been unsatisfactory to say the least. In case of Momentum, we do have Hedge Funds and ETF’s trading the same in the United States but the AUM is measly in comparison to the mainstream ETF’s

Here is a performance comparison of iShares MSCI USA Momentum Factor ETF vs S&P 500

India is yet to see anything close to that. One reason I believe is a major inhibitor – liquidity. Momentum or Price chasing works on the concept of buying what is going up and selling what is going down.

But if you are managing a 1000 Crore fund with a 20 stock portfolio (5% equally weighted) and don’t want to move the market, how many stocks shall qualify (assuming that you can buy / sell upto 10% of the volume traded in a day?

Using a 12 day average volume (not delivery which is even lower), we can get only 32 to 35 stocks where you can buy or sell 50 Crores worth of securities without exceeding 10% of total volumes. If you are willing to go upto 20%, the number of stocks available move to around the 75 mark, better but way lower.

Most fundamental portfolios have a long holding period (even though they may churn a small bit of the portfolio much more frequently). Even with a monthly reshuffle, my own holding period falls to just around 4 months. Dip to Weekly and you shall end up churning the portfolio every second month.

In advisory, since it’s up to the client to execute, all these headaches vanish instantly. Momentum Investing in many ways is similar to Micro Cap Investing. There is a reason for no Micro Cap funds out there too – again it’s a question of Liquidity.

Today, there are close to 22 advisors on smallcase alone who have a Momentum Portfolio. Since many have more than one portfolio, we are talking of nearly 75 to 100 portfolios. I have no subscription to any of them but my guess is that the stock overlap would be close to 80% across the board.

Having started my stock market journey on a regional stock exchange and one thing we feared the most – market orders. With low liquidity, we had no way to know how far away we would get filled. I don’t remember punching in a market order once, it was always limit orders at the best Ask or Bid price. New age rodeo’s on the other hand fancy market orders. While market depth has definitely improved quite a bit, the hard reality is that when thousands of orders are punched at market, there is a risk of the cart moving the horse than vice versa.

“Not everything that counts can be counted, and not everything that can be counted counts.” goes a popular saying wrongly credited to Albert Einstein. While we can count the impact of Brokerage and Taxes, what is missed out is the Slippage.

While slippage is low when we send an order for a few thousands of rupees, the impact of slippage when the amount becomes bigger becomes very noticeable. Big funds hence spend a lot of time and energy to try and reduce such impact to a level that is more comfortable.

Compared to other factor based strategies, Slippage is something that can have a large impact in Momentum based strategies versus Value or Quality where the churn factor is very low. A value fund can take months building up a position while a Momentum fund would have already entered and exited a stock in a month or less.

Momentum strategy like any other strategy is bound to go through its bad times. My own equity curve hit a high in January 2018 and that high was surpassed only in late 2020. The worst thing though was that this happened even as the markets continued to hit new highs.

This is tough compared to say a Mutual Fund or a PMS since you are required to continue to monitor / action every month or week. If you are not mentally prepared for such eventuality, you will find yourself exiting the strategy at the worst possible time.

Momentum in recent months has seen a huge upswing, but then again, what hasn’t really. This seems to have made it seem like a riskless way to make money. This has been further encouraged by advisors who are experienced enough to know that risk in do-it-yourself is multiple times higher than with even an average mutual fund.

As I was writing this, the wonderful Bob Seawright’s newsletter landed up and one quote that stood up

“There’s plenty of people who sell bad stuff knowingly, but I think the far bigger problem is inappropriate sales that are well-intended. I’ve seen people who sell bad stuff to their moms, because they thought it was the right thing.”
Bob Seawright

Momentum or Value or Growth – everything can be mis sold. It’s finally your money on the line and if you don’t care enough, no one else will either. If you are not prepared to be invested for a long period of time, no strategy or investment will ever suit you.

Prudential Asset Allocation

Few days back, this tweet by Muthukrishnan caught my eye.

Had a long chat with a SME client last evening. He is temporarily shutting down his business as he has one year receivables pending.

He says his clients are honest but are in genuine distress. He is stopping SIPs today. Going to live on emergency fund which would last a year.— D.Muthukrishnan (@dmuthuk) August 21, 2019

While I have used the tweet of @muthuk, my views below are not with respect to him. I believe there are hundreds of such examples but not highlighted.

A genuine advisor starts investment counselling process by concentrating on the asset allocation mix. These days, the only advisors one hears about is those who start off by recommending what they believe is the best fund to invest in.

Asset Allocation is the foundation on which you build the structure. In good times, read as when markets are bullish, advisors would rather first build the structure and only then think about if any foundation is required.

Asset Allocation is personal – my allocation mix is suitable to me only. It’s not possible for others to coat tail or just copy. Being personal unfortunately works against for when we don’t even disclose all the details to our Doctor, providing our financial position to an adviser is an unknown concept.

This has meant that the advisor is working with data that is not full and hence liable to make mistakes. Assume for instance a client walks in and says that he wishes to invest in Equity, a distributor with little or no data on his other assets can only provide him a list of funds he believes are good investments.

As an analogy, think about going to a Chemist shop and asking for tablet for fever. In all likelihood, he would disburse you with a strip of paracetamol. But what if you are experiencing fever accompanied by shivers. That would require a different approach since shivers come for specific reasons that paracetamol alone won’t help.

In India, main stay for Mutual funds are distributors who are by SEBI disallowed from advising on asset allocation. They can only give incidental advice and this is restricted to selecting MF schemes for investment. In other words, they are more of a Chemist than a Doctor who can diagnose the issue properly and provide the treatment necessary.

If you are not invested in equities, its seen as if you are missing out. Fear of Missing Out happens even more in bull markets, but not everyone requires equity exposure in the first place. Let me take a couple of examples where you maybe better off with Debt than Equity.

If you are a business owner, you are already upto your neck in equity – just that its your own firm’s equity that is most of the time pretty illiquid. Business fail all the time and while I don’t have data, I think there is a very high correlation between failure and the state of the economy.

When things are good, your investments are good, your business is good, life is great. When things turn rough in the market, market goes down, your business goes down and your life suddenly sees a different trajectory.

Being a Chemist and Druggist is a wonderful business. It comes with certain moats that have made it tough to disrupt in the way other businesses have been disrupted. Yet, disruption is always round the corner for who knows what the future holds.

A chemist I know has invested in savings in buying a commercial complex that yields a sizeable rent. This has ensured that even if tomorrow his business is somehow disrupted, his life can go on as usual thanks to the continuous cash flow.

In other words, he has invested in what can be compared to Dividend Yielding stocks that may not give much capital appreciation, but can provide good cash flows over time. While Real Estate is looked negatively from the angle of asset allocation for being a dead asset, for him this is as good as equity with only draw-back being it is illiquid in nature.

Buying a house these days invariably means taking a loan with monthly EMI’s eating substantially into ones earnings. Thanks to the tax treatment, it may seem to make sense to take loans these days than save and pay by cash. Yet, how do you treat the loan has large implications when times are bad.

The biggest fear than most young employees express is the risk of layoff’s since many are burdened with staggering amount of loans – from Mobile Phone to Cars to Homes and what not.

In 2006 / 2007, Americans had bought homes on loans. While the focus for long has been about loans offered to people who had no credit history or even ability to pay back, a lot of loans were also to people with steady jobs.

When the financial crisis erupted, it not only brought down housing prices but also meant loss of jobs. Take a look at the change in Unemployed Rates during that period

If one was invested in addition in equities, he saw his portfolio cut by 50%. Its easy to ridicule those who sold equities near the bottom, but if one had lost his job and his house at risk of being possessed for not making the monthly payment, better something than losing everything.

A friend of mine was recently asking about how he should treat his house in his asset allocation mix. Thinking on the same, I believe that if there is a loan repayable, you are better off treating it as equity than as fixed asset which is what it is.

Advisors to Fund Managers use the Warren Buffett quote

“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”

While we can summarize the quote as one about how long term is rewarding in equities, another way of looking at is that if you need money over the next 10 years, equities may not be the best bet.

That doesn’t mean that you need to have zero exposure to equities, but given the fact that India is one of the few countries where you can get real positive returns on Debt, its unwise to load up on Equities if the objective of the investment is to help you in times of distress.

Have a prudent asset allocation plan that plans for worst case scenarios. Debt while not seeming sexy as equities can actually deliver better results if you face volatility in your career.

Assets can be temporary, Liabilities are permanent. Stress test your allocation to ensure that a quotation loss doesn’t become a permanent loss. As a quote goes,

A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.

You don’t want to be without an umbrella when it starts to rain.

Discipline through Shorting

I admire Elon Musk. I believe he is one of the greatest Entrepreneurs of the 21^st Century, no doubt about that. Yet, he can be devastatingly wrong – for like when he recently railed against Shorts and called them to be made Illegal.

Shorts for all their claims and prophecies aren’t gods descended from heaven who have the ability to make or break companies. While they do push those companies on the edge to the other side, the companies that aren’t so precariously positioned have been able to devastate the careers of more than one such bear.

In India, shorting stocks other than those in the Futures and Options list is next to impossible. There is no easy way to borrow stocks to sell short with the intention of covering later. Yet, way back when derivative market in India was well in its infancy, it was Shorts who short circuited the market and the career of Ketan Parekh and his friends.

Mathematician Carl Jacobi came up with the term “Invert, always Invert” but it was Charlie Munger who popularized the same when it comes to the market. At its root lies the thought that if you are bullish on a stock, you should also be able to argue on the bearish side for this shows that not only have you worked on the positive side but also have the understanding of the risks that the investment can bring forth.

New age bulls while chanting the mantra’s of Warren and Charlie though seem to have forgotten that it’s more than just a theory, it’s the reality. Not surprisingly, as markets kept seeking lower lows, we have had bulls railing against everyone who they believe are responsible for the current situation – the government to RBI to Media to those who Short.

The other day, a recently famous option expert commented that Put option buyers want India to be destroyed just because they want to make some money. Not very different from saying that Life Insurance policies are being bought to bankrupt the Insurance company.

Shorting is not a piece of cake for even the most accomplished of fund managers – Jim Chanos the supposed King of Short Selling was revealed in a recent long form article that appeared in the Institutional Investor to have lost around 0.7% in his Short only fund since Inception which was in 1985.

Yet, his long short fund has generated a net annualized gain of 28.6% since launch in October 1985, more than double the S&P 500. As a fellow hedge fund manager commented, if the numbers are true, “It’s one of the greatest records ever”.

As investors, we abhor the short side. The long side gives us plenty of comfort since we know that the worst we can lose is only our capital already employed in the trade. A short on the other hand can lose an unlimited sum for a stock can theoretically go to Infinity and beyond.

Its isn’t easy for the small investor to create a Long Short model either for the capital requirements for a short are much higher and demanding. But the shorts don’t just demand money – they demand attention and continuously question our beliefs and methods.

We are optimists by nature and yet when the market turns against us, we become the worst pessimist – from wondering whether we went wrong to whether the whole world was loaded against us.

In markets, most of us aren’t optimists in the first place and therein lies the problem. We are at best opportunists who think we can piggy back on the market for some easy money. But when thing goes south, we find ourselves wondering if optimism is over-rated. Technical Analysis works on the fact that human psychology doesn’t change & every cycle proves the same.

Investors these days are better informed than those of us who started out in the pre-internet era. They have a better understanding of allocation, behaviour biases, market psychology among others and yet, I find them not immune to excesses and when things go sour, most seem to follow the path of those who haven’t studied history or human behaviour or cycles – rail against the system first and throw the towel at the worst possible time.

As much as it’s important to read more – especially financial history and human psychology, I am beginning to believe that portfolio construct needs to form the basic foundation. A good portfolio needn’t be made up of longs only for shorts do have their own space.

One doesn’t need to have a short position as big as the long position, but even a small short position keeps the investor on his toes and asks him to take the tough calls. A short challenges ideas and views like no longs can ever do.

The other day, I heard Safir Anand claim that 90% of investors lose money – by lose money I don’t think he meant that they actually lose money but many lose by missing out on opportunities or missing out on getting market returns.

But in the age of everyone being above average, it wouldn’t be surprising if the percentage of investors who despite the best efforts not just underperformed the markets but actually lost money by buying high and selling low – the exact opposite of what they wanted to achieve is 80% or so {Pareto Principle}.

I incidentally run a Long Short Portfolio on my personal books – the short position being placed not by way of understanding, intent or thought but by accident. Yet, when markets were booming and the short was losing money, it kept me thinking about the range of possibilities and where and how far I could go wrong and the likely remedies for soothing the pain.

While the initial thought was to close out the short as soon as got back to my Anchor bias level, deeper or 2^nd line of thinking now seems to suggest to me that shorts can be a very effective instrument against one’s own biases going off tangent.

As Jim Chanos has experienced, the shorts may not actually make money for you but can be an efficient risk management tool that helps manage your Risk at a level that ensures survival in the deepest of bear markets.

Shorting is Risky, no doubts about that – yet, Investors, many of whom are down 40 to 50% in the current down cycle didn’t really anticipate such risks when they came into the market. We accept risk ex-post, why not accept it ex-ante.

Striking Gold – Some Risks can Pay off Brilliantly

This week was a good one for many a Flipkart Employee as they finally were able to convert their paper wealth into real wealth. While startup’s getting acquired by bigger companies is common in the United States, Mergers and Acquisitions are pretty low in number out here in India.

From Angel Funders who funded the company when it was just an idea to employees who joined late but yet early enough to earn their stripes and Esop’s in the company, this one exit is a game changer when it comes to their lifestyle and personal choices they otherwise would have tended to make.

Saurabh Mukherjea who is a well-known name in the Investment Circles in an interview with Bloomberg Quint suggested that for a comfortable retirement, Retirees need at least Rs 150 Million of corpus for generating an income of Rs 5 Million to to Rs. 10 Million.

While it’s false to equate that everyone requires such a stupendous amount of money to retire and live a comfortable life, having such a sum can really change a lot of things and give you different perspectives on how you want to spend the rest of your life.

Of course, the money didn’t drop by without most of them taking risks, some really big risks. Working in a start-up is like no other job. Taking the job early on generally means taking a salary cut for no start-up can afford market salaries and the only way they can compensate for the loss is by way of Shares.

But shares are literally pieces of paper worth a big zero if the firm doesn’t succeed in its venture. Its like the Banks that owned the Kingfisher Airline Brand as a collateral – when the company failed, the brand failed too regardless of the highs it had reached in better times.

The only way to safe retirement one is told is to save more, spend less and try and ensure that the savings earn the best possible return without having to take risks that can hurt the capital enormously.

For anyone who will be retiring in say 2050, Vanguard recommends 90% in Equities and 10% in Bonds. This is based on the belief that over time markets will provide a much higher return and given the time span remaining on the clock, the investor can take higher risks than normal.

Of course, theory is always easy, the tougher part is to actually be able to execute and be invested even 60% of one’s assets in equity for it Scares the shit out of most people who would rather play safe with a lower allocation to equities, higher allocation to bonds and Real Estate hoping things will turn out fine the time of their eventual retirement. Then again, who knows what the future holds?

One of the standouts of the Flipkart sale was Ashish Gupta who invested 10 Lakhs when Flipkart started and now stands to reap 130+ Crores on the sale.

While such opportunities will never be available for the general public at large, we do have opportunities creep up once in a while in the public markets that offer a high risk reward relationship.

I believe its Taleb who has outlined the idea of risking a small part of capital to ventures that can offer a very high return. If the venture fails, the risk to capital is small enough to not impact you on a longer term and if the return is great, it bumps up the total return of the portfolio by a solid margin.

When Elon Musk sold his stake in Zip2, much of the money went into a new high risk ventures that subsequently got merged into Paypal. In turn, when Paypal was sold, much of the money went to high risk ideas such as SpaceX and late by way of a Series A investment into Tesla (among other companies).

Of course, not all risks pay off which is why it’s still called a High Risk Venture. But unlike private markets where the risk is all or none with little or no liquidity, secondary markets offers the best of both worlds.

As Investment Advisers and Agents start crowding around the new Millionaires and Billionaires created by the Flipkart sale offering safe investments (with a nice commission inbuilt for themselves), I do hope most remember that they are there because of the risks they took, not because they turned out to play it safe.

Errors, Omissions & Commissions

The downside of strategies comes to the fore both at the best of time and the worst of times. At the best of times, the risk that suddenly pops open is disregarded as a one off incident that doesn’t entail much significance. But when similar kind of risk opens up during the worst of times, it generally is the last nail on the coffin of the strategy.

One of the stocks of my portfolio until recently was Vakrangee. Like any other stock in the portfolio, this was chosen based on just one Criteria – Momentum. And for a time, it did wonderfully indeed. While buying using a systematic plan took the average buying price higher than where I had started accumulating it, at its peak the stock had doubled in value.

All good things tend to end and this wasn’t any different though the violent ending it faced meant a bit of heartache as one saw the profits dwindle even as Exit was impossible, thanks to the stock circuiting at the lower end every day. Finally, I was able to come out at the same price I entered – tough in terms of the opportunity cost, but no damage to the portfolio.

But its instances like these that make investors worry about whether Momentum is really a good strategy for the long term and for larger capitals.

On the other hand, if I were to be trading the same system in 2008 / 2009, one stock that wouldn’t have been a part of my portfolio would be Satyam. Or for that matter, Punjab National Bank which has cratered 33% in this month alone hasn’t been in sniffing distance of getting a entry into Momentum portfolio.

Beating the benchmark Indices isn’t a piece of cake – big time professional fund managers are having a tough time beating the Index they benchmark against year after year. Active Investing requires one to beat the benchmark if only for the reason that there is no point in wasting time and energy if your returns could be generated by less action – by buying an Index fund for instance.

Concentrated or Diversified Portfolio is a question that has bothered many a brilliant mind. While Concentration can help if you get things right, Diversification ensures survival when things as usually they tend to do – go wrong.

In the latest Berkshire Hathway Annual Report, Warren Buffett writes and I quote

“Charlie and I view the marketable common stocks that Berkshire owns as interests in businesses, not as ticker symbols to be bought or sold based on their “chart” patterns, the “target” prices of analysts or the opinions of media pundits. Instead, we simply believe that if the businesses of the investees are successful (as we believe most will be) our investments will be successful as well. Sometimes the payoffs to us will be modest; occasionally the cash register will ring loudly. And sometimes I will make expensive mistakes. Overall – and over time – we should get decent results.”

As much as we would love to think ourselves as part owners, the truth is that you are not. Anyone and everyone who has held any share for any part of the company is part of a business. But it’s the Management who are the real owners – be they holding 100% or 10% for finally it’s the way they run the company that determines how (in the long term) good or bad your investment can turn out to be.

When you as an investor think of a company as “your company” and as many an analyst talk to the management of companies by using the word “our company”, you are setting up for disappointment.

When it’s time to exit an investment, the illusion of control and knowledge can make it more difficult to make the choices you would have made in the normal circumstances.

Momentum Investing comes with the same risk as Value Investing – nothing more, nothing less. But once that risk opens, how you deal with the risk is what it all matters.

Liquidity, Spread and ETF

While the Asset under Management Exchange Traded funds are a tiny sum compared to the amount Mutual funds have been able to mobilize, they are slowly but surely growing despite it being a product that neither the producer takes interest in selling nor the distributor (stock broker in this instance).

Unlike a Mutual fund where funds charge a trailing commission (non direct) of upto ( and a few even above) 300 basis points per year, most ETF’s have a expense ratio of 50 basis points or less. When it comes to returns, they being passive investments currently hog the middle band when compared with Mutual funds of the same class.

But the biggest issue facing ETF’s to me is the issue of Liquidity and Spreads. Rather than try to explain the meaning, let me post a picture of the definition (plus a tongue in cheek remark) from the book, The Devil’s Financial Dictionary by Jason Zweig

A key way to understand liquidity is by comparing a asset such as Stock / Mutual Fund / ETF vs a asset such as Land. Selling a piece of paper is way easy than selling a piece of land. No wonder that holding period of stocks are low while holding period of land is pretty high.

Spread on the other hand is the cost that will accrue to you to do the deed. Once again, unless markets are in turmoil, you should be able to sell your stock without suffering large slippage. In case of Mutual Funds, its the headache of the fund manager since he is obliged to give you the NAV regardless of how liquid his portfolio is.

ETF’s in many ways behave like stocks since unless you are a big investor, you will ideally be buying and selling it in the stock exchange rather than dealing with the fund house behind the ETF. But how liquid are ETF’s in the first place?

Following is a list of 12 ETF’s that track Nifty 50 and were traded today, a day of pretty low volatility and no panic by either the buyer or seller.

In the table, check out the dates. Do you notice that not all dates are that of 11th May 2016? LIC ETF did not trade a single unit today while Edelweiss ETF has not traded for 2 days now (database I am using is updated till y’day, but if you were to check today’s trading data, you shall see that no trades took place today either).

So, how does it impact you as a investor?

Rather than assume the worst (exiting say the Edelweiss ETF – Nifty 50), lets assume you wanted to Buy SBI-ETF Nifty 50 which thanks to investment by EPFO has a sizable AUM of 6,400 Crores. On the NSE, you shall find the spread as shown in the pic

As you can see, there is real limited liquidity despite it being just 1 / 100 of Nifty (Nifty Bees for instance is 1 / 10 while Edel is 1 / 1). In fact, if you wanted say 500 units, you will need to buy at 81 and for 1000, you may have to buy at 83.

You may think that like in stocks, a rupee or two should hardly make a difference. But you couldn’t be more wrong for every Rupee in this ETF equals 100 points in Nifty. In other words, if you were to buy at 81, you are essentially buying Nifty at 8100 (vs Spot Price close of 7900 and NAV of 7948 (79.48). In other words, just to get in, you may have to pay a premium that is more than what its worth.

And this on a calm day like today. Just think of wanting to exit when the markets are in turmoil with Nifty having fallen > 3% (lets not even bother with bigger numbers). I guess, you can think of how much a impact such a move will make in terms of your returns.

Liquidity begets Liquidity and the same couldn’t be more truer in the above case. I personally use only Nifty Bees and despite it being the most liquid of the choices we have, you can still have a pretty big slippage if you want to buy or sell in a volatile market.

The advantages of ETF are many, but let it not blind you to the risks they carry. Liquidity is the biggest risk as a ETF investor and the spread can seriously affect your returns even if you are using this not for trading but for investing.

Do note that I have no affiliation with any ETF / Mutual Fund house. Above views is just for sake of helping you make the right decisions by providing you with the right perspective of how to look at things.

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.

Share this:

Share this:

Share this:

Share this:

Share this:

Share this:

Share this: