How to hedge your Portfolio using Derivatives

Posted on September 24, 2008February 6, 2019 by Jagoinvestor

When it comes to invest in equities or mutual funds lots of people becomes concern about their investments. This article is surely for you if you invest in Equities (Direct shares or Equity Mutual funds). In this article I’m going to tell you how to hedge your portfolio using Derivatives.

Risk Management of Portfolio using Derivatives

Many people might have seen their investments go down to anywhere between 20-50%, if they invested in Indian Stock markets around Dec 2007 or Jan 2008, and they might be wondering if it will go more down in value .

Just like we know take life Insurance to cover the risk of Life, Home insurance or car insurance to cover the risk if anything goes wrong, Can we also take Portfolio insurance?

What does insuring the portfolio means?

What does insurance means? It means securing something from some event which can cause loss or damage. We ensure our Lives, our homes, our Car. What happens when nothing happens to our lives, Home or Car.? We pay a small price for it and that is a kind of fees, which we pay for the security.

In the same way, we can also insure our portfolio, we can make sure that our loss is limited, the loss is always limited. If you are one of those who invested in Equity mutual funds or Shares during 2007 or Jan 2008, and you are sitting on a loss of 30-60%, you will understand this very well.

Anyone who invested Rs.1,00,000 in stocks or mutual funds has loss of anything from 30,000 to 60,000 (depending on his investments). Just wonder if they could insure their portfolio and make sure that there loss cannot go beyond a certain limit. That would be wonderful. We are going to discuss this today.

How to insure your portfolio?

There is no specific product or service for this , you have to manage it using Options (Derivative Products). ( Read it in Detail)

I assume that you now understand what are Options and how do they work , what are call and put options and what is expiry date, in case you have not read about it, please read it at above links (try first link to get basic info).

If you have invested in Mutual Funds

Ajay has invested Rs.2,00,000 In Equity mutual funds in Aug 2008, Nifty is around 4,200. He has invested his money for 4 months and would like to withdraw his investments in Jan 2009. He is a smart investor and knows that markets can crash and there is no limit to how much down it can go, so he decides to minimize his risk.

For this he has bought Nifty 4200 PA DEC-2008 trading at 200, for which he spent Rs.10,000 (Rs.200 * 50 lot size).

Now let’s see 3 different cases and what happens to his portfolio

1. Markets boom and goes up to 5,000 : Nifty has gone up by 20%

I am assuming that his investments followed and his Rs.2,00,000 has grown to Rs.2,50,000

Value of his Nifty PUTS : 0

Profit from investments : 50,000
Loss in Puts : 10,000

Total Profit : 50,000 – 10,000 = Rs.40,000

2. Markets Crash by 25% and nifty goes down to 3,100.

His investments follow and now its value is around 1,40,000, but his PUTS will be valued at 1,100 (4200-3100). So its value at the end would be 1,100 * 50 = 55,000.

Loss in investments : 60,000
Profit in PUTS = 45,000 (55,000 – 10,000 investment)

Loss = Rs.15,000

Here you can see that Out of his loss of 60,000, 45,000 is covered from PUTS.

3. Nothing happens and markets are still at 4,200.

His investments will be almost same, and his PUTS will expire with value 0.

Profit from investments : 0
Loss from Options : 10,000

Total loss : Rs.10,000

In all the 3 cases, we should note that in all the cases his Losses are minimized.

Let us also take an example of Shares.

Ajay bought 300 shares of Reliance @2,000 on 1st Jun 2008. He wants to sell these shares around Dec 2008.

He senses that markets are uncertain, so he buys 4 lots of RELIANCE 2,000 PUTS DEC 2008 @100. One lot of Reliance options has 75 shares, that’s the reason he buys 4 lots, so that he has total 300 shares control.

What does it mean? It means that on Dec 2008, he has the right to see 300 shares of reliance @2,000 and for this right he has paid Rs.100 for each share.

The maximum loss for him is now Rs.100 per share.

Let us see the 3 cases.

1. Shares price has gone up to 2,500.

Profit in shares = 500 * 300 = 1,50,000
Loss in Puts = 100 * 300 = 30,000

Total profit : 1,20,000

2. Shares price remain same at 2,000

Profit in shares : 0
Loss in Puts : 100 * 300 = Rs.30,000

Total Loss = 30,000

3. Shares price go down to 1,500

Loss in shares = 500 * 300 = 1,50,000
Profit in Puts = 500 * 300 = 1,50,000 – (30,000 investments)

Total Loss = 30,000

Again, we can see that in any case his loss is capped by 30,000 (5% of his investments of 6,00,000)

So options can be used to hedge or security. Watch this Youtube video to understand.

Summary

So the main idea of options is to use them to minimize the losses. If there is loss in investments, the puts will end up in profit and we will have very less loss or maybe we can get some profits only. The same way, if people do short selling they can use calls to minimize their losses.

So if you have invested in Shares or mutual funds and want to minimize your losses, use options or Futures as Hedging tools.

Creating Wealth for Long Term through Equity

Posted on August 28, 2008February 6, 2019 by Jagoinvestor

We are going to discuss today, a huge wealth creation by investing with discipline over long period of time. We often think that investing a small sum of money will not be able to generate huge Wealth and we need to invest huge amount of money.

Creating Wealth

Its obviously true that more money will create more wealth, but we are going to see today that we underestimate small savings and how small investments over a long period of time can generate fortunes.

How much wealth you can create, if you earn around $1000 /month (Rs.40,000 per month) and can invest 10% of that amount every month for next 30-35 yrs. I am assuming you are a 25 yrs old and retiring at the age of 60 (though i want to retire at 40). Total dependents are 3-4.

And monthly expenditure is Rs.25,000 ($600/month).

What kind of wealth can this person create?

Can he invest Rs 5000 ($125) in a diversified Equity Mutual fund per month till his retirement. I hope the answer can be YES

As we said that he is investing in Equities, What kind of return should we expect? 5% , 20% or 50%, but Wait … Equities are risky, it can be negative also !!! that’s very true … but People may not know that Equities are extremely risky in short term, but its almost not at all risky in long term, and if the long term = 35 yrs, then forget it, you can get some great returns.

Risk in Equities are inversely proportional to the investment tenure. Well that’s a different topic to talk about (And i will post an article on that soon , keeping an eye !!!) Just for the data, Indian Stock markets have given return of 17%+ CAGR return in 28 years, from 1979 (inception) to 2007. We are talking about Sensex.

So, to be safe we can easily consider 15% CAGR return in Long term (remember LONG TERM).

Coming to the point, It may happen that during initial years, our investor may face difficulty investing this much money considering, he may have other important things to take of and later he may have more responsibilities. But during is career life, his salary will also rise and then 5000 will be a small percentage of his salary.

So assuming he can do the investment we are proposing, what kind of retirement corpus he can build? Guesses?

I am sure most of the people will be thinking the following way:

He invested 5000 * 12 in a year, which is 60,000, and then he does it for 35 yrs , so he invests total of 60,000 * 35 = Rs 21,00,00 0 (21 lacs). And he will get some return of 15% every year. if we take 15% of this 21 lacs, it will be around 3,00,00, so total corpus = 24,000 and also as this is compounded , his interest will also keep growing at 15%, so it will be more than 24,00,000 , so lets take it 50,00,000. Fine …

Ok , let take 70,00,000 (70 lacs) to be safe. This is a calculation done not exactly by the proper annuity formula, but a workaround, which a general person can think of.

How much does he generate with this strategy

You can also look at my another article on Early investing and power of Compounding to get an idea about early investing and how compounding is a great tool. But keep going ahead if you are enjoying this article.

So the question is What will be his corpus , can it be anywhere near to 70,00,000 . The answer is that his actual Wealth will be way beyond this amount. After doing the actual calculation i can see that it will come around 7.43 Crores (Rs 74 million) .

But how is it possible , such a big amount !!! .

That’s because of compounding power . The interest earns interest and that again earns interest and this keeps on going. Initially the interest earned is very small , but as the time passes , the amount keeps growing and the interest also grows at an unbelievable amount.

Can you believe that this investor will earn more than 1.04 Crores only in interest in his 35th year (last year) , more than 4 times the money he actually invested whole his life. That’s all possible because of systematic and consistent investing with out fail and because of Power of compounding.

That’s the reason why one of the greatest Scientist Albert Einstein said “Compound interest is the 8th wonder of the World”.

So it that all we are going to talk about today , NO !!! We have more to talk on this topic.

Why does this investor takes pain of investing that 5,000/month all this life. What if he invests just 10 yrs and leaves that money to grow for another 25 yrs. What if this is his plan till retirement.

The sudden thing which will come to your mind is that he invests for 35 yrs and created wealth of 7.43 crores , What if he just invests for 10 yrs .. it should be 10/35 * 7.43 crores = 2.12 Crores . Is that true ?

Will it actually be 2.12 Crores only. The answer is NO !!! . Then the question is how significantly different will his Wealth be in this case. The Answer is 5.88 Crores. Yes it will not be significantly less but just 21% less .

So Just by not investing for 71% tenure he actually gets 21% less money , that’s not a bad deal !!!

But wait , What if he wants that same 7.43 crores at the end , and still wants to invest for 10 yrs. the obvious way out is to invest more than his regular 5,000 per month . The question now is HOW MUCH MORE !!!

The answer is Rs 1420 more . Instead of 5,000 , he should invest Rs 6,420 per month for 10 yrs and then leave the money to grow for rest of 25 yrs. And he can generate wealth of Rs 7.43 Crores.

Watch this video to know how one can use Equity to create wealth over long term:

What we can learn from this

So there is a learning here and a very important thing to note , that more pain we take in the start , the better it is . In the initial years of career , its possible for people to invest more , as they have less responsibilities to handle and less dependents.

So it may be feasible for them to invest heavily in the initial phase of there career, which will benefit them for long term . Now see this person . Instead of investing 5,000 for whole of 35 yrs , If he chooses to take a little more pain in the initial 10 yrs and manages to invest Rs 1,420 more per month, then he can save investing for 25 yrs of his life and still can generate same Money.

One great question now !!!

What if our investor is ready to invest his 50% salary (20,000) per month for starting 2 yrs and then let it grow for rest 33 yrs. He is ready to heavily invest first 2 yrs of his career and do some sacrifices like not spending too much , no vacation , no fancy spending and all.

Can he still beat the target !!

Will he be able to generate the same Wealth for himself like in earlier examples !!

So here you go !!! , He will not only achieve the target , but exceed it.

His Wealth will be 9.24 Crores (Rs. 92.4 million) at the end of 35 yrs. I know that’s an Eye-opener . So now you know that the best time to invest was 5, 10 or 20 yrs ago , but if you missed it , don’t worry 🙂 . there is another golden chance and that’s NOW !!! .

please let me know what you feel about this article , that helps me to refine and write better articles.

Thanks, Happy Investing.

Note: The formula used for calculation is called Annuity. https://en.wikipedia.org/wiki/Annuity_(finance_theory) See formula under “Annuity Due” on this wiki page

An investment advice for all the beginner investors for their healthy financial life

Posted on August 26, 2008February 6, 2019 by Jagoinvestor

People say its always a wise thing to Diversify your investments. Its gives you better security and better returns. It minimizes your risk and if one part of your portfolio is doing bad, it will not affect others and you will benefit from other side.

That is true, But then there are some things to note here.

Diversification – By investors point of view

Ask any investor who Started investing in Equities around 2002 and then sold his holdings at the end of 2007. If he sold it just by luck its great, but if he managed to take this decision based on his study on markets and hard work. Then its worth appreciating.

Diversification is very good, but only when you don’t have much time to track whats happening in things which you have invested in. Its a trade off between return and the time you can contribute tracking your investments.

What if you can watch your investments closely and take decisions based on any move in markets or investing world. In that case Diversification is not that important.

Warren Buffet’s views on diversification:

One of the greatest investors of all time Warren Buffet also says that Too much diversification is needs only when investors doesn’t know what he is doing. If you are cautious and well aware of things which affect your investments, then too much diversification is not required. Because you will take actions fast as an when required.

People who can not give time for there investments on daily or even weekly basis need better diversification. Read https://finance-and-investing.blogspot.com/2008/04/what-is-diversified-portfolio-and-how.html
to read more on diversification of portfolio.

Warren Buffet says that he likes to put his eggs in a single basket and watches it closely.

Lets take a Case study.

Ajay and Manish want to invest 1,00,000 each for 1 yr. During this period returns from different things were

Equities : 25% (for a year, but there were ups and downs in Equities market for whole year)
Gold : 20%
Debt : 9%
Real Estate : -10%

These were returns after an year, so before making investment both of them did not knew that what will be returns.

Ajay do not have time to track his investments, but Manish has, so Ajay diversifies his investment like this/

Equities : 50,000
Debt : 10,000
Gold : 10,000
Real Estate : 30,000

His portfolio after 1 yr looked like after getting respective returns

Equities : 62,500
Debt : 10,900
Gold : 12,000
Real Estate : 27,000

Total : 112,400, which comes to 12.4% before tax.

On the other hand Manish do not diversify, because he has much time to track things closely, He does some study and understands that Real estate has short term bear market as there is lot of supply and interest rates are also going up which will affect demand and hence prices. He Invests most of his money in Equities and some money in Debt and Gold.

His portfolio looks like :

Equities : 80,000
Gold : 15,000
Debt : 5,000

His portfolio after 1 yr:

Equities : 1,15,000 (He sold his equities when he sensed that markets may fall in near term and then again bought at low levels, because of his good timings he earned more than 40% return)
Gold : 18,000
Debt : 5,450

His total = 1,38,450
Return = 38.45%

Conclusion:

Though this is hypothetical example, it shows that Because Manish kept a close eye on this investment, he does not need very highly diversified portfolio. He can have more concentration on something which he can closely track.

Diversification in portfolio is to minimize risk and to get benefit of all the form of investment.

But risk can also be minimized by keeping a close eye on your investments, So the investor can choose more risky products and hence also increase there chances or earning higher returns.

All you want to know about Options trading – For beginner investors

Posted on June 16, 2008February 6, 2019 by Jagoinvestor

What is an Option?

Option is a contract which gives buyer the right, but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date. An option has an Expiry date, when its automatically exercised if it has any intrinsic value left.

When you buy an option you have to pay some premium at the time of buying it.

You can buy or sell Options just like you buy or sell Shares. They are traded in real time. An option value depends on some underling, which can be a stock or an index or even interest rate, The scope of this article is restricted to Stock options or index options.

An example of index option is Nifty option, so its underlying is Nifty.

You must know that its a kind of Derivative : Derivatives are any instrument whose value are derived from some other thing, there value depends on some other thing, like In case of options in stock market, there value depend on either a stock or an index.

Futures are also a kind of Derivatives, The minimum money required for trade in Futures are much more than Options. You can trade in options with as little as 2,000 or 3,000 (depending on the option you are trading in).

Types of option: CALL and PUT

CALL option gives you the right to BUY something anytime before expiry at a predetermined price. The value of the CALL option increases as the Price of the underlying thing increases. The reason for this is because you can still buy it at the fixed price and the difference is your profit.

PUT option gives you the right to SELL something anytime before expiry at a predetermined price. The value of PUT option increases as the price of the underlying Decreases. The reason is that you still have the right to SELL it at fixed price and difference will be your profit.

SOME OPTION TERMS

Exercising an Option :exercise an Option means to Buy(CALL) or Sell(PUT) the stock on the expiry date if they are European style else Buy or sell anytime on or before Expiry if they are American Style.

Expiry Date : The date on which an option will expire and then it will be exercised automatically if it has any intrinsic value left.

Option Style : Options are of two styles, American style (It can be exercised any time before or on expiry date) and European Style (exercised on expiry only).

STRIKE Price : Strike rate is Stated Price for which the underlying stock can be purchased or sold on expiry date.

SPOT Price : The current price of the underlying at a particular time.

LOT : Options are traded in lot size, you can buy 1 lot, 2 lot or any number of lots, and a lot has a particular number of shares in a single lot, Like Nifty options have lot size of 50.

Premium : Every option has some premium which users have to pay when they purchase an Option. So for a CALL option, the premium increases when its underlying price increase and decreases when its underlying price decreased and just opposite of PUT option.

How does an OPTION look like?

Example : CHAFER 90 CE 1.95, EXPIRY 26th June

CHAFER is the symbol for a stock called CHAMBAL FERTILIZERS, so its a Stock option. The expiry date of this option is 26th June (current year).

90 CE means its a CALL (C) option, which is European Style (E, can be exercised on expiry date only) and the Strike rate is 90, means that you have right to buy 1 lot (3450 shares, it depends on the option how many shares a lot has) of chambal fertilizers shares at Rs 90 on the date of expiry if you want.

What are the Profit and Losses you can make?

The Losses are always limited to the extent of premium you pay (in worst case you do not exercise the option and you let your premium go), On the other hand the profits are theoretically unlimited, because the option price can keeps increasing when underlying increases or decreases depending on the type of option.

What is time value and option value ?

The Premium you pay for the option has two components
– Time Value
– Intrinsic value

Premium = Time value + Intrinsic Value

Intrinsic value is the true worth of the option (premium) and Time value is the value which is there because of the time left for the expiry, because as the Expiry time comes near the risk of loosing the money is high. So time value keeps decreasing as the expiry comes closer.

There fore you will see that even if STRIKE price is closer to SPOT price, the option price will be very high if the expiry is after many days.

For CALL option price moves towards 0 if SPOT is less then STRIKE price and expiry comes closer.
For PUT option price moves towards 0 id SPOT is higher than STRIKE and expiry comes closer.

Watch this video to learn more details about Options trading:

How does it works?

You can either sell it at the profit or still hold it.

Case 2: If market does not fall as per your expectation and still is at 4400 before 10 days of expiry and the current price of premium is suppose 10, you can sell it at loss, because you don’t want it to become 0.

Suppose you didn’t sell it and market really closed above 4300 on expiry date, then you loose whole your premium (as SPOT Options used for Hedging

Example 1:

Suppose you buy CHAFER 90 CE EXPIRY 26th June, at a premium of 1.95 (you will have to pay Rs 1.95 * 3450 to buy this option), and the SPOT is 78, means currently price of Chambal fertilizer share is Rs. 78, now the price of option will follow the price of the share price.

If price increases to say 85, then the option may increase to 4.5 (depending on demand and supply), and at this point you can sell the option and earn a profit of 4.5-1.95 = 2.55 Per share, profit of 130%.

Now suppose on 26th June (Expiry day), the price of Chambal Fertilizer is Rs 100, then the option will be exercised and who ever has the option at that time will receive the profit of Rs 10 (total 10 * 3450) and the option will not be exercised if the SPOT (current price) of share is below 90, because then he will make loss if exercised.

(Remember, its not your obligation to exercises the option (you exercise if its in profit, or you loose your premium)

When do you buy Options?

Example 1 :

Suppose Infosys is at 2000 today (1st June) and you are optimistic that its price will go further go up 10% or 15% (2200 or 2300). so you buy a CALL option of Infosys which is going to Expire in approx 1 month, say INFOSYS 2200 CE 10.5 26th June is available and lot size is 1000, so you pay 1000 * 10.5 = Rs 10,500 for this option.

Now option price will move the same way as the price of Infosys share. At the end of the Expiry date if Price of Infosys share will be more than the 2200 then the option will be called “In the Money” as it will be in profit when exercised Else it will be out of money.

So suppose Price of Infosys share is 2280 at the end of Expiry then you exercise the option and get 1000 * 80 = Rs 80,000, you can also sell the option anytime before Expiry date if you want to make profit and convinced that the option price has reached at a good point.

Example 2:

You think that Economy is not doing well and markets as whole will fall because of high inflation news and political issues (or for any reason), Suppose Nifty is at 4600 and you believe that it will fall to 4300 in 2-3 months, Suppose current date is 1st June then you can buy NIFTY PE 4300 AUG , assume premium is Rs 15.

Case 1: If markets fall badly and reaches 4500 in 1 month and the premium increase to 330. You can either sell it at the profit or still hold it.

Case 2: If market does not fall as per your expectation and still is at 4400 before 10 days of expiry and the current price of premium is suppose 10, you can sell it at loss, because you don’t want it to become 0.

Suppose you didn’t sell it and market really closed above 4300 on expiry date, then you loose whole your premium (as SPOT Options used for Hedging)

The main use of Options is for hedging, So if you have bought some 1000 shares of company ABC at Rs 20 , and think that price may fall to 15 in one month ,you can ABC PE 20 or 19, and pay a small premium, Now you are covered for the loss you will make on shares, because you have right to sell the shares at 20 or 19 (depends on the price you bought the options at).

Some other important points

1. Options are very risky and very rewarding, it can give returns of even 100% or 200% in day, or can give negative returns of 50% or 80% in a day.

2. Options are very volatile, so its a good idea to be patient with options.

3. Buying Options near its Expiry dates are highly risky, because if they go in wrong direction they don’t have time to come back.

4. Its not a good idea to buy a option with strike price very far from the SPOT price unless there is some good reason for it. Options with more gap between between STRIKE and SPOT have less premium, but very risky (and can be very rewarding too).

5. Its not a good idea to put a Stop loss for your option very near to the current price, because its highly probable that it will come to Stop loss point and then again bounce back because of there high volatility.

6. Its a good idea to set a target to book profits and get out, rather than trying to get maximum out of option. If you don’t exit at a good point, the chances are that value will again bounce back to normal price and you will miss a chance.

(I sold Chambal Fertilizer CALL 90 option when it price went up to 6.5 though 8-9 looked achievable target next day, but i thought its a great return and didn’t miss the chance of booking 250% return in 2 days, Buy price was 1.95).

I would be happy to read your comments or disagreement on any topic. Please leave a comment.