Case Studies in Equity and Derivatives Strategies

1 hour 15 mins

Portfolios & Strategies

Case Studies in Equity and Derivative Strategies– Part 3

TABLE OF CONTENTS

CASE STUDIES IN EQUITY AND DERIVATIVES…

Case studies on equity and Derivatives are practical situations that investors face, which are converted into a debatable problem and a solution is proffered. In this section we cover case studies pertaining to:

Equity and equity markets
Strategies to buy and sell stocks
Futures related strategies
Options related special strategies
Finer points of fundamental equity analysis

How are cases structured

For the purpose of simplicity, cases are broadly structured into three distinct parts, which are explained below.

Case description: this is a quick snapshot of the choice that the investor or trader needs to make within the limited information available.
Problem statement: this captures the crux of the problem or the question that the investor or trader is trying to address through the case.
Body of the case: this is the core of the case where the numbers, data and the domain intelligence is clubbed together.
Inferences: This is the last aspect where the trader / investor can draw logical inferences from the case study. These may not necessarily be conclusive.

For the sake of simplicity and brevity, we have combined the case description and the problem statement into a single item.

It needs to be noted that case studies are not exactly mathematical illustrations and are just meant to trigger a thought process to improve and sharpen your understanding of the topic.

CASE STUDY 01 – KNOW WHEN TO SELL A STOCK…

Ashok Patil had been a trader for over 10 years and he appeared to have a knack for identifying stocks. But he had one problem. He has been trying to get better at exiting stocks. Often, he would sell the stock and it would then double from that level. On other occasions, he waited too long and the stock corrected after being profitable. He needs structured model for stock exits.

It is said that in the stock markets you only make money by selling. Notional profits are pointless and profit opportunities lost are not too wise. The idea is to adopt a structured approach to selling stocks. Here is how a framework can look like.

Trade trigger: Abide by stop losses and profit targets

The first thing if you are a trader, it is suggested to buy favorable momentum stocks at reasonable prices and exit as soon as there is an opportunity. Firstly, be disciplined about the stop loss level. It is the level at which you book loss and exit the position without any second thoughts. Secondly, respect your profit targets. The golden rule in trading is to buy on expectations and sells on announcements.

Macro trigger: Sell when interest rates are rising

Interest rates are a key macro trigger impacting equities. If RBI is hinting that interest rates are headed upwards, then it is better to exit equities. Why is it so? A spike in interest rates will impose greater strain on borrowing costs. Also, future cash flows of a business get discounted at a higher rate reducing the present value of the stock. You must be specifically willing to exit rate sensitive sectors like banks, automobiles, NBFCs and realty.

Market trigger: Sell if FIIs are consistently selling

Sharp falls in the market are normally accompanied by heavy FII selling. October 2008, January 2016 and March 2020 are classic examples. Focus on consistent selling by FIIs and ignore routine profit booking. FIIs sell on a consistent basis only when they have changed their view of the Indian market from a medium term perspective. FIIs are big contributors to cash delivery volumes and hence have an oversized impact on price levels.

Currency Trigger: Sell when rupee is weakening sharply

This is often linked to the FII selling trigger, but it is important nevertheless. The trigger comes from debt because the rupee normally falls when FIIs sell bonds. We saw that in June 2013 and again in March 2020. A run on the rupee normally has a domino effect because it reduces the dollar returns that FIIs earn. For example, if FIIs earn 15% in the market and rupee weakens 10%, then net dollar returns are just 5%.

Industry trigger: Watch out for structural shifts.

One rule is that the stocks that drove the current rally rarely drive the next rally. It was cement in 1992, IT in 2000 and real estate in 2008. Some industries undergo structural shift due to factors outside their control. Retail sector got hit by online marketplaces. Auto stocks are being hit by better public transport and could get further hit by electric cars. When you see these big shifts, it is best to stay out till there is clarity.

Company trigger: If you find too many governance issues

When there are major problems with the company regarding disclosure practices, transparency, inter-group dealings, money laundering etc you must immediately think with your feet. It is not worth taking a risk on such companies. Institutional investors are extremely touchy about governance issues and this can impact stock prices deeply.

Valuation trigger: When valuations are not justified by growth

Don’t go by P/E and P/BV ratios alone. The question is whether the P/E ratio is justified by growth. FMCG companies are able to sustain high P/E ratios due to the high levels of growth and ROE that they are able to sustain. If you suddenly find growth faltering, rest assured that ROE will also falter and the P/E will compress. It is time to exit the stock.

Key Inferences for Ashok Patil

There are enough triggers given by the market and the news flows about exiting a stock. You just need to keep an eye on them.
Keep a scrap book and evaluate your holdings on the above factors each month. That should highlight gaps and sell triggers for you.
You cannot practically buy at the bottom and sell at the top. Set a target return and use these factors as triggers.

CASE 2 – EVALUATION OF PROS AND CONS OF IPO FUNDING…

Ravi Sinha is a HNI investor who traditionally kept away from IPOs. Before investing in the IPO market he wants to be clear about two things. Firstly, he wants to take a view on whether he should opt for IPO funding. Secondly, he wants to calculate his breakeven point for the IPO, after funding costs. He wants to take his decision on IPO investing and IPO funding based on evaluation.

IPO funding is normally for a very short period. The idea is to invest in the IPO with borrowed funds and exit on listing. Exiting on listing leaves him with little leeway and he also cannot hold for too long as that would add to his interest costs.

Factors driving the success of IPO funding

Look for cases where the IPO pricing is conservative rather than aggressive. When pricing is too aggressive, it leaves little on the table for the investors after funding costs.
Market conditions matter a lot to the success of any funded IPO. If market conditions are tepid at listing, you will have a tough time covering IPO price plus funding cost.
NBFCs charge higher rates than banks and rates could also be higher if the financier expects lower levels of oversubscription. It ranges between 10% and 18%.
Listing price is the key. You are profitable in a funded IPO if you exit close to the listing date so that funding cost is minimal. Else, the breakeven level will also go up.
Level of oversubscription is a key factor in funded IPOs. Higher the oversubscription in the HNI category, higher will be your breakeven point and you need a much better IPO listing to be profitable.

Comparing 2 IPOs on funding assumptions

The extent of HNI oversubscription makes a big difference to your break even in IPO investing based on funding. Here is a comparison of 2 IPOs on actual data.

Particulars	IPO Financing of Galaxy	IPO Financing of Amber
Name of Company	Galaxy Surfactants Ltd	Amber Enterprises Ltd.
IPO Dates	29^th Jan to 31^st Jan, 2018	17^th Jan to 19^th Jan, 2018
Date of Listing	08^th Feb 2018	30^th Jan 2018
Discovered Price of IPO	1480	859
Listing Price	1565	1122
HNI Oversubscription	6.96 times	519 times
HNI Shares Assumed Applied	6960	10380
HNI Proportionate Allotment	1000	20
Interest Cost (Annual Rate)	9%	9%
Interest Cost Calculation	(6960*1480) = Rs.1.03 crore Days Funded = 10 days 9% Interest for 1000 shares = Rs.25,399 Interest Cost/ share = Rs.26.40	(10380*859) = Rs.89.16 lakhs Days Funded = 10 days 9% interest for 20 shares = Rs.21,985 Interest Cost/share = Rs.1099.25
IPO Breakeven Price	(1480+25.40) = Rs.1505.40	(859+1099.25) = Rs.1958.25
Profit / Loss at listing price	(1565-1505.40) = Rs.59.60	(1122-1958.25) = (Rs.836.25)

Galaxy Surfactants saw relatively tepid oversubscription of 6.96X in the HNI portion and as a result, the cost of funding added just 1.7% to the cost of the IPO. In this case, despite a relatively nominal premium on listing, the IPO funding was profitable.

Amber Enterprises is a different ball game. It has got a substantial premium on listing but the problem is the oversubscription at 519 times. The funding cost adds 128% to the cost of the IPO. Although Amber listed at a 50% premium it was not sufficient to make profits.

The two diverse cases of Galaxy Surfactants and Amber Enterprises highlight that it is not just enough to get a good listing price. A substantial oversubscription can push your break even for IPO funding very high and make a premium listing meaningless.

Key Inferences for Ravi Sinha:

It is always advisable to invest in IPOs that are conservatively priced as they leave returns on the table. This is more applicable in the case of funded IPOs.
Extent of oversubscription is a key factor and hence HNI quota applications are best put on the last day so that the likely oversubscription can be projected with a reasonable degree of certainty.
Cost of funding also matters to the final IPO breakeven price and it is always better to opt for the lowest rate of interest. It is advisable to sell out of the IPO close to listing to maximize return on investment.

CASE 03 – DESIGNING AND MAKING COVERED CALLS WORK…

Rajesh Shah had bought SBI at higher levels hoping that the stock price would go up. However, after the Yes Bank episode, the stock of SBI corrected lower. However, Rajesh is in the stock for the long term so he is not worried. However, he is keen to understand how he can use covered calls to reduce his cost of holding SBI. He has a 3 year holding period for SBI.

F&O strategies are combinations of futures and options or two different options. One such strategy is the covered call strategy. In a covered call strategy you are long on an equity stock and you sell a higher call option to earn the premium. This is a useful strategy when you are stuck in a stock and want to reduce your cost of holding.

Breaking up the covered call strategy

We go back to the SBI case of Rajesh Shah. He had bought 3000 shares of SBI at Rs.220. What do you do if the stock has come down to Rs.205? One way is to sell 1 lot (3000 shares) of SBI 220 call option at Rs.2.50 in the 1-month contract. What happens after a month?

If SBI stays around Rs.205, the 220 call expires worthless. So the Rs.2.50 premium will become the income for Rajesh Shah and reduce his cost of SBI to Rs.217.50.
If SBI spurts to Rs.250, then maximum profit will be capped at Rs.220. Above the price of Rs.270, whatever you gain on the SBI stock you will lose on the SBI 220 call option sold.
If SBI falls to Rs.180, losses can be unlimited. The investor has only downside cover till Rs.217.50. Below that price, his losses will be unlimited so he must be cautious.

Using covered calls to reduce cost of holding the stock…

In the above instance if SBI is likely to hover around the Rs.250 levels, then each month the higher calls can be written to reduce the cost of holding SBI, even as the price does not move too much. Consider the illustration below…

Stock	Month 1	Month 2	Month 3	Month 4	Month 5	Month 6
*SBI Bought at Rs.220*	Sold 220 call at Rs.3.25	Sold 220 call at Rs 2.25	Sold 220 call at Rs.2.95	Sold 220 call at Rs.1.55	Sold 220 call at Rs.1.25	Sold 220 call at Rs.4.25
What about 220 call?	Covered at Rs.1.25	Expired worthless	Covered at Rs.0.50	Expired Worthless	Exited at loss at Rs.2.65	Covered at Rs.2.85
Net Profit / loss on call	Rs.+2.00	Rs.+2.25	Rs.+2.45	Rs.+1.55	Rs.-1.40	Rs.+1.60
Total Profit / Loss on Calls in 6 months			Rs.+8.45

Instead of sitting idle if Rajesh Shah had structured this covered call, he would have brought down his cost of holding SBI from Rs.220 to Rs.211.45 (220-8.45) over 6 months.

Cover your downside risk of covered call by converting to collar

If you are worried about the unlimited downside risk of covered call, you can convert into a collar. You just buy a lower put and attach to the covered call. In this case, you can buy a 200 put at Rs.3. Let us look at the pay-off of this collar under different price levels of SBI

SBI Different Price Levels	Profit / loss on SBI spot bought at 220	Profit / Loss on SBI 220 Call option sold	Profit / loss on SBI 200 put option bought	Overall strategy profit / loss
170	-50	+2.50	+27.00	-20.50
180	-40	+2.50	+17.00	-20.50
190	-30	+2.50	+7.00	-20.50
200	-20	+2.50	-3.00	-20.50
210	-10	+2.50	-3.00	-10.50
220	+00	+2.50	-3.00	-0.50
230	+10	-7.50	-3.00	-0.50

A collar is a completely closed strategy and a covered call can be graduated into a collar to avoid the unlimited downside risk. The maximum loss of Rs.20.50 is calculated as (Difference in strike) + (net cost of hedge) i.e. (220-200) + (3.00-2.50).

Key Inferences for Rajesh Shah:

- A trader who is stuck in a stock that has fallen can reduce his cost of holding the stock by selling call options of higher strikes. Premium earned reduces the cost of holding the stock.
- The covered call strategy can be used by Rajesh Shah only if he is reasonably confident that the stock price will not fall vertically, in which case losses are unlimited for him on the downside.
- Downside risk of covered call can be protected by converting it into a collar. However, this is a multi-leg strategy and can be quite expensive in terms of brokerage and statutory costs.

CASE 04 – HOW TO EVALUATE SUSTAINABILITY OF MARKET TREND…

Nikhil Vora has been a trader for a long time and has learnt one thing. The best way to make profits in the stock market is to identify the point when market is going to change direction. Quite often, a falling market bounces or a rising market capitulates so suddenly that there is no time to capitalize. Nikhil is looking for a model that can help him identify such market turnarounds.

No trend is permanent and market trends change direction without warning. Actually, they don’t. It gives enough signals of whether a trend is sustainable or it is likely to turn. This will help traders like Nikhil Vora position their trades appropriately before turnarounds. Investors normally worry that they may enter too high or exit to low.

While there are no sure-shot solutions, it is possible to create a multi-factor model to estimate turnarounds in the market. You may not be able to exactly catch the top and the bottom, but you can be pretty close. Here are 5 important factors that tell whether trend is sustainable or likely to change.

Factor 1 – Look at the Advance Decline ratio (A/D ratio)

Advance/Decline ratio is the ratio of number of stocks that advanced to the number of stocks that declined in a day. The A/D ratio is expressed as:

A/D ratio = Number of stocks that advanced / Number of stocks that declined

If 700 stocks advanced and 800 stocks declined then A/D ratio is 700/800 = 0.875 .or.

If 850 stocks advanced and 650 stocks declined then A/D ratio is 850/650 = 1.308

A/D ratio of more than 1 is considered positive while A/D ratio of less than 1 is negative breadth. However, to identify market turnarounds, you need to focus on a trend over a period of time. In such cases, the shift tells you about likely change in market direction.

Factor 2 – Ratio of new highs to new lows

You can look at this ratio in terms of all time highs and all time lows or in terms of 52-week highs and 52-week lows. Normally, 52-week is a better measure because stocks touching all-time highs do not happen frequently and small data points may distort results. This ratio is a good indication of the short to medium term trend. Like in the case of A/D ratio, it is not the absolute ratio but the trend of the ratio that matters.

Factor 3 – Ratio of Upper Circuit hitters to Lower Circuit hitters

Circuits are defined at anywhere between 5% and 20% depending on the stock. Some stocks in the F&O list do not have any circuit filters at all. This is also a good measure of mid cap participation because stocks hitting upper circuit or lower circuit consistently indicate absence of counterparty. Like in the case of A/D ratio and the high/low ratio, it is not the absolute ratio but the trend over a 6-12 months period that gives insights.

Factor 4 - Delivery trades ratio

The first 3 factors are direction shift indicators. Delivery trades ratio helps to confirm the trend. For example, if A/D ratio, high/low ratio and circuit breaker ratio are all rising and hinting at a market bounce; pick-up in delivery ratio is a confirmation. It signals that the bounce is driven by delivery buying rather than short covering. That is more sustainable.

The typical delivery trades on any average day could range from 30% to 50% depending on the extent of speculative activity in the market. A higher ratio of delivery trades in the midst of a market uptrend signal shows investors are taking a long term buy view on the stock.

Factor 5 – VIX divergence from mean

This is an indicator that rarely fails. VIX or volatility index is published by NSE on a real time basis. It is called the fear index because it shows fear in the market among traders. Normally, sharp falls in the index are preceded by a sharp rise in VIX. Similarly, when VIX is low i.e. below 15, you rarely find deep market corrections. Look for mean divergence!

Key Inferences for Nikhil Vora:

Nikhil Vora must use the combination of A/D ratio, High/Low ratio and circuit breaker ratio to take a view on shifts in market trend
Once the direction is clear, look for delivery volumes. Trend shifts must be supported by a rise in delivery ratio for it to be sustainable. This is a macro indicator.
Finally, time your trade close to the turnaround and for that the VIX is a very sound indicator. If all indicators are negative, start selling when the VIX spikes.

CASE 05 – HOW VOLATILITY ACTUALLY IMPACTS PORTFOLIO RETURNS…

Bhaskar Banerjee has been an equity investor for over 10 years. However, he finds it difficult to understand why volatility should impact returns. According to Bhaskar, volatility should be a concern for short term traders and not for long term investors. How exactly does volatility impact returns; especially in the case of a long term investor? The answer is that volatility matters.

If you are a long term investor with a 10 years perspective, why should volatility really concern you? Equities have done relatively well over longer time periods and to an investor the volatility really should not matter. But the reality is that volatility impacts valuations.

If you compare HDFC Bank and RBL Bank; which stock is more volatile? RBL Bank will be more volatile in price because people see RBL Bank as more risky. In other words RBL Bank stock is more volatile, and therefore, more risky compared to HDFC Bank.

Volatility reflects risk in the stock. Higher volatility is associated with higher risk and therefore they are also associated with lower risk adjusted returns for the investor. That is why volatility matters so much for your portfolio.

Link between volatility and portfolio returns

Let us take the hypothetical example of 3 portfolios; Gamma, Kappa and Lambda, which have all yielded mean returns of 5% over last six years. Does it mean that their returns will be the same? Let us look at how the 3 portfolios would actually look like.

Year	Portfolio Gamma	Gamma Value (Start Rs.1 cr)	Portfolio Kappa	Kappa Value (Start Rs.1 cr)	Portfolio Lambda	Lambda Value (Start Rs.1 cr)

FY-15	5%	105,00,000	15%	115,00,000	30%	130,00,000
FY-16	5%	110,25,000	-5%	109,25,000	-20%	104,00,000
FY-17	5%	115,76,250	15%	125,63,750	30%	135,20,000
FY-18	5%	121,55,063	-5%	119,35,563	-20%	108,16,000
FY-19	5%	127,62,816	15%	137,25,897	30%	140,60,800
FY-20	5%	134,00,956	-5%	130,39,602	-20%	112,48,640

Mean Returns	5%		5%		5%

Portfolio Value		134,00,956		130,39,602		112,48,640

Why has Gamma created the most wealth while Lambda created the least wealth after 6 years? The answer lies in volatility. You will see that as the volatility consistently goes up from Gamma to Kappa and from Kappa to Lambda, the portfolio value is coming down. Portfolio Kappa is more volatile than Portfolio Gamma and Portfolio Lambda has the highest volatility. Clearly, portfolio returns are inversely proportional to the extent of volatility in the portfolio returns. Now for the reason; why is volatility hitting portfolio value?

Compounding works in favour of consistency

Just as captains prefer a consistent player over erratic players, stock markets and investors also prefer consistent portfolios over volatile portfolios. For example, if your portfolio grows at 10% annualized for 2 years then Rs.100 becomes Rs.121. On the other hand, if your portfolio gives -20% returns in the first year and +40% returns in the second year you will end up at just Rs.112. That is because the second year return of 40% is on a much smaller base. That works against portfolio returns.

Human mind is averse to volatility

This is a psychological aspect and at times it also becomes a policy issue in the case of institutional investors. For example, if the portfolio falls by 30% in the first year, it may breach the risk limit and fund managers may forcibly close positions. Even though the portfolio may not be all that bad, the rush for the exits might itself lead to all round selling and fall in prices. We saw that happen in IndusInd Bank because the risks got elevated after the moratorium on Yes Bank. That is the reason you see that consistent stocks command higher P/E ratios while inconsistent stocks command lower P/E.

Upfront performance leads to upfront greed

What does this mean? Greed on good returns is a key factor. Let us take the reverse of the previous situation. If your portfolio is up by 35% in the first year, what do you do? Fund managers may be scared by the rally and choose to book profits. In the process they may miss out on the full rally. Alternatively, small investors may rush in at higher levels to avoid missing the bus. Either ways, it leads to sub-optimal investment decisions.

Key Inferences for Bhaskar Banerjee:

The market always puts a premium on consistent stocks and consistent portfolios as they are perceived to be less risky.
Upfront underperformance may trigger panic exits and portfolio stop losses forcing investors to take a more myopic approach to investing.
Upfront outperformance may either result in investor greed or averaging. Either ways, lack of consistency results in sub-optimal investment decisions.

CASE 06 – BEING PROFITABLE IS MORE IMPORTANT THAN BEING RIGHT…

Swarup Mohanty has been approached by 3 brokers to open a trading cum demat account. Each broker has provided a complete report on the returns that their research calls would have given to Swarup. Now Swarup is in a fix. How should he make a choice? Should he make his choice of broker based on paper returns? Can paper returns really guarantee actual returns?

If you think being right and being profitable in the market are the same; think again. That is the problem confronting Swarup Mohanty. Being profitable in stocks is not just about being right. There are 3 steps to being profitable. The first step is to take the right trading calls because you cannot make profits by buying bad stocks. Secondly, time your trades. Don’t hold losses too long and don’t cut your profits too soon. Lastly, you must actually act on the trade idea. The proof of the pudding is in the eating. There are 4 trade-offs for Swarup.

Trade-off 1: Practical action versus intellectual inaction

When you trade or invest you put your money at stake. Let us consider two investors here. The first investor sees a small trading opportunity on the Nifty. He takes a position and exits with 0.8% return in the day. That may not be impressive but is a profit nevertheless.

The second investor identified Tata Steel and Vedanta as solid short term plays due to improving Chinese demand. However, he waited for the right price. Both stocks were up 9% intraday but the second investor could not get his price.

Who was the better trader on the day? Nifty returned 1% and the first investor got just 0.8%. The second investor identified stocks that gave 9% but the investor made nothing due to intellectual inaction? Irrespective of the better trade idea, the first investor made money!

Trade-off 2: High returns with too much risk is pointless

Look at two hypothetical stocks. Stock A has 10% return potential with 8% downside risk. Stock B has 25% return potential with 50% downside risk. If you are lucky, you may end up with super returns in Stock B, but that is gambling. As a trader you need consistent returns.

As a trader, you may have made good profits. But, you have taken an unjustified risk on Stock B. If you get it wrong on the third occasion because it opened gap down, you have lost all your profits of the first two trades, and perhaps more.

If you opt for high risk calls, stop loss triggers may be bad enough. Don’t fall for stocks that did well in the last two occasions because they may not do well again. Consistency is more important here. Being consistently profitable to a plan is better than the freak trade.

Trade-off 3: Theoretical returns versus practical returns

This is slightly more nuanced. Assume you get 10 trading calls in a day of which 5 were right and 5 were wrong. In all the wrong calls, stop losses minimized your losses. On paper, you earned 10% in a week. That is great but is it practical?

Here is the first risk. I may not take all your calls and may only trade 3 out of the 10 positions where I am comfortable. Alternatively, I may be short of margins. If these 3 positions happen to be among the losers, then my returns are not 10% but well below zero.

There is a second risk. Performance of the first call impacts my receptivity to your next call. One call going wrong is OK but second and third calls also going wrong means that I am already switched off as a trader. Theoretical returns are meaningless in such cases.

Trade-off 4: Beware the cost of idle capital

The purpose of trading is to churn capital in a systematic and profitable manner. If you hold a trading position for 6 months and earn 12%, it sounds attractive but in the process you have missed out on a plethora of trading opportunities. You have locked up your capital in a single position and lost the chance to be more profitable. It is about lost opportunities.

Key Inferences for Swarup Mohanty:

What you make in reality is never like what the advisor claims. The calls are not based on real money but you trade on real money.
Returns claimed on calls can never be looked at in isolation. It must be looked at in terms of the risk involved.
Your reaction to initial returns impact the actual performance. Also, idle capital has a cost so don’t give too much credence to theoretical returns.

CASE 07 – GLEANING TRADING IDEAS FROM UNLIKELY SOURCES…

Lokesh Singh was surprised to visit a home appliances store in Chennai in 2005 and find a virtual beeline for the TTK Prestige products. His first reaction was to ask his broker in Mumbai if he should buy the stock. His broker dismissed the company as an unknown South-based company. Over the next 6 years the stock was up 40 times. What did Lokesh see, which his broker could not see?

The moral of the Lokesh case is that it is possible to glean investment ideas from the most unlikely sources. Even star fund managers like Peter Lynch of Fidelity used to pick up multi-bagger ideas at shopping malls rather than at investor meets.

There could be a number of plain triggers. Buyers may be making a beeline for a product. Your farmer friend is gloating about the ITC E-choupal. Your kids may be singing paeans of a new product. You can have a 6-factor model for multi-baggers from unlikely sources.

Trigger 1: There is a lot of intelligence in advance tax numbers

In the late 1980s and early 1990s one cement company was seeing a spurt in advance tax numbers. One savvy investor started buying ACC based on higher advance tax numbers. Cement was a boring industry but advance tax numbers were the trigger. Digging deeper, he found that highly profitable cement companies were trading at deep discounts to replacement value. Over the next 2 years, ACC triggered a massive bull market rally.

Trigger 2: There is a lot of wisdom in the supermarket

It happened in the US with Apple and it happened in India with Nirma. Back in the mid 1980s, Nirma was eating into the market share of Hindustan Unilever. This was before the era of supermarkets so the first hints came from Kirana stores. TTK Prestige was one such trigger as it was benefiting from kitchen appliances shifting to organized scale. If the salesman complains that he is struggling to keep pace with demand it is time to look deeper.

Trigger 3: The real picture comes from last mile channels

The pain in auto stocks from 2018 was first visible in auto dealer conferences. That is where you must look for early triggers as it represents the last mile. A recent example was how Jio changed the market when they launched their telecom plan with free voice and almost unlimited data. Over the next 3 years, RIL became a 4-bagger, not an easy task for a heavyweight. But the first indications were found at the Jio sales outlets.

Trigger 4: Keep a tab on Auditors and rating agencies

This has been quite evident in the last 2-3 years. When auditors qualify a report, it is indicative of a larger problem which the company does not want to acknowledge. When debt gets downgraded, it is indicative of financial stress. These triggers are very useful in identifying early turnaround cases. Use these triggers to jump out of the stock in time.

Trigger 5: Keep some space for futuristic ideas

Adani Green became a 10-bagger in one year because it represented a very futuristic idea beyond fossil fuels. There are top quality publications like the “Futurist” that feature high quality potential ideas. For example, electric cars and hyper-loop may still be some time away but these magazines can help you keep them on the radar. Scan ideas in digital technology, genetic engineering, nanotechnology, artificial intelligence, 3D printing etc. These can throw up good and workable investment ideas

Trigger 6: Tap grapevines but take them with a pinch of salt

It is said there is no smoke without fire and there is no rumour without a story in the market. Inside stories are best captured in the market grapevine. However, the market grapevine can be a double-edged sword because many companies have mastered the art of manipulating the grapevine as a publicity tool. You must separate the wheat from the chaff. For example, long before Satyam went bust, the grapevine was full of discussions about the rot in the system. Use it as a sounding board.

Key Inferences for Lokesh Singh:

There are a number of structured sources of information you can look at to get triggers to invest or divest in stocks.
These non-traditional sources only give triggers and not recommendations. You must back up such triggers with your own research and data analysis.
This approach has a higher degree of risk involved because not all good ideas turn into good investments. That is the price of a multi-bagger.

CASE 08 – HEDGING PORTFOLIO RISK WITH BETA HEDGING…

Mini Nair was told by her equity advisor that she could protect her risk by selling futures against her equity holdings. Over the last 10 years, she had gradually built a portfolio of around 14 blue chip stocks. Now she has a problem! Selling futures against individual stocks would be too cumbersome. Secondly, 3 of the stocks are non-F&O stocks. Can she still hedge her risk? The answer lies in Beta Hedging.

Mini has a challenge because she has a portfolio of stocks. When you create a portfolio of stocks you automatically reduce risk because of correlation with each other. If you create a portfolio of stocks with low correlation to each other, your overall risk will be reduced.

Let us understand systematic risk before getting to Beta Hedging

Equity investing entails two types of risks; unsystematic risk unique to stocks and systematic risks that are macro risks. A smart portfolio manager will reduce unsystematic risk by diversification. But systematic risk factors like impact of inflation and currency are not in your control. That systematic risk is measured by Beta and cannot be diversified.

Beta > 1 is an aggressive stock and beta < 1 is a defensive stock. Beta of a diversified index like Nifty is always 1. In a well designed portfolio, unsystematic risk is diversified away, so only systematic risk needs to be hedged. That is best done with Beta hedging.

How to beta hedge a portfolio of 5 stocks as under?

Stock Name	Stock Beta	Investment Value
Infosys	1.15	Rs.4,50,000
Reliance	1.25	Rs.5,50,000
Axis Bank	0.95	Rs.3,50,000
BPCL	0.90	Rs.6,00,000
Larsen & Toubro	1.10	Rs.2,80,000
	Total Value	Rs.22,30,000

For Beta Hedging, the first step is to calculate the Portfolio Beta. Portfolio beta in this case is just the weighted average of individual stock betas. Here is what Portfolio Beta looks like.

Stock Name	Stock Value	Stock Weight	Stock Beta	Weighted Beta
Infosys	Rs.4,50,000	20.18%	1.15	0.2321
Reliance	Rs.5,50,000	24.66%	1.25	0.3083
Axis Bank	Rs.3,50,000	15.70%	0.95	0.1760
BPCL	Rs.6,00,000	26.91%	0.90	0.2422
Larsen & Toubro	Rs.2,80,000	12.55%	1.10	0.1381
	Rs.22,30,000	100.00%	Weighted Beta	1.0967

As stated earlier, the key to beta hedging is the portfolio beta which is the weighted average of individual stock betas. How did we get the weights of various stocks? It represents the relative weight of the stock in the portfolio and will change with the changing price. In the above example if all the 5 stocks are weighted to the overall portfolio then weighted portfolio beta comes to 1.0967. This is the basis for beta hedging.

How to apply portfolio beta for beta hedging

In the above case the portfolio value is Rs.22.30 lakhs and the weighted beta of the portfolio is 1.0967. Remember, Beta hedging is about approximate hedging and not about perfect hedging. To get your approximate beta hedge for the portfolio you must sell futures equivalent to Beta-times portfolio value. Here is how to go about it!

Value of the Portfolio – Rs.22,30,000/-

Weighted beta of portfolio – 1.0967

Value of Futures to be shorted = Rs.24,45,641 (22,30,000 x 1.0967)

We know that futures are traded based on minimum lots.

The current lot size of Nifty 75 units and the Nifty spot value is 11,470.

That means the value of 1 lot of Nifty futures is Rs.8,60,250/-

To Beta Hedge your portfolio you need to sell 2.84 lots of Nifty (24,45,641/8,60,250)

How to practically sell 2.84 lots of Nifty?

You cannot sell fractional lots of Nifty so you have to either sell 2 lots or 3 lots of Nifty depending on your view on the Nifty. In this case, 2.84 is close to 3, so you can sell 3 lots of Nifty to get an approximately good Beta hedge for the portfolio. You will not be perfectly hedged but this Beta hedging will help you to get as close to a perfect hedge as possible

Key Inferences for Mini Nair:

When you have a diversified portfolio of stocks, then it is economical and also more convenient to do beta hedging rather than individual stock hedging.
Beta hedging is done on the basis of the portfolio beta, which is the weighted average of individual betas of all the stocks in the portfolio.
You cannot sell fractional Nifty so traders must use their discretion and round off the Nifty futures selling to the nearest round figure for an approximate hedge.

CASE 09 – HOW TO USE OPTIONS ARBITRAGE IN PRACTICE?

Swati Iyer is a conservative player in the options market. Being an engineer and a CA, she understands the nuances of risk quite well. She has forayed into options trading some 5 years back and has done pretty well by focusing more on strategies. Now she wants to explore if there could be more risk-less methods of making profits in the options trading market. These opportunities are called Options Arbitrage.

As the name suggests, arbitrage is about riskless profits. The market is a random mover and hence at times due to volatility, fear and greed, it gives opportunities to make riskless profits. Options arbitrage can be gainfully applied to make riskless profits. In the case of Swati Iyer, there are 2 interesting opportunities that she can explore. There are 2 common approaches where Swati can do arbitrage in options and earn riskless profit.

Scenario 1: Riskless arbitrage via discrepancies in put/call parity

Let us spend one moment understanding put-call parity as a concept! It says that for given strike price on an underlying asset and the same strike price, the put and the call must have a static sustainable relationship. If this relationship is violated it gives arbitrage opportunity.

Strategy 1	Pay Off	Strategy 2	Pay off
Strategy	Long on Call	Strategy	Protective put strategy
CMP of Reliance	Rs.2100	CMP of Reliance	Rs.2100
Buy 2100 Call	Rs.50	Buy RIL Futures Buy RIL 2100 put	Rs.2100 Rs.40

Let us assume that parity is when the 2100 call is available at 50 and the RIL 2100 put is available at Rs.40. The difference of Rs.10 is accounted for by the cost of margin that you need to put for the long futures position. At this level of put call parity there is no arbitrage opportunity. But arbitrage could arise in 2 situations as under.

The markets may expect that upside of the stock is limited. That will bring down the price of the 2100 call from Rs.50 to Rs.42. This creates an arbitrage opportunity. You can buy the relatively underpriced call option and sell the combination of futures and put option. That is like riskless arbitrage; although you must consider transaction costs.
Alternatively, the imputed cost of futures may drop from Rs.10 to Rs.5 because the RBI has cut the repo rates signalling lower cost of funds. This will result in an arbitrage where the combination of futures and put can be bought and the call option can be sold.

Scenario 2: Arbitrage when options strikes are mispriced

Strike arbitrage in options is available between two options on the same underlying but different strikes. Normally, price discrepancies do not last for too long as arbitrageurs come in and trade these differences. Here is how it works.

Particulars	Option	Particulars	Option
SBI CMP	Rs.255	SBI CMP	Rs.255
SBI 255 Call	Rs.5	SBI 250 call	13
Intrinsic Value	0	Intrinsic Value	5
Time Value	5	Time Value	8
Nature of Option	ATM	Nature of Option	ITM
Option pricing	Relatively Underpriced	Option Pricing	Relatively Overpriced

Arbitrage by buying 1 lot of 255 SBI call and selling 1 lot of 250 SBI call

Buy 1 lot 255 SBI Call	-5	Sell 1 lot 250 SBI Call	+13
If, SBI expires at 270	+10 (Leg Profit)	If SBI expires at Rs.270	-7 (Leg Loss)
*The net profit on the above arbitrage will be Rs.3 if SBI expires at Rs.270/-*
If SBI expires at 220	-5 (loss on option)	If SBI expires at 220	+13 (Let profit)
*The net profit on the above arbitrage will be Rs.8 if SBI expires at Rs.220/-*

The above asymmetric options arbitrage is set up in such a way that irrespective of the price at which the underlying stock finally expires, the profit on the arbitrage will range between Rs.3 and Rs.8. That is profit range that you will lock in. These riskless opportunities are normally best captured by machines and algos as they can disappear quite fast.

Key Inferences for Swati Iyer:

Riskless arbitrage is available in options too and these are mostly found when the option is mispriced with reference to its payoffs or intrinsic value.
Riskless options arbitrage is a game played by institutions so they vanish quickly. Swati must realize that it is tough to execute these arbitrages manually.
When Swati calculates the breakeven in such options arbitrage positions, transaction costs can make a big difference as these are multi-leg deals.

CASE 10 – LEVERAGING THE POWER OF ROE ANALYSIS

Padma Naidu has just read that the best way to understand the strength or weakness of a company is through ROE analysis. Padma is interested because, apart from being an investor, she is also joining as a finance manager in a large e-commerce company. One of her mandates in the new rule will be to use financial metrics and balance sheet intelligence to identify how various units are doing. She wants to understand ROE analysis better.

While it is popularly called as ROE analysis, this was first applied by the American chemical company, Du Pont. Hence, this ROE analysis is also better known as Du Pont analysis. Padma is absolutely right that Du Pont analysis can be used by investors to understand investments and also by finance managers to decide which business segment deserves more capital.

Essence of Du Pont or ROE analysis

Du Pont uses ROE as a principal measure of the strength of any business. What matters is the business returns for the shareholders. Higher the ROE; better the company and lower the ROE, less attractive the company. But the devil normally lies in the details and hence it becomes essential to break up the ROE analysis into sub-components. Du Pont analysis breaks the ROE into 3 critical components as under…

So, what does ROE depend on?

ROE is a function of 3 factors viz. profitability, asset turnover and financial leverage. Profitability measures how profitable the business of the company is. An important aspect of ROE is the asset turnover showing how efficiently assets are being utilized. Financial Leverage measures of how much debt the company is using.

What exactly will the ROE or Du Pont analysis tell you?

Is ROE of 20% better than an ROE of 10%? The answer will depend on how the ROE is achieved. We will come back to this point later but suffice to say that on must also look at the ROE trend over time and a gradually rising ROE is a better signal of health. Also, different sectors have different benchmarks. For example, FMCG has high ROE while telecom has low ROE. Hence they must be benchmarked to the industry average.

Let us come back to a more important point; and that is the reason why we need to break up the ROE. On paper, Company X and Company Y may look the same because their ROE is the same. But your view could change when you consider the break-up of ROE.

Component of ROE	Company X	Company Y
Net Profit Margin (A)	25%	16%
Asset Turnover Ratio (B)	0.60	3.00
Financial Leverage (C)	3.20	1.00
Return on Equity (A x B x C)	48%	48%

Company X has a much better net profit margin compared to Company Y. This is despite the higher leverage; which means Company X has lower cost of debt. However, asset utilization is very poor and any rise in interest rates could be a big risk for Company X.

Company Y is extremely efficient in the use of its productive assets as is evident from the asset turnover ratio. Then, why is net margin so low? It is partly because of not managing expenses and costs frugally and partly due to an inefficient capital structure.

So, can Padma really use Du Pont analysis to her benefit?

For Padma, there could be four distinct benefits flowing from the ROE analysis.

As a finance manager, she can communicate to business heads numerically how their segment is contributing to the overall ROE of the company. This can also be used as tool of performance measurement divisions.
As part of her management information systems (MIS) dashboard, she can outline which segment needs capital and which segment deserves capital and which segments require management attention.
When dealing with potential acquisitions and mergers, this analysis can quickly lay out whether the target company is generating value or burning cash. Value can only be created when the ROE is sustainable.
As an investor in stocks herself, Padma can use ROE analysis to track stocks and pin down what is driving performance and whether it is sustainable.

Key Inferences for Padma Naidu:

ROE analysis can quickly identify the problem areas and the strengths of any company via an integrated dashboard for the top management
Investors, analysts and fund managers can apply ROE analysis to get value added insights about their investments.
More importantly, Padma can use the ROE analysis even as an insider in a company for more efficient divisional and segmental performance.

CASE 11 – DISCERNING THE RISKS IN A SHORT STRANGLE…

Charu Mehta has been an options trader for some time and her experience had been quite mixed. Her broker has advised her about a new product called short strangles, but she has always been scared about the very idea of short strangle ever since she read about how short strangles had bankrupted Barings. She wants to understand the risks of short strangles and also how she can trade in short strangles within these limitations.

Most of us are aware that selling options entail unlimited risk and limited returns. In a short strangle, there is double selling of options because you sell a call option as well as a put option. That means, technically, you can take a big hit if the price goes up and also if the price goes down.

How does a short strangle pay-off look like?

Let us assume that the spot Nifty is at 11,400. If the expectation is that the Nifty will be in the range of 600 points, the strangle strategy can be structured as follows. Sell 11,600 Nifty Call at Rs.80 and sell 11,200 put at Rs.120. The total premium income from short strangle will be Rs.200 (80+120). Here is how the pay off will look like…

Nifty Level	P/L short 11,600 call	P/L short 11,200 put	Total Profit / Loss
10,800	+80	-280	-200
10,900	+80	-180	-100
11,000	+80	-80	00
11,100	+80	+20	+100
11,200	+80	+120	+200
11,300	+80	+120	+200
11,400	+80	+120	+200
11,500	+80	+120	+200
11,600	+80	+120	+200
11,700	-20	+120	+100
11,800	-120	+120	00
11,900	-220	+120	-100
12,000	-320	+120	-200

Maximum profit on the short strangle is Rs.200 (sum of two premiums) realized between the two strikes of 11,200 and 11,600. The lower breakeven at 11,000 and the upper breakeven at 11,800 are marked in pink. You are profitable as long as Nifty expires between the levels of 11,000 and 11,800. Beyond that point, losses are unlimited.

What are the short-strangle risks that Charu must bear in mind?

Short-strangle are vulnerable to overnight risks. If you sold strangle on the Nifty and overnight if Lehman had gone bankrupt, as in 2008, then you are sitting on a time bomb. That is what happened to Barings in 1995. Avoid overnight risk to the extent possible as things can get really out of control, unless your range is very large.
There is a huge price risk if the short-strangle is on individual stocks rather than the Nifty. For example, a short strangle on Infosys or Reliance ahead of their AGM can be very risky, so you got to be ultra careful. Short-strangles are best designed on broad-based indices like Nifty or Sensex.
Option premiums are not only impacted by price movement but also by volatility movement. This is more so if you have done a narrow range short strangle. They are extremely vulnerable to shifts in volatility. In such cases, you may end up paying huge MTM margins and could even force you out of positions.

Should you really look at strangles; is the question that Charu needs to address. The answer is that if she can get a good range then short strangles can be profitable on a sustained basis. Of course, stop losses and position management is extremely important in such cases. Remember, strangles gets riskier with time. When you sell a strangle strategy you are exposed to the dual risk of a short call and a short put.

Key Inferences for Charu Mehta:

Short strangles can work profitably if designed over a broader range on the index and monitored closely with appropriate stop losses.
Overnight risk is best avoided in case of short strangles as most factors are beyond control and losses can escalate rapidly.
Ideally, short strangles are best restricted to broad-based generic indices like Nifty and Sensex. Avoid short strangles on sectoral indices or stocks.

CASE 12 – STOCK FUTURES FOR LONG TERM INVESTING…

Jayesh Arora has identified a list of stocks he wants to own for the next 3-4 years. While he has the cash to buy these stocks he wants to explore the option of buying the stock in futures segment and rolling it over for the next 3 years. The margin saved by not buying in cash can be invested in a liquid fund that is earning some returns yet it is liquid at any point of time. Is Jayesh’s strategy workable and what are the risks?

STOCK FUTURES FOR LONG TERM INVESTING

Jayesh has an interesting proposition here. He wants to buy in futures instead of buying in cash market. So instead of paying the 100% required in cash markets, he only pays 20% as futures margin and sets aside another 10% for MTM margins and the balance is invested in a liquid fund. Can futures be looked as a substitute for cash market investing? The answer is yes, but you must be familiar with the pros and cons of holding futures long term. Broadly, there are 3 ways to substitute your cash market trades with futures trades.

Method 1: Plain vanilla, buy in futures instead of in cash market

Let us take a very simple example here. If you are holding 500 shares of Reliance Industries in the cash market, you can reduce your funds locked in by purchasing 1 lot of Reliance futures which is equivalent to 505 shares. When you buy futures, you only pay a margin so the balance money gets freed up. But, you also need to make a provision for MTM margins if the price move goes against you.

So the balance freed up can be invested by splitting 20% in liquid funds and 80% in debt funds. We have assumed 6% annualized returns on liquid funds and 10% annualized returns on debt funds. This will ensure liquidity when required. Here is how they compare.

Particulars	Buy RIL in cash market	Buy RIL in Futures	20% balance in liquid fund	80% balance in debt funds
Buy Date	Aug 01^st 2020	Aug 01^st 2020	Aug 01^st 2020	Aug 01^st 2020
Buy Price	Rs.2100	Rs.2100
No. of Shares	505	1 Lot (505)
Buy Value	Rs.10,60,500	Rs.10,60,500
Margin (26.52%)	Rs.10,60,500	Rs.2,80,000
Balance Invest		*Rs.7,80,500*	Rs.1,56,100	Rs.6,24,400
Sell Date	Oct 31^st 2020	Oct 31^st 2020	Oct 31^st 2020	Oct 31^st 2020
Sell Price	Rs.2250	Rs.2250
Sell Value	Rs.11,36,250	Rs.11,36,250	Rs.1,56,100	Rs.6,24,400
Profit booked	Rs.75,750	Rs.75,750	Rs.2,342	Rs.15,610
Total Profit	Rs.75,750	Rs.93,702
3-Month Return (%)	7.14%	8.84%

In the above case, had Arora adopted the route of futures buying instead of buying directly in the cash segment, the returns would have been higher at 8.84%. Here the leverage is permitting the investor or trader to earn more attractive ROI.

That is the power of leverage that futures provide. Here we are assuming that the holding period is just for 3 months so we can straight away buy a 3-month future. But, what happens if you intend to hold the stock for a period of 1 year. We have to roll over the stock for that period as we shall see in the next case.

Method 2: Investing for long term by rolling over futures

If we are looking for a period of 1 year, you will not get such a long dated future so you must focus on rolling over futures. Assume you have liquidity in mid month futures, there would be a total of 6 rollovers in 1 year. How does the cost work out in the above case?

Particulars	Amount	Particulars	Amount
XYZ Aug-20 Futures	Rs.938.85	Roll cost (4.65/938.85)	0.495%
XYZ Oct-20 Futures	Rs.943.50	Annualized Roll Cost	3.01%
2-month Spread	Rs.4.65

Let us see how this annualized roll cost of 3.01% impacts the profitability of futures versus cash investment…

Particulars	Buy XYZ in cash market	Buy XYZ in Futures	20% balance in liquid fund	80% balance in debt funds
Buy Date	Jan 01^st 2020	Jan 01^st 2020	Jan 01^st 2020	Jan 01^st 2020
Buy Value	Rs.9,20,000	Rs.9,20,000
Margin Paid	Rs.9,20,000	Rs.1,20,000
Balance Invest			Rs.1,60,000	Rs.6,40,000
Sell Date	Dec 31^st 2020	Dec 31^st 2020	Dec 31^st 2020	Dec 31^st 2020
Sell Price	Rs.1,150	Rs.1,150
Sell Value	Rs.11,50,000	Rs.11,50,000	Rs.1,69,600	Rs.7,04,000
Profit booked	Rs.2,30,000	Rs.2,30,000	Rs.9,600	Rs.64,000
Total Profit	Rs.2,30,000	Rs.3,03,600
1-Year Returns	25.00%	33.00%
Roll Cost		-3.01%
Net Returns	25.00%	29.99%

Instead of buying in the cash market, if the trader decides to buy it in the futures market and hold the balance money in a mix of liquid funds and debt funds, then he would be better off by nearly 500 basis points on an annualized basis. Arora can fruitfully use this method but too much leverage can work against him.

Method 3: With futures you can do reverse arbitrage

This is a limited application strategy, although it is quite interesting and can be applied in times of high volatility. How does it work? If you are holding on to a stock and the futures is quoting at a deep discount to the cash market price (without dividend), then you can capitalize by selling your cash position and buying in futures instead. This is the opposite of an arbitrage and can only be done if you have the cash market position.

To cut a long story short, Arora is right that futures can be used as an alternative to cash markets for enhanced yields.

Key Inferences for Jayesh Arora:

When you replace cash market positions with futures positions, consider the roll over cost and then calculate the returns.
The substitution with futures is best done in stocks that are not too volatile and the long term secular trend is up. That is when leverage works in your favour.
Tax implications of futures are very different and the net impact of the strategy must be evaluated net of tax to get the right trade-off.

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