# What are derivatives and its strategies?

Derivatives, as the name suggests, derive their value from an underlying asset. Let us take the example of a tomato farmer and a ketchup factory. The farmer grows tomatoes in his farm and supplies it to the ketchup factory on a regular basis. However, the ketchup factor and the farmer want more predictability and stability in their price and their costs and revenues. Let us assume that tomatoes are currently being supplied at Rs.20/kg to the ketchup factor. But there are sharp seasonal variations in these prices. The farmer will be happy if he can get a price of Rs.19-22 per kilogram for his tomatoes while the ketchup factor is open to a price of Rs.20-23 per kilogram in the ideal case scenario.

Now the farmer and the ketchup factory can enter into an agreement wherein the farmer supplies tomatoes to the ketchup factor at Rs.21/kg. This suits the interests of the farmer and the ketchup factory. At the end of 3 months, the farmer agrees to supply 2 tonnes of tomatoes at Rs.21/kg to the ketchup factory and the ketchup factory, in turn, commits to buy the said quantity at Rs.21/kg. What we have seen here is a basic derivative contract come into existence. This called a forward contract. The underlying in this case is the tomatoes and the farmer and the ketchup factory are bound by the agreement.

## But what if the market price of tomatoes turns volatile in the next 3 months?

That is perfectly possible. For example, the crop may have been hit by bad weather and the price of tomatoes would have gone up to Rs.26/kg. The farmer ends up with a notional loss because he has to sell 2 tonnes at Rs.21 as against the market price of Rs.26/kg. This 5 rupee loss will be the gain for the ketchup factory. On the other hand, if there is a glut of tomatoes in the market and the price falls to Rs.16/kg then what happens? The tomatoes will still be supplied at Rs.21/kg. In this case, the farmer will gain Rs.5 and the ketchup factory will lose Rs.5.

The question is why are the factory and the farmer getting into a forward contract where one of them could lose. That is because both want certainty. Both are going to be profitable at a price of Rs.21/kg and that is what matters in business. They are not traders who are looking to profit from price movements. They are just looking at protection from price volatility. Forward contract is the most basic form of derivative.

## Forwards, futures, options and swaps

While there are many more permutations and combinations in derivatives, these are the four most popular categories of derivative contracts in the market. Let us look at each of them in some detail.

A forward contract, as explained above is an agreement to buy or sell an underlying asset at a future date at a fixed price. The price and the date of delivery are decided in advance. Such contracts are not regulated by any exchange and are only governed by the Indian Contacts Act.

• Futures are exactly like a forward contract in structure but there are 2 key differences. Firstly, futures are standardized in terms of lot sizes, strike prices etc. This makes them a lot more liquid compared to forwards. Secondly, futures are traded on a stock exchange and cleared through the clearing corporations. Thus all trades are guaranteed by the clearing corporation and hence there is no risk of default.

• Options are slightly different from futures and forwards. Both futures and forwards are symmetrical contracts; meaning losses and profits for the buyer and the seller can be unlimited. But in case of options, the contract is asymmetric. For the buyer, the returns are unlimited but the risk is limited. In the case of seller of option, the return is limited to the premium but the risk is unlimited.

• Swaps entail an exchange of one set of flows for another. You can swap the cash flows of fixed rate bond for floating rate bond and vice versa or dollar flows for Yen flows. Swaps are not as popular as the other three in India.

## Understanding derivative strategies

Derivative strategies refer to the combination of futures and options positions to created limited loss strategies. Here are four such popular trading strategies in derivative Markets.

• In a protective put, a future on a stock is purchased and it is protected by buying a put option of lower strike.

• In a covered call, the higher call option on a stock is sold to reduce the cost of your holdings either in the stock or in the stock futures.

• A bull call spread is created by buying a lower strike call option and selling a higher strike call option. The trader is moderately bullish on the stock and uses the premium on the higher call to reduce the price of the lower call option.

• A strangle is a volatile strategy where a call of a higher strike and a put option of a lower strike are simultaneously purchased. Once the premium costs are covered, the trader makes profits either ways as long as there is volatile movement.

# Trading Rule – Top 5 Rules For Successful Trading in Stock Market

DURING THE COURSE OF TRADING YOU MUST HAVE SURELY TRIED TO EVALUATE HOW OFTEN YOU GOT YOUR CALLS BANG ON TARGET. FOR MOST SUCCESSFUL TRADERS THE SUCCESS RATIO IS ABOUT 55-60% IN A BEST CASE SCENARIO. THEN WHAT DRAWS THE LINE BETWEEN A SUCCESSFUL INVESTOR AND A NOT SO SUCCESSFUL INVESTOR. THE PROBLEM IS THAT THERE IS JUST TOO MUCH FOCUS ON BEING RIGHT. BUT BEING RIGHT IS NOT THE SAME IS BEING PROFITABLE. WHAT REALLY MATTERS IS WHAT YOU DO WHEN YOU ARE RIGHT AND WHAT YOU DO WHEN YOU ARE WRONG. REMEMBER, WHEN IT COMES TO TRADING BEING RIGHT IS NOT THE SAME AS BEING PROFITABLE…

## BUT, WHAT YOU DO WHEN YOU ARE WRONG IS LOT MORE CRITICAL…

“The best traders only get a few trades right. It is how long you hold your rights and how quickly you correct your wrongs that matter” – A trader

## 5 WAYS TO ENSURE THAT YOU ARE PROFITABLE RATHER THAN RIGHT…

1. The first step is to always trade with a stop loss. Keep the stop loss as a discipline and don’t compromise on your stop loss under any circumstances. When the stop loss is hit just close your position and then take a fresh view.

2. When you trade it is not just about putting stop losses but also about profit targets. The idea of profit target is to churn your money quickly. That is how your ROI can be maximized in trading. You don’t want to get stuck in positions and lose out on other opportunities along the way.

3. Make the best of your profits when you are right. This may sound like a contradiction to the previous point, but it is not. When you are in a trade and you are right, there is a trade-off in front of you. Should you put trailing stop losses and hold on to the position or should you exit and shift. This decision is crucial to your profitability.

4. Don’t lost perspective when you trade and that is the key to being profitable. You need to evaluate your risk in terms of your daily loss, your positional loss and your loss on capital overall. This will constantly keep you on your toes.

5. Keep a tab on costs, they matter a lot. Costs are not just in terms of brokerage but also in terms of statutory costs as well as in terms of hidden costs like liquidity, spread risk etc. As a trader, the onus is on you to keep these costs at the bare minimum so that your effective return on investments can be maximized.

## BEING PROFITABLE MATTERS MORE THAN BEING RIGHT…

That is the bottom-line when it comes to trading. Don’t fret over how many calls you get right and how many calls your got wrong. Even if you get 40% of your calls right and if you cut your losses short and hold your gainers long, you are likely to perform much better than other traders. It is not being right or wrong or the percentage of right trades that matter. What matters is what you do when you are right and what you do when you are wrong. That is what makes the difference!

# Stock Analysis - Know How to Analyse a Stock Effectively

You have just about learnt that equities can generate tremendous profits for you over the long term. But you cannot jump into any stock. You need to take a well thought and calibrated investment decisions. Broadly, you need to consider fundamental factors and technical factors before zeroing in on the stock.

## Fundamental factors to examine in a stock

Fundamental factors have got to do with the core business of the company. These factors can be quantitative or qualitative. Here are some key fundamental factors to examine…

• Growth is the primary motivation. After all, you want to invest in a company that grows. We are talking about growth in business volumes, growth in revenues and also growth in profits. It is only when these 3 combine that you have an attractive proposition. Higher growth means higher valuations in the market.
• Profitability is the key. Eyeballs and footfalls can only take you that far. Your business needs to be profitable. What is the net profit margin and what is the operating margin. This will tell you how good are the business. Check the ROE and the ROCE of the company. That will tell you how well the company deploys its capital.
• Efficiency is the binding force. You have up cycles and down cycles in a business. What holds a business together in tough times is the efficiency of operations. How efficiently the company churns its total assets and fixed assets? How well is the working capital of the company managed? All these add up to efficiency.
• Brand image is what will give you the advantage in a competitive market. Companies like Hindustan Unilever, Britannia, HDFC Bank and TCS have built a formidable brand in the market. That is why they get premium valuations in the market. Brand image is an intangible factor and cannot be seen or felt, but it can be experienced and monetized.
• Management quality separates the wheat from the chaff. A good management can make a success out of a mediocre business but a mediocre management can make a mess of even the best of businesses. Generally, companies with solid managements tend to outperform their peers as well as the index overall.
• Business moat is the unique advantage that you have created in the business. It could be a unique product, a special distribution channel, some key entry barrier or a brand that cannot be replicated. The value of the business comes from the moat and it is companies with moat that are better equipped to handle disruptions in the business.

## Yes, you will have to examine some technical factors too…

No investment decision is every complete by just looking at the fundamentals of the company. You need to look at the technicals too. Here are a few technical factors to examine…

• Price patterns are largely technical factors. You can compare the price chart with the 100-DMA and the 200-DMA to get cues about the stock. You can examine the supports and resistances on the technical chart and also whether there are any double bottoms, double tops or serious breakouts. These are the key to your investment decision.
• Volumes can be seen either in terms of number of shares or value. Normally, the number of shares is a better indicator of volumes, especially in smaller stocks. Volumes show whether the interest is building or waning. Volumes are useful in ratifying whether the price trends you see are credible or not.
• Spreads and basis risk is a case study on how easily you can enter and exit a stock. Volumes are only one side of the story but these volumes must come with narrow spreads and low basis risk. If an order for 10,000 shares is going to take the stock up by Rs.1 then you are running a huge basis risk on the stock.
• Volatility represents the standard deviation or the risk of the stock. Prefer stocks that show movement and sensitivity to news flows but are not too volatile. When stocks are too volatile, they become hard to predict and the stop loss risk becomes too high in them. Such stocks are better avoided.

Even after you consider all these fundamental and technical factors, you must examine whether the valuation offers a margin of safety to you. That is the last test. Only then, a final decision must be taken.

# What NRIs need to know before investing in Mutual Funds?

The mutual fund route is gradually getting popular among non resident Indians (NRIs) as it facilitates an easy method of participating in the equity growth story without taking undue risk and without having to bother about tracking your portfolio. While most funds have the facility of permitting NRIs to also invest, there are some basic things NRIs must be aware of. While these may sound to be quite fundamental and simplistic, NRIs need to be aware of these minor items to that disappointments can be avoided in the future.

## Ensure that an NRI applicant already has a PAN number…

Today the Income Tax Department issues permanent account numbers (PAN) to both resident Indians and non-resident Indians. Many NRIs who do not file returns in India do not bother to apply for their Indian PAN number. Remember, NRIs are not permitted to invest in Indian mutual funds if they do not have a PAN number issued by the Income Tax Department. The PAN is a must even if the NRI in question is not filing his returns in India. Mutual funds do not accept applications from NRIs if they do not already have a PAN number. As an NRI it is essential to have a PAN number issued by the Income Tax department and mention the PAN number in your application form. Otherwise your mutual fund application is liable to be rejected.

## There is a TDS for NRIs as per the Income Tax Act…

When a resident Indian applies for a mutual fund and earns capital gains on sale of units, the onus is on him to ensure that the capital gains tax are paid to the Income Tax department before the stipulated date. In case of an NRI, the tax treatment is slightly different. The registrar of the mutual fund (CAMS or Karvy as the case may be) is required to ensure that the Tax Deduction at Source (TDS) is deducted before paying out the redemption proceeds to the NRI. Of course, if the NRI is eventually not liable to pay the tax then he can always apply for a tax refund from the Income Tax department. But unlike in case of a resident Indian, the NRI’s tax on capital gains will be deducted at time of redemption itself.

An NRI bank account is tagged separately by your bank as opposed to your resident accounts. When a person acquires his NRI status, they normally do not bother to change the status of their Resident Account status to an NRI account status. Remember, an NRI can only apply through a specified and dedicated NRI account, which could be an NRE account, NRO account or an FCNR account. If you try to apply for mutual funds as an NRI but your bank account is still tagged as a resident Indian account, then your MF application is likely to be rejected. Since the bank account is central to all your mutual fund investments, ensure that your NRI status is updated first and foremost in your bank account before you apply for Indian mutual funds.

## NRIs also need to go through comprehensive KYC…

Mutual fund investments by resident Indians entail a comprehensive Know Your Client (KYC) procedure. The same comprehensive KYC applies to NRIs too. The NRI can download the KYC form from the mutual fund website or from the Point of Sale (POS). The same can be filled and submitted with all documents to the POS or can be mailed to the mutual fund. An NRI opting for KYC needs to furnish his certified true copy of the passport, certified true copy of the overseas address as well as his permanent address. Any documentations or attestations that are in a foreign language need to be translated into English before submissions. Such documents can be attested either by the Consulate or by the overseas branches of the scheduled banks registered in India.

## Special approval in case of certain geographies…

While the NRIs based in Middle East may have a much easier route, the compliance is much more strict if the NRI is based in the US or Canada. In case of certain funds which have foreign ownership, applications cannot be invited from certain geographies like the US and Canada for example. Such applications are likely to filtered and rejected right away. Most funds clearly disclose this fact in their prospectus and NRIs need to consult their advisor or the specific fund for clarification on these points.

Mutual funds do offer NRIs an easy and efficient way to access the Indian markets. However, there are some statutory and compliance requirements that NRIs need to familiarize themselves with. The above points are a basic primer for NRIs looking to invest in India and can go a long way in avoiding disappointments and rejection of mutual fund applications.

# Investors should try to stagger investments into equity markets

Markets are sometimes driven by sentiments and today one of those times. Hope has trumped fundamentals. The National Democratic Alliance has received clear majority in the elections and the Modi wave has catapulted the BJP securely to power. The allocation of ministerial portfolios is also done and there are no allies to please. This makes for a strong government which can take big decisions quickly, at least during its honeymoon period over the next 12 months.

With political risk blown away, a shrinking CAD and our emergence as an emerging markets sweet-spot, any step to revive the economy, draft business-friendly policies and follow general good governance will result in across-the-board increase in share prices. In fact, our best-case target for the S&P BSE Sensex for March 2015 is 32,000.

Given the initial determination and articulation on policy from the new government, we believe that the economy will perform better going ahead. So it makes sense to invest in companies that earn more from domestic sales. In any case, we recommend buying only quality stocks and that too with a long-term investment horizon.

Since the markets are at their all-time high, investors should invest in a staggered manner only in fundamentally strong stocks taking the benefit of any possible dip.

Yes, India is in a bull market and this is probably going to continue. There will be corrections along the way and there will be disappointments, as India still has problems in the economy. But at the end of the day, it will continue to have a very bullish market. The S&P BSE Sensex is trading over 15 times its forward earnings. Are valuations expensive? Perhaps the earnings growth has not been as good as it should be. But with reforms, those earnings numbers and estimates will be revised. Valuations may get stretched. So we have to be careful and make course corrections as markets correct. One must also remember that there has to be revision of those earnings estimates in view of the reforms that are planned for the economy. It’s a bull market and it will continue. The budget is also around the corner and hopes are high.

Buy low, sell high. This has been a timeless (and fairly pointless) advice given to investors by all and sundry. In fact, the reverse usually happens as one doesn’t buy low due to fear that prices will trend lower and one definitely doesn’t sell at a high because of unending greed that the markets and specially your stocks will continue upwards endlessly. Today is yet another time when investors wonder whether it is still safe to make a safe entry into markets and which part of the cycle the markets are in.

Over the years, the resilience and optimism of Indian investors has been quite amazing. Every bull-run has been sharp and swift, and full of opportunities. Right from Harshad Mehta’s infamous 1991 episode to 1994 when the FIIs came in to the dot com boom in 2000 and then the last, long global bull-run from 2004 right up to January 2008, the opportunities were as clear as the writing on the wall just before decline. But it is difficult not to be blinded by the relentless hype. The question on everybody’s lips is: How long will this bull-run last? Well, nobody really knows how long but I advise you to buy but don’t borrow money and buy, not in this or any other bull-run.

Many investors are still skeptical and feel there is too much smoke and no substance in this rally. For them, I recommend unending systematic monthly investments into Sensex or Nifty. Trust your gut and safely bet on India. Due to a likelihood of the rupee appreciating as well as confidence in companies with sales within a resurgent India, investors can reduce investments made in IT companies and convert to private banks, cement, FMCG and energy stocks. Till we see some real action, infrastructure too remains on the back-burner.

While the indices have run up quickly and substantially, stock specific movements continue with renewed interest from retail investors. In fact, investors should use this rally to exit weak counters they held on to during the just-ended bear market and convert to top quality stocks.

# How to trade options profitably?

A successful self trader – Rule # 30

According to a global study, over 90% of people who buy options lose money. It may appear that selling options is a safer proposition. Not exactly! When you buy options, there are components to that decision. What strike to buy; at what premium to buy; how much time value to pay etc. Unless you understand these finer points of buying options, you will be on the losing side. How to join that other 10%?

## HOW TO BUY OPTIONS AND NOT LOSE MONEY

Buying options is not rocket science. But it is not just about determining the direction of the market and deciding to buy a call or a put option. An option is a lot more complicated as compared to plain vanilla futures. There are four unique features of options you need to remember. Understanding their interplay can go a long way in helping you become a smarter player of the options game.

Firstly, an option is a time value game. When you pay a premium for buying an option, you are paying for the price difference and for the expectation of price movement. Secondly, being a time value game, it is a wasting asset. For example an out-of-the-money option will keep losing value consistently in the beginning and rapidly towards the end of the month. Time works against the buyer.

Thirdly, buying options always works best in a volatile market. Both call and put options tend to become more valuable in a volatile market and less valuable in a flat to range-bound market. Lastly, options are primarily hedging instruments and hence they should be predominantly used for counter balancing your risk in other investments. Options as trading choices should always be secondary.

### PROXY FOR PRICE OR PROXY FOR TIME

If you are buying options as a proxy for price, ideally stick to in-the-money options where time value is limited. If you are willing to bet on uncertainty over a period of time, then prefer out-of-the-money options. That is the key.

### IS IT A HEDGE, OR IS IT A BET

As mentioned earlier, buying options should primarily be for hedging. But one needs to be clear on the purpose. In a hedge the net cost and the breakeven matters. In case of a bet, the cost and volatility matters. Touché!

### WHAT IS MY COST OF TRANSACTING

Options have become cheaper to trade, but read the fine print. Are you paying fixed brokerage per lot or variable brokerage? This matters when you trade in bulk. The statutory costs also add up. When you are trading on wafer-thin margins, costs matter a lot.

“Derivative instruments like futures and options have the potential to become weapons of mass destruction” – Warren Buffett

### 6 STEPS TO A SOUND OPTION BUYING STRATEGY

1. Don’t get obsessed with buying out-of-the-money options. It may appear to be a good bet as the downside risk is low. Remember, deep OTM options are cheap because they are actually worthless. You may end up getting upset over the OTM options you keep on buying, that expire worthless. Be careful.
1. There are investors who say that they are bulls or bears and hence they will only buy calls or puts. This kind of a one-size-fits-all strategy will never work. Buying options is all about being fleet footed to grab opportunities. You must be open to buying calls, puts or even synthetics like strangles. Period!
1. Check if the option is underpriced before buying it. Your broker trading terminal or even your online interface has a simple algorithm, which identifies which options are underpriced based on the Black Scholes Model. While this may not be a sure-shot money spinner, it definitely gives you a margin of safety.
1. Do you want to buy index or stock options? It depends on what you are trying to bet on or hedge against. If you are looking at broad macro factors like GDP, fiscal deficit, currency etc, then stick to index or sectoral options. If you are looking at company-specific factors, then focus on stock options.
1. Beware the liquidity trap. Check the past liquidity of options before jumping into them. This is very true of options on mid-cap stocks. You surely don’t want to end up holding a pile of illiquid options. Check that you can exit in bulk from that option, without disturbing the price too much. That’s critical.
1. Options buying is all about moderation. Avoid concentrating on just 1-2 options and don’t spread yourself too thin. Set a target for option premium and exit. Avoid waiting till the rapid time-value erosion starts. Avoid the temptation of buying more to reduce your average cost of options. It rarely works.

### RISKS TO AVOID WHEN BUYING OPTIONS

There are those eager beaver traders who buy a certain option just because a particular institution or star trader bought it. Perish that thought. You don’t know what is behind their trade. Also don’t buy a call option, the moment you are convinced about the fundamentals of a stock. It may take 3 years for the stock price to fructify. By then your options cost may well and truly finish you. Avoid the bandwagon strategy while buying options.

Remember, a cheap option is not necessarily valuable. It is most likely cheap because that is what it is worth. Averaging is a cardinal sin. An option trader once told me that he had reduced his risk in an option by buying on every dip. That is a myth. While your average cost of holding may have come down, your concentration risk is substantially up. Be cautious of illiquid options for two reasons. Firstly there is a danger of no exit and secondly, it normally attracts regulatory scrutiny.

### TAKEAWAYS FROM THE “OPTIONS BUYING” DEBATE

The gist of options was best summed up by the legendary George Soros. “Markets are constantly in a state of uncertainty and flux. Therefore money is made by discounting the obvious and betting on the unexpected.” Buying options provide the best route to bet on the unexpected. For the past many quarters, Infy has been volatile on the day of results. Buying strangles (a call and a put simultaneously) has almost always worked in case of Infosys. Watch out for such mug trades in the market.

Option buying is surely more complicated than buying equities or plain vanilla futures. But then, you at least know your worst case scenario. The aspect of time value surely adds a new dimension to it. There are some basic building blocks to a smart options buying approach. If you focus on options valuation, scientifically decide the strike to buy, monitor your position carefully and avoid the standard pitfall of averaging your position on each dip, you too can be a fairly successful options buyer.