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CM Strategy

Optionalysis: Making Money When Markets Fall

The market’s falling, eh? So what, says the trader. What difference does it make, if money can be made?

Making money from falling markets is almost considered unethical, but obviously, it’s not. (If it were, selling toothpaste for a profit would be unethical too) There are three ways you can do it:

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Shorting futures

You sell a future, pay a margin and as the market goes down, you make a profit. A Nifty future short would cost you around Rs. 30,000 per lot in margin, and then, for every point drop in the Nifty, you gain Rs. 50. The downside? For every point increase in the Nifty, you must pay out Rs. 50 as well. It’s a linear payoff – you make as much on the way down as you lose if the index goes up a similar number of points.

You can buy it back anytime you want; you shouldn’t have to wait till expiry.

If you have many positions you don’t want to sell, you can also short futures on those stocks to cover from a potential downside. You can also take Index futures positions to hedge against a broad market move against you, instead of hedging individual stock futures.

Typically people own long term portfolios, and have shorter term positions. We would classify these separately, instead of using consolidated returns.

Buying puts

You pay a premium today and make a profit if the stock goes down. In general, premium will increase if the stock or index falls, regardless of whether the stock price has reached that level or not. So if you buy a 7700 Nifty put at Rs. 50, when the index is at 7820, you will profit if the index falls to 7750, even though 7750 is higher than the strike price of 7700! Since the market is willing to now pay a higher premium than earlier, the premium could be Rs. 70, which means your Rs. 50 investment can be sold for Rs. 70, a 40% profit.

Notice what just happened.

The index fell from 7820 to 7750, which is 70 points. If you had a futures contract you would have made Rs. 70 per share. But the put option went from Rs. 50 to Rs. 70 only – or, only 20 points.

The lower return is to compensate for the fact that as an out of the money option, you have the ability to keep your losses lower (you will never lose more than the premium anyhow). While you may be tempted to think of the fact that you got a 40% return, remember that there is a chance of losing 100% of your money – a chance that is very very unlikely if you bought the future.  

The way to handle this: position sizes.

Where you might buy 5 contracts of the future, you might have to buy 10-15 contracts of the put option to make a comparable return.

For instance for a portfolio of Rs. 500,000 you might not take more than 5 contracts of the future (50 shares per contract = 250 shares), with a stop loss of say 100 points higher. This exposes you to a loss of Rs. 25,000.

For the same Rs. 25,000 you could buy 500 put options at Rs. 50 each, which is 10 contracts.

A 100 point move in the Nifty may result in only a Rs. 50 move in the option premium, which makes up by the fact that the position size is higher.

The problem with the put is that premium loses time value all the time. As options go closer and closer to expiry, we see that premiums are lost on a continuous basis. Look, for instance,at our long strangle – which we exited at a minor loss – taken when the index was at 7958.

On Sep 30, We bought the 7900-8100 strangle (lower put, higher call) at a premium of Rs. 140 together. Today, just about 18 days later, we see the index at 7780 – a good 200 points below – and yet, the 7900-8100 strangle is at Rs. 145 only! (Rs. 135 for the put and Rs. 10 for the call!)

This means that if you buy options you better expect a quick move. We expected the volality, we got it right, and we still lost money!

(In our portfolio, we moved over to the 7500 put at Rs. 10, which we’ve sold at Rs. 27 and Rs. 16 in the last two days. This has more than made up for the losses on the strangle. Options requires us to be quite dynamic, on a regular basis, and markets like this with high volatility will need extremely quick action.)

Selling Calls

Selling a call option sounds stupid. Your gain is capped, your loss is unlimited (if the stock or index goes up!). But if you look at the data, and the fact that options lose premium very fast, a consistent option writing strategy might actually work wonders. In the last few years, “eating premium” has become such a huge strategy that even large Portfolio Management Systems have risked client capital and made good returns.

While a strategy of only selling calls without stop losses will be suicidal, you could use proper option strategies to profit from market falls.

We’ve spoken of selling calls as a part of a “Covered call” strategy, when you own the underlying stock or index, to benefit from an up-moving market. But you could also sell calls in a down-moving market, or even a flat market to benefit from time decay.

Look at a weekend, when there are 12 days left to expiry. If the Index is at 7800, and the 7800 call is at Rs. 100, that premium would decay by about Rs. 15 in two days, if the Index is at the same level. If there is a downward bias, the premium could fall even further.

When you sell options, you don’t even need the market to fall fast. All it has to do is stay flat or fall, and you’ll profit. You can never be a perfect predictor, so you will lose some – but a simplistic strategy is to sell calls when the stock or market is bearish, and to book profits as you go.

The risk is of course that the market goes up. And given how options are, you could sell an option for Rs. 50 and have to buy back at Rs. 100 – is that a huge loss? The answer is: no.

A sold call will involve placing margin – as much as a future – to the exchange. So 100 Nifty (2 contracts) will involve your paying Rs. 40,000 as margin. If you lost Rs. 50 per share, your loss is Rs. 5,000 which is about 12.5% of your investment (not 50% or 100%).

(Even 12.5% is high, so we recommend that even if you give the exchange only Rs. 40,000 you should probably allocate Rs. 100,000 for such a trade)

Going To Cash

One thing mutual funds can’t do is what we’ve done in our mutual fund portfolio. With only 6 positions out of a possible 10, we are about 60% allocated. We could go to zero percent as well! But mutual funds cannot, and one of the ways to beat your mutual fund or index when the market’s falling is to simply go to cash.

Going to cash and keeping the money in, say, a liquid fund can beat the market on the downside by making interest.

You might ask: what if the market goes up? Remember, most money in large moves involves a change in trend, a long trending move, and then a change in trend again. The long trending move is 70% of the total trend – 30% is in the swings.

If you can make the meat – the 70% – you don’t have to bother about the swings. So if you keep strong stop losses and only invest when the trend is clearly in your favour, you are likely to make the meat of a strong move. You’ll always miss the first 30%. Which should be fine, but peer pressure makes us desire to buy at the absolute low and sell at the absolute high.

Look at Bharat Forge. We bought it at Rs. 660, and sold it at Rs. 811. The stock had moved from Rs. 400 to Rs. 900. Are we terrible traders? No – our opportunity started at Rs. 600 or so, we got in at Rs. 660, and then after the Rs. 900 we saw the Rs. 840 as a stop, and could only exit at Rs. 811.

Or, see BEML. The move from Rs. 540 to Rs. 800 was very very fast, and we grabbed it, but got off at Rs. 700 on the downside
. Our money went out of the stock, the stock has retraced to Rs. 550, but we made out bit and moved away. 

Relative to the two stocks above, our exit into cash has been profitable. And the fact that we earned interest on that money, even more so.

Cashing out isn’t entirely a bad thing; but only if it is done with discipline (having an acceptable stop loss).

Profiting From The Downside

We’ve now seen three ways to profit.

  • Selling Futures (Short)
  • Buying Puts
  • Writing Calls

We could actually do a combination of all the above. Sell a future, but buy a call as a hedge if the market moves up. Sell a call, but buy a higher strike call to limit potential upmove losses.Move half your positions to cash, and hedge the rest.

The degree of profit depends on what you do, and how much you do it. Much about our posts on position size and stop losses will also be useful.

The problem with the downside is that we often look at it as temporary. It is usually when it seems temporary that it lasts way longer than we think! It might be silly to take every minor move as an opportunity to short, but a sustained down move – when a stock or market moves down 5% or more – gives you opportunities to profit. Like it has been in the last few days – and unless the market goes back up to 8,000, possibly in the next week as well.

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Disclaimer

Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mind. This is educational or informational matter only, and is provided as an opinion. 

Disclosure: The authors at Capital Mind have positions in the market and some of them may support or contradict the material given above, or may involve a direction derived from independent analysis.

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