182) Securities Lending and Borrowing System(SLBS)

It has been almost four months since the Securities Lending and Borrowing (SLB) system was launched amid great fanfare. But there has not been a single trade in this window for over three months now.

And unless capital market regulator the Securities and Exchange Board of India (Sebi) overhauls some of the “user unfriendly norms”, that will continue to be the case, warn market watchers.

Custodians and institutional players have already made representations to SEBI, suggesting some amendments that could revive interest in this segment. These include extending the tenure of contracts, providing a longer duration for placing trades, and relaxing margin requirements.

While the SLB segment has failed to take off, foreign institutional investors (FIIs) continue to actively lend and borrow Indian equities in the over-the-counter (OTC) market.

FIIs authorised to issue participatory notes (PNs) are lending shares in their inventories to overseas investors for a fee, say sources at foreign broking houses. One of the reasons for the active OTC market is the lacunae in the domestic lending and borrowing mechanism, they claim.

“Why would FIIs want to play the over-regulated SLB market, when the offshore market is far more efficient and a lot quicker,” says an official at the Indian arm of a US-based brokerage.
At present, the tenure of a borrowing/

lending contract is seven days. This means that the borrowed shares have to be returned on the eighth day from transaction, to the lender.

Market participants say this time frame is too short. In the OTC market, players have the flexibility to borrow shares for up to a month or more. But the bigger problem is that of margins.

There are five types of margins levied on trades in the SLB segment. These include value at risk (VaR) margins, extreme loss margins, mark-to-market (MTM) margins, fixed percentage of lending price (to be paid by both the borrower and lender), fixed percentage of lending fee to be paid by the borrower.

The margins for the last two categories have been set at 25% and 100% by the National Stock Clearing Corporation - the clearing arm of the National Stock Exchange.

If all these margins are added, it works out to be as high as 100% or sometimes even more, say market participants. This means that to borrow Rs 100 worth of shares, you need to pay Rs 100 worth of margins, which then makes the trade unviable.

Such high margins make little sense, considering that the list of securities eligible for lending and borrowing is that same as that eligible for futures and options (F&O) trading. In such a scenario, a prospective borrower could as well go short on single stock futures by paying a margin of 25-30%.

“In the offshore lending market, the margin requirement is just about 20%,” says an official from an institutional brokerage house.

A group of custodians and officials from foreign brokerage houses is already said to have met the NSE, seeking easier margin norms.

These players are also seeking extension of the duration for which the trades can be placed in the SLBS window. At present, this window is open for only hours between 10 am to 11 am on trading days. Then comes the matter of transparency - how much is good enough?

The Sebi guidelines mandate the authorised intermediaries publicly disseminate the details of SLB transactions executed on the platform provided by them and the outstanding positions on a weekly basis.

Some players feel this could lead to front-running or other forms of market manipulation, as the market would be aware which player is short in which stock.

“Like in the offshore market, SLB has to exist in a dark pool of liquidity, or there could be attempts to distort prices,” says the official from the institutional brokerage.

181) Don`t worry about the Balance of Payments

The merchandise deficit is rising and FII inflows are falling, but higher FDI and stable ECB flows will ensure there's no forex crisis.

The recent sharp rise in the Current Account Deficit has brought attention back to the Balance of Payments accounts. Like many emerging markets, India has seen significant increase in capital inflows over the past few years as consistently above-8 per cent domestic growth attracted global investors. But, it has also seen a rising import bill on account of escalating oil prices and accelerating domestic demand for capital goods and metals. As India relies on oil imports to meet much of its oil needs, it remains vulnerable to volatile and uncertain oil prices. Moreover, relatively lesser liquidity in the global economy and an expected slower domestic growth this fiscal are also likely to generate smaller net capital inflows. But do these risks translate into a serious threat to the balance in external accounts?

Since the beginning of the decade, external transactions have resulted in an addition to the foreign exchange reserves as Capital Account Surplus and this has continually offset the Current Account Deficit. But the Balance of Payments composition and magnitude has changed significantly over the period. Acceleration in economic growth since 2002-2003 not only created increased thrust for imports of both oil and non-oil goods but also attracted large capital inflows. Thus the gap between Current Account Deficit and Capital Account Surplus has continued to widen every subsequent year. In 2007-08, where Capital Account Surplus jumped to record $108.3 billion, the Current Account Deficit soared to a record deficit of $17.4 billion.

The merchandise deficit has been the dominant component influencing the Current Account Deficit, with its contribution increasing sharply. Even though exports grew at a compound annual growth rate of about 20 per cent, imports grew at a much faster 24 per cent over the last seven years. Exports were driven primarily by demand for engineering goods, gems and jewellery, chemicals, and more recently petroleum products. But imports have been driven by demand for crude oil, electronic machinery and electronic goods, gold, machinery and iron and steel in accordance with rising demand for production.

Thus, the surging international price of most of these commodities in the last few years resulted in a much higher payments outflow on account of a higher import bill. Oil imports which constitute one-third of total imports have shot up 5.5 times since 2000-01 to $77 billion and meanwhile non-oil imports have ballooned four times to $171.5 billion. Consistently rising net invisibles balance (sum of net transfer payments, net incomes received from abroad and net services trade) has only partially offset the merchandise deficit. Even as net software services grew at a 26.2 per cent compound annual growth rate in the period, it offset only 40 per cent of the merchandise deficit every year. In 2007-08 specifically, invisibles surplus surged at 36 per cent to $31.7 billion but the merchandise deficit grew a further 42 per cent to $90.9 billion, bringing the Current Account Deficit to 1.5 per cent of the nominal GDP.

In contrast, the Capital Account Surplus has been driven by large inflows on account of portfolio inflows (FII), which have been virtually doubling every year over the past three years whilst the stock market rallied to record highs. Over the decade, these flows have increased 15-fold to $29.3 billion. While robust domestic economic growth and corporate performance attracted FIIs, easing investment regulations across sectors and greater interest rate arbitrage opportunities facilitated inflows of the other two significant constituents — external commercial borrowings (ECBs) and foreign direct investment (FDI). Both components have grown 5-fold to $22.2 billion and $15.5 billion respectively over the decade.

Significant increase in foreign acquisition of Indian companies and widening participation of global private equity players in India raised FDI flows to $9.2 billion in 2005-06 and further to $34.9 billion in 2007-08. The rapidly growing service sector and computer hardware etc. sector have been the largest recipients of these inflows. In 2007-08, housing and real estate and not surprisingly the petroleum and natural gas sector emerged as the other two important sectors attracting FDI.

Meanwhile, as the interest rate differential widened, ECBs became more attractive and easier to obtain as impressive corporate financial performance over the last few years reduced their risk perceptions.

But, de facto capital account convertibility over the last few years has provided resident individuals and companies greater opportunities to diversify their portfolios. This is reflected in the manifold rise in portfolio outflows, to $206.4 billion last fiscal. Importantly, rising global aspirations of Indian firms led to the emergence and growth of Indian multinationals encouraged by the steady rise in limit on their outward acquisition to 300 per cent of their net worth. From an average of about $2 billion for years, FDI outflow jumped to $6.4 billion in 2005-06 and further to $19.4 billion in 2007-08.

But these trends are set to change this fiscal as slowing domestic economic activity, tight global liquidity conditions, and more recently, slowing corporate profit growth point to moderating momentum of FII inflows this year. Yet, the long-term attractiveness of the Indian market will sustain FDI interest in the market and relatively high domestic interest rates are likely to prevent a sharp decline in ECB inflows. Moreover, volatility in equity markets across the world and relative strength in domestic growth vis-à-vis in other emerging countries will deter high capital outflows. The last two trends will cushion the impact of lower FII inflows this fiscal. Thus, the Capital Account Surplus is expected to drop to $ 70 billion or 5.3 per cent of GDP.

This would offset the Current Account Deficit completely. Even as high prices of oil, fertilizers and some commodities persist into fiscal 2008-09, a depreciating exchange rate (Rs 41.5-42/$ by year-end) will accelerate exports and encourage a fall in imports at the same time. While, demand for goods exports from the Asian neighbourhood and the Middle East will bolster growth, diversification of markets for software service exports will propel overall growth. This would partly offset the impact of high oil import bill. The oil import bill is likely to grow at 45 per cent to $111.7 billion in 2008-09, but the already evident fall in non-oil imports will take the total imports bill to $311.1 billion. The merchandise deficit is expected to rise to $123.8 billion as exports clock a 19 per cent growth. Moderation in invisibles surplus growth will result in a Current Account Deficit of $33 billion or 2.5 per cent of GDP.

Thus, while the gap between the Current Account Deficit and the Capital Account Surplus, will narrow in 2008-09, the Balance of Payments situation is still stable. Oil prices are the single-largest factor exhibiting considerable stress on the Current Account Deficit, but they have already begun to moderate, taking off some of the pressure. As of the end of March 2008, the merchandise imports cover of foreign exchange reserves was 15.6 months. By the end of 2008-09, the import cover is expected to reduce by a month and half by our calculations. Thus, while there is some stress, an overall healthy economy will prevent any crisis situation.

Radhika Anand & Parul Bhardwaj

The authors are economists at Crisil. ranand@crisil.com, pbhardwaj@crisil.com

180) Will dear money policy pay off?

The RBI seems to have accorded highest priority to liquidity management to tackle inflation. While it remains to be seen whether this will work or not, such tightened monetary policy does have a bearing on the other sectors of the economy.

The RBI’s move to raise the repo rate and cash reserve ratio (CRR) sharply upwards has raised a lot of eyebrows with some feeling that it may be an overreaction to the inflation threat. This is especially so given that it follows a hike in repo rate by 75 bps (25 bps on June 11 and 50 bps on June 24) and CRR by 50 bps on June 24, which took effect in two tranches in July.

The fact is that an adjustment of aggregate demand through monetary policy was warranted to anchor the heightened inflationary expectations, which were engendered by global commodity price pressures.

The apex bank seems to have accorded highest priority to liquidity management. It apparently seeks to achieve price stability by ‘taming’, and not merely moderating, inflation. To meet the pressures of rising inflation, slowing growth and higher deficits, the RBI has frontloaded the monetary policy.

The money supply or M3 (broad money) continues to be a relevant target and indicator. It was 20.5 per cent on July 4 against 21.8 per cent a year ago, reflecting the deceleration in time deposits. However, it is higher than the 16.5-17 per cent indicative trajectory of the RBI.

Similarly, bank credit to the commercial sector has been 24 per cent, above the 20 per cent indicated in the Annual Policy statement. These factors necessitate ‘continuous vigilance and appropriate and timely policy responses’ such as a rate hike in order to temper demand for money and thus, the velocity of money. The WPI inflation has been high when the inflation-stoking money supply was high (see Table)

The spread between the repo and reverse repo rates has increased from one to three percentage points over the last three years (see Chart). This signifies the heightened uncertainties in the financial markets. There is a positive correlation between the levels of uncertainties and the spread between the rates.

The spread was one percentage point when the level of uncertainties was relatively low in the markets. The increasing spread between repo and reverse repo rates now captures the myriad uncertainties. Recently, the RBI called upon banks to share some of the costs of uncertainties.

Effect on economy

The GDP growth over the past three years has been close to 9 per cent and has been fuelled by robust domestic demand and availability of credit at competitive rates. But the consumption and investment demand are likely to shrink in the current situation of hardening interest rates, thus reducing the aggregate demand.

Recently, the RBI revised the GDP forecast for 2008-09 to around 8 per cent from 8-8.5 per cent as the fundamentals of the economy continue to be strong. However, the fiscal deficit is likely to increase on account of the huge under-recoveries on oil account. The decelerating growth coupled with higher inflation gives the semblance of a stagflationary scenario in India.

With an increase in the repo rate, it is inevitable that the lending and deposit rates of banks would also go up.

In recent years, the reverse repo has been more frequently used than the repo window, which has also witnessed relatively greater number of fluctuations than the former. During the last one year, the repo window has been used in only 25 per cent of the days.

The frequency of resorting to the repo bids has been low as the call money rates have been hovering at less than the repo rate. On a similar note, bankers may increasingly resort to the call money market, as the call rate has been higher than the reverse repo rate.

Notwithstanding the frequency of using the repo window, the cost of funding increases following a rate hike and there is a pressure on net interest margins. Furthermore, the repayment schedule of bank loans gets affected in view of the increase in interest rates and there is a greater tendency for borrowers to default, thereby enhancing the scope of NPAs.

This creates the need for greater provisioning under prudential norms, as the quality of some assets turns suspect, thus having an impact on the balance-sheets of banks.

The RBI stated that banks should now lay greater emphasis on stricter credit appraisals on a sectoral basis, monitor loan-to-value ratios and ensure the health of credit portfolios on a durable basis, without encountering undue asset-liability mismatches.

It has been urging banks regarding the containment of credit growth and may even take a supervisory review of the banks, indicating that the financial sector has to be in sync with the monetary policy.

Banks that depend more on bulk deposits, which come with higher interest rates, are likely to be affected more on account of hike in CRR, rather than the ones that have low-cost deposits (current and savings deposits) from retail savers.

Corporate sector IMPACT

An increase in repo rate has a ripple effect on industry, as some of the projects that were hitherto viable owing to the low interest rate regime may be rendered unviable in the face of higher interest rates.

Despite fluctuations in the Index of Industrial Production (IIP), the capital goods sector has been growing at a steady pace and the investment demand up to April has been strong. This was because of the availability of funds and relatively lower interest rates.

However, both the IIP and capital goods growth figures declined significantly in May, indicating the state of things to come. Moreover, there has been a downward revision in the April data from 7 per cent to 6.2 per cent. There is a time lag between rising costs and rising prices. The costs of inputs are going up and this invariably gets translated into higher prices for the consumers. The slowdown in the capital goods sector would have an impact on the consumer goods sector as well. Given the current inflationary situation, companies that have a higher component of debt in their capital structure are going to face the brunt of hardening interest rates. The capex plans of these companies may be put on hold.

There is likely to be a slowdown in the manufacturing sector as corporates face the double jeopardy of drying liquidity and higher debt burden, on the one hand, and rising input costs, on the other. The impact of curtailed demand and sluggish investment are likely to be seen with a lag in FY10.

The economy has to brace with a higher level of structural inflation and it cannot be conclusively stated that the current correction in oil prices is a trend reversal. Though the double-digit inflation in India has been a harbinger of a tightened monetary policy, the quantum and the deployment of both the instruments in the Quarterly Review, were not expected in many a quarter.

While inflation is largely imported, attributable to the rising global commodity prices, factors such as incomplete pass-through of oil prices on the domestic front and rising fiscal and trade deficits continue to be irritants in the domestic economic milieu.

C. N. M. Lavanya

179) When numbers don’t meet expectations

If a stock falls, post-results, only because the quarterly numbers did not match ‘expectations’, it may be best to avoid selling the stock.

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As we put the June earnings season behind us, one question that is likely to linger in investor minds is about how stock prices react to results announcements. Sometimes, a lot of hype is generated before the declaration of the results and the stock is on an upward march, only to be hammered once the numbers are out!

The numbers not being up to ‘expectations’ is often the reason cited for such events. If the numbers don’t meet street expectations, does it automatically mean that the company is not doing well and that you should sell that particular stock? Not necessarily. To understand a company’s performance, you must know how to read and evaluate quarterly numbers.

Trends in input costs: High costs of input can affect a company’s profit margins to a considerable extent and input costs (mostly commodity prices) can be cyclical as well as seasonal.

Therefore, price trends in a particular quarter may not sustain in the next one. For instance, airlines have been affected by the high cost of aviation turbine fuel last quarter, but if prices fall, that could improve profits next quarter. The high cost of steel has dented the profitability of automobile companies and any correction in steel prices can help in the next quarter.

Seasonal business: Some businesses are seasonal in nature, with much of the revenues or profits being made over one period of the year. Hotels register their peak performance in the winter season, when tourist arrivals are at a high. Cement sales and construction activity are usually down in the monsoon months.

Launch or project expenses: Some businesses may have to incur huge initial expenditure while launching a product, commencing a business or floating a project. This can also be on research and development cost or those associated with acquiring or merging entities. Though such expenses, in the short run, can affect profits, in the long run, they may aid the company’s growth. The investor should carefully evaluate if project-related expenditure is on account of delay in implementation or cost-overruns, which may be negative.

One-time expenditure: Employee VRS expenses, one-time settlement charges for any legal dispute, charges payable on account of statutory dues may drag down a quarter’s profits on a one-off basis, but may actually have positive implications for the long term. Corporates such as Century Textiles, Phoenix Mils, Bombay Dyeing have incurred high expenses on account of VRS in the past.

However, the resources such as land and building that were released as a result of the closure of units have resulted in windfall gains or opened up business opportunities for them.

Non recurring income: The sale of a division/asset or a stake in subsidiary company can provide a one-time boost to income in one quarter and artificially depress growth rates, if calculated on this base.

For instance, HDFC had booked a sizeable profit from sale of its stake in Intelnet BPO in the recent past. Such income is not likely to be of recurring nature and should not be considered for the purpose of stock evaluation.

Provisioning requirement: Provisions made towards losses on derivative contracts, decline in the price of debt securities, doubtful debts, etc may impact earnings one quarter, but may not necessarily sustain. The important point to note is that these provisions may be reversed in future in case there is any change in the asset price of security or recovery of debt.

Quarterly numbers is not the key parameter to judge a company. The same should be read along with the sustainability of earnings and general business conditions. A quarterly analysis should be used to find out if there is a systemic decline in the business or profitability. Only that is a case for an exit. If a stock falls, post-results, only because the quarterly numbers did not match “expectations”, it may be best to avoid selling the stock. Wealth maximisation requires you to stick with a business for the long term. This may require riding over short-term blips in stock prices and earnings as well.

A. V. Pai
(The author is a free lance writer.)

178) How much cover do I need?

Do you need Life Insurance? In the Financial Planning that I do for my clients, this is usually my first question. The right question that we need to ask ourselves is — Do I need to protect my family even if I am not around? The answer is ‘Yes’.

The next question that I ask my clients is: How much of life insurance do you need on yourself to protect your family’s lifestyle, if you are not there?

The answer that usually comes back to me is — “I have lots of insurance policies – I am sure I have enough”. Yes, most of us have a number of life insurance plans. But do we have enough life cover to protect our families? How do we find whether we have enough life cover in our insurance plans?

Methods to Find Insurance Requirement

There are a number of methods to calculate the need for insurance. All these are based on finding an economic value (called Human Life Value) of the bread-winner of the family. Then insurance should be equal to Human Life Value.

The first method is the Income Replacement Method. Technically, this method defines human life value as the present value of all future incomes. The logic is that the family of the deceased should have the benefit of getting all the salaries/incomes that the deceased would have brought home otherwise. The other method is the Need-Based Approach. Here the present value of different milestones/goals/dreams in life, that the bread winner has planned for the family are added. To this the present liabilities are also added to calculate the insurance requirement. In other words, the present value of all milestones planned and liabilities held is calculated.

Let us illustrate these concepts with some examples:

Income Replacement Method

Mr Amar, 30, plans to retire by 58. His current salary is Rs 10,000 per month. He expects his salary to increase by 15 per cent annually. Inflation decreases his earnings by 6 per cent on an average.

The insurance need for Mr Amar based on the above calculation is nearly Rs 97 lakh, even though he earns only Rs 10,000 per month today.

Calculation Insurance requirement based on Needs Approach

Mr Akbar, 30, lives in a rented house with wife and son. He plans to buy a car worth Rs 3 lakh after two years. His dream house is to be ready at an expense of Rs 20 lakh after seven years. He plans to educate his son, who is 10 years old, with an engineering degree which today costs a total of Rs 4 lakh for the four years. He plans to gift his wife a diamond necklace worth Rs 5 lakh on their Silver Jubilee Marriage Anniversary in 15 years’ time. He plans to retire at 58 with Rs 1 crore in his bank account.

The average expected inflation is 6 per cent and average investment returns is 12 per cent. His dream car would be worth Rs 3.37 lakh after two years, factoring inflation.

Similarly, the house will cost Rs 30 lakh, the college education would cost Rs 16 lakh, the diamond necklace would cost Rs 12 lakh and the retirement fund would need to be Rs 5 crore, after we factor in inflation. Next, we can calculate the present value of each of his goals and sum them up. To protect his dreams and goals of his family, Mr Akbar should have about Rs 46.5 lakh as his life insurance.

Simplified Income Replacement Method

The above illustrations are highly mathematical and will require a good calculator or a spread sheet on computer to calculate. Is there a simplified way to find my life insurance need? Yes, help is on the way.

A simplified and uncomplicated way is to use what I call the Simplified Income Replacement Method. This gives the bare minimum of the life insurance that anyone should have. The limitation is that this method does not consider the effects of inflation. Here is our example:

Mr Anthony, 30, earns a salary of Rs 10, 000. He earns Rs 1,000 every month from tuitions. His personal expenses Rs 2,000 per month. He is currently saving Rs 500 in a mutual fund. The balance of the money he gives to his wife for running the household.

Thus, for a person earning a salary of Rs 10,000, and without any lavish expenses, a minimum life insurance of Rs 12 lakh is required.

Are we Sufficiently Insured?

Based on the calculations above, please calculate the life insurance you would need. Are you sufficiently insured? Most of us do not have enough life insurance. What prevents us from having enough life insurance? The Cost of Insurance This is the answer I get from practically all of my clients. “How can I afford to pay premiums if I were to have Rs 12 lakh as insurance at a salary of Rs 10,000 per month?

“One of my insurance agents says it will cost me Rs 25,000 per year for Rs 5 lakh insurance. The other one says that if I pay Rs 10,000 per year I can, at the maximum, get Rs 4 lakh as insurance. How can I insure myself for Rs 12 lakh,” — This is what one of my clients asked. The problem here is with the choice of insurance plans. In the above two types, one is an endowment plan and the other is a ULIP. The issue with the above plans is that they combine savings and investment respectively, with insurance. Hence they are bound to be costly.

The most elementary and basic of all insurance plans is the Term Insurance Plan, which is least costly. This is also the reason most insurance agents do not sell these plans — their income is also going to be lesser.

Life Insurance is not costly!

For Mr Anthony the cost of a term plan will be only Rs 3,600 per year for Rs 12, 00,000. Now is that affordable? Yes it is.

In fact the cost of the term insurance, is many fold lesser than most of the comparative vehicle insurance. For example the insurance for a car worth Rs 12 lakh will be Rs 36,000.

In fact, since insurance is basically to preserve the life style of our family and not for ourselves, then we can infer that we don’t need any insurance other than term Insurance. All the other plans are optional, for specific purposes which can be taken up only if we have a surplus.

Karthikeyan Jawahar
(The author is Director – Research & Consulting, Finerva Financial Solutions Pvt Ltd.)

177) Covered calls – here is how to use it

Derivatives by the virtue of their nature are perceived as instruments best put to use only by traders.

That, however, is not entirely correct for even long-term investors can use a few derivatives tricks to improve their return on investments. Using covered calls is one such way you can boost your equity returns.

How to set it?

This strategy involves selling ‘out of the money’ call options in a stock, against the purchase of an equivalent number of shares of that stock. Covered calls can also be written if you already hold an equivalent position in the underlying.

Since the strategy is almost always backed by equity holding, it is considered less risky.

When to use it?

Covered calls can be used when you are bullish on the underlying stock over the long-term but feel that the stock price will trade in a tight range over the lifetime of the contract.

Investors sitting on idle long-term holdings, looking to exit it in the near-term can also consider this strategy.

To better understand how this strategy can be used and what its limitations are, let us suppose you are bullish on the long-term prospects of TCS (trading at Rs 845).

But over the near-term, you feel that the share price would trade sideways, weighed down by the waning appetite for IT stocks in the market.

Depending on what you foresee as the upper trading range of the stock (say, Rs 900), you can consider selling calls at that strike price.

So, if you have bought, say 500 stocks of TCS at Rs 850 each, you will need to sell two lots of TCS August month

Call option at strike price Rs 900 (trading at Rs 23 per share) to cover the purchase completely.

This is so because TCS stock options have a lot size of 250 shares.

Alternately, you can also chose to partly cover your equity purchase by selling just one lot of TCS call options.

The profitability of your strategy would depend on the share price movement of TCS.

If TCS trades flat and ends the month at about the same price at which you purchased the stocks, then your sold call option will expire worthless.

This means, you will get to pocket the premium (Rs 23 per share).

But, if the stock price falls from your purchase price, while you would still get to pocket the premium, you may have to bear some notional loss on your equity investment, as its value would have also gone down by as much.

However, you can take heart from the fact that the premium pocketed from selling the options would bring down your net cost of purchase of the stock.

So, in both these cases, where the stock price fails to trend upwards you would have, in essence, outperformed the stock returns in the cash market, courtesy premium received on selling the calls.

However, if the stock price of TCS were to rise beyond Rs 900, then you may be required to part with your shares, since your sold call option would then stand the risk of being exercised.

In such a case, your upside would be capped at Rs 900, regardless of the extent of gains in the underlying’s share price.

Caveats

Since the strategy involves selling call options on a stock, note that it would limit the near-term upside potential of your stock.

So, even if the stock’s price zooms significantly above your purchase price, your returns would be limited to the difference between its purchase price in the cash market and the strike price of the sold option.

Further, writing covered calls may not be possible for all the stocks, even if they are traded in the derivatives segment, as not all stock options enjoy adequate liquidity.

This means, that you may also stand the risk of not finding any takers for your calls.

Srividhya Sivakumar

176) Benchmarks: Do multi-style managers justify alpha fees?

Last week, this column discussed about how to identify closet indexers — those that claim to be active funds but essentially hug the benchmark index. The problem with closet indexers is that they charge a high fee for beta exposure. In response to that article, readers posed several interesting questions. One such question was how to choose benchmarks for diversified funds.

We address the issue of choosing an appropriate benchmark for diversified equity funds. We discuss the importance of benchmarks and the constraints a benchmark poses on truly active managers.

Need for benchmarks

It is both fortunate and unfortunate that most equity funds in India follow multi-style investing. It is fortunate because multi-style funds can generate higher alpha (market outperformance). It is unfortunate because performance evaluation of such fund managers becomes difficult.

Alpha is the excess returns that a portfolio (adjusted for beta) generates over the benchmark index. This excess returns is due to the manager’s skill at security selection and/or market timing.

Suppose a large-cap styled active fund generates 40 per cent returns during a certain period. Suppose the S&P CNX Nifty, the appropriate benchmark, generates 25 per cent return during the same period. If the portfolio beta is 1.5, the beta-adjusted return on the fund should be 37.5 per cent (25 per cent times 1.5). The excess return or alpha is, hence, only 2.5 per cent. Investors usually pay high management fee for alpha returns. Take Reliance Equity Fund. This fund has an expense ratio of 1.81 per cent. The fund’s stated benchmark is the S&P CNX Nifty. If this fund does not generate sizable excess returns, an investor can just as well switch to an index fund that has expense ratio of one per cent or lower.

Benchmarks, therefore, enable investors to ascertain whether fund managers justify the high ‘alpha’ fees that they charge. But choosing benchmarks is not easy. For one, using a narrow-style index as a benchmark for a multi-style fund is not suitable. For another, most diversified equity funds do not provide clear investment objectives so as to enable analysts to apply suitable benchmarks.

Benchmark for multi-style managers?

Truly active managers do not like benchmarks. The reason is that, in order to beat the benchmark, an active manager is forced to select stocks within the benchmark universe. And that acts as a constraint in generating alpha. Small wonder that Peter Bernstein argues that “traditional benchmarking for active portfolio managers is contrary to the client’s best interest.”

Peter Bernstein’s argument will be more practical for institutional investors. Such investors follow liability-driven investments. That is, they match their investment with their liability structure. The benchmark is the required return on the liability structure. Importantly, the benchmark return varies between one institutional investor and the other. This does not pose any problem as institutional portfolios are typically separately-managed accounts.

Mutual funds are collective investment vehicles. Pooling the required returns of various unit-holders into one useful benchmark becomes difficult. So, required return cannot be used as a performance evaluation benchmark for mutual funds. A benchmark index, thus, becomes the preferred alternative.

To ensure that truly active multi-style managers are not constrained by narrow benchmarks, a broad-based benchmark such as the S&P CNX 500 can be considered. This serves two objectives. First, such a broad-based index encompasses all investment styles ranging from large-cap growth to mid-cap. And second, because this index is stuffed with all kinds of stocks, generating alpha returns becomes difficult. This will weed out funds that invest in large caps and mid caps but use S&P CNX Nifty as the benchmark index to show some alpha returns.

Peer Universe?

There is a tendency among analysts to use peer universe as a benchmark for performance evaluation. If an analyst wants to evaluate a multi-style fund, the peer universe would be all funds following multi-style investing.

There are several problems in using such peer-group evaluation. The most important characteristic of a good benchmark index is that it should be investible. That is, an investor should be able to replicate the benchmark portfolio either by taking exposure to such shares directly or through an index fund.

A peer group of all diversified equity funds, for instance, fails on this count. The benchmark portfolio is only known at the end of each month, not before. How can this benchmark be replicated?

Conclusion

Appropriate benchmarks enable investors gauge if active funds justify alpha fees. It is equally important to ascertain if such managers consistently generate alpha to justify the higher fee structure.

B. Venkatesh

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

175) If crude falls further, equities may follow suit

Stocks, bonds, gold and every other financial asset have been dancing to global gyrations in crude oil prices. In 2008, Indian stocks have moved exactly in the opposite direction to crude prices. The BSE Sensex dropped to its low of 12576 points on July 16, shortly after crude hit a record of $147.27 a barrel on July 11. And the recent recovery to 15000 has been triggered by tumbling oil, which is now below the psychological $120 mark.

If rising oil triggered a flight of investments from Asia, the recent correction in oil prices has injected fresh life into Asian stocks.

Net importers of oil, such as India, are no longer pariahs and are suddenly back on the “buy” list of institutional investors. Oil exporting economies are being hastily downgraded. But is there another side to the relationship between crude oil and Indian stocks? Will stocks continue to rise if crude continues to fall?

Point: Declining crude prices should directly tame inflation, the biggest worry for emerging markets such as India. If inflation subsides, the RBI may turn dovish on interest rates, which is good for the companies and stocks.

CounterPoint: Oil prices may have to dip below $100 levels and stay low for the RBI to review interest rates. That appears unlikely for now. Even if oil prices do stay low and inflation drops, the RBI may take its time to cut rates, given that the inflation rate it is targeting is still much below current levels.

Point: With crude oil becoming unattractive from an investment perspective, ‘smart’ money may come back to equity investments, especially in the emerging markets. With India among the worst affected markets in 2008, our markets are now attractively placed and might attract a huge share of those funds.

CounterPoint: Rising crude prices helped wealth creation in the oil producing countries, especially the Gulf nations. A lot of investments from this “oil money” has entered emerging markets such as India. A sharp correction in crude oil prices would lead to a dwindling of fund flows from those countries. Second, with every asset from real-estate, bond prices and equities all witnessing a sharp fall, crude oil was the last bastion to earn returns. If that gives way, investor wealth can only be further eroded.

Point: Falling crude oil is good for the earnings of India Inc, which was facing pressure from rising input prices.

CounterPoint: Index heavyweights such as ONGC (to some extent), Reliance Industries and Reliance Petroleum stand to benefit from firm crude oil prices. The weakening of prices could put pressure on them. Moreover, prices of other industrial inputs such as steel, non-ferrous metals and agri-commodities were also responsible for margin pressures on companies. These too need to cool off to help margins.

Point: A major worry with rising crude oil was that it widened India’s current account deficit, weakening the rupee against major currencies. If this deficit narrows, the rupee may gain strength. That may prompt foreign investors to view India more favourably, as their returns from India investments could improve.

CounterPoint: Though the rupee is influenced by the current account deficit, it can stage an appreciation only if capital inflows into Indian markets pick up substantially. That, in turn, depends on how FIIs view Indian stocks.

K. S. BADRI NARAYANAN

174) FII activity in 2008 — Still some glimmer of hope

FIIs are not unabashedly bullish about the Indian stock market any more, as is evident from the $6.4 billion of net redemptions by them so far in 2008. That accounts for about 11 per cent of the cumulative investments put in by them since they first started investing in India in 1993.

However, if these numbers bring to mind an image of FIIs scrambling en masse to the exit doors, that may not be entirely right either.

In the first seven months of 2008, registrations by FIIs seeking an entry into Indian markets have continued to climb. Gross purchases by FIIs, the actual indicator of foreign investor activity in India, are greater than last year. And shareholding pattern disclosures for June show that the FIIs have increased their stakes in quite a few stocks in the mid- and small-cap spaces.

This article looks at some of these trends and identifies stocks that featured in the FIIs’ buy list in the last quarter. .

Total FII registrations with SEBI, which were 1,219 in December 2007, were 1,457 at end-July. New registrations by FIIs, which slowed between February and April, went up significantly between May and July. January, when the stock market touched its pinnacle at 21k, saw 60 new FIIs and 151 sub-accounts being registered.

The number of new registrations, however, dwindled with the correction, to bottom out at just 15k in April 2008. The months that followed did see a revival in registrations, though, with 54 FIIs and 113 sub-accounts registered in July. In the last three months, 123 new foreign institutions registered with SEBI.

There was a sharp increase in the number of sub-accounts too (376). The new entrants may not rush to make their first investments in Indian stocks; but the pick-up in registrations is surely indicative of sustained FII interest in the Indian markets.

Last year’s crackdown on investments through the participatory note route has probably prompted investors with more long-term India ambitions to register with SEBI, despite the more stringent disclosure norms.

A profile of the new registrants shows quite a few institutions from West Asia — particularly Qatar, Oman and the United Arab Emirates. Also seen were institutions from Poland, the Netherlands, Ireland and France, apart from FII havens such as the US, Singapore, Mauritius and the UK.

Quite a few of the registrants were pension funds and insurance companies, suggesting that their investments in stocks, as and when they happen, may be of a lasting nature; the entities include Qatar Insurance, The Financial Corporation (Oman), College Retirement Equities Fund (US), Amansa Capital (long-term returns; US), UPMC Health System (US), National Social Security Fund (China). One interesting registration in July was from Nalanda India Fund, a PE firm investing only in public enterprises.

Higher gross purchases

It is usual, when analysing FII data, to look at the “net” picture alone — that is, the difference between the total purchases and sales put through by FIIs. But what has been happening to “gross” purchases, which are more reflective of the total quantum of buying or selling by FIIs in a period?

Though FIIs have recorded net sales of Rs 5,36,800 crore so far in 2008, their gross purchases during the year were significantly higher than last year, totalling to Rs 4,93,884 crore till end-July, or 28 per cent higher than the gross purchases recorded in the corresponding period last year (Rs 3,83,957 crore). Of course, gross sales too have been much higher, at Rs 5,23,650 crore, against Rs 3,41,153 crore last year, resulting in a net sale of stocks.

However, the gross data certainly shows that overall FII interest in Indian stocks has, if anything, risen this year and that, for every FII in exit mode, there are others willing to pump money into this market.

It is also possible that the FIIs which sold their holdings invested in new-found opportunities. The pace of FII ‘net’ selling in the Indian market also decelerated in recent months, from a level of Rs 5,011.50 crore in May, to Rs 1,445 crore in July. So, if FIIs have been pumping money selectively into the stock market, what have they been buying?

On screening the stocks in the BSE-500, the April-June quarter saw 190 stocks registering an increase in FII holdings. Interestingly, of the lot, there were 35 large-cap stocks (market capitalisation of over Rs 7,500 crore), while the others were all mid- and small-caps. In the list of stocks that saw a significant (4 per cent plus) increase in FII holdings, there were seven stocks in the small-cap and five stocks in the mid-cap space.

The only stock from the large-cap space was Cairn India. But the space where FIIs chose to rejig their portfolios most significantly (sales and purchases of over 4 per cent) was in the small-caps. The number of small-cap stocks recording a big net “decrease” in FII holdings was much higher than the number which saw an increase.

Bulk Deals Route

FIIs displayed no specific sector bias and acquired and sold stocks from a range of sectors. Also, they didn’t ramp up stakes on too many large-caps, nor did they reduce them. But for ACC (which saw a 6 per cent fall in FII stakes), no large-cap stock saw a fall in FII holding of over 4 per cent. The assumption that some FIIs could have sold their holdings to invest in new stocks is also supported by disclosures made to the exchanges on bulk deals. Such players as Morgan Stanley, Merrill Lynch Capital Markets, Fidelity Investments and Goldman Sachs Investments were seen re-shuffling their portfolios and were active on both the buy and sell sides. Morgan Stanley was seen selling Balrampur Chini, Elder Pharma, Gujarat NRE Coke, and buying LIC Housing Finance, Shree Renuka Sugars and Temptation foods. Fidelity Funds, on the other hand, sold Saregama, Piramal Life Sciences, ING Vysya Bank, Britannia Industries, Apollo Hospitals, Alembic and bought , Rallis India and Titan Industries.

July, in particular, saw fresh buying by FIIs that registered late last year — Credit Suisse Singapore and CLSA Mauritius, among others such as Warhol, Swiss Finance and Morgan Stanley, that continued to display optimism. The major selling in the last two months was by Deutsche Securities, Templeton Mutual Fund and ABN Amro Bank.

The moves by FIIs were company-specific and provided no signals as to their overall stance on sectors. With sufficient proof that FIIs haven’t deserted India, domestic investors may look for some suitable stocks to add to their portfolios at present.

Rajalakshmi Sivam

173) Little less fear, little more greed

Financial markets are waking up to the possibility of the RBI lowering rates later in the year.

Inflation is inching up, the RBI is on the warpath, interest rates are tightening and company profits are beginning to disappoint. Despite all this, I sense a shift in the mood of our financial markets — from one of utter gloom to very cautious optimism. For a while, asset markets seemed to be drowned in a flood of bad news. They now seem to have returned to doing what they are meant to — look beyond the present and try to price in the future. The future, it appears, does not seem as bleak as the current flow of data and news would suggest.

A number of things could be responsible for this turn in mood. The sharp decline in prices of oil and other commodities has quite obviously lifted spirits. It might be interesting to figure out exactly why. Markets are used to the idea of recession. What bothered them for much of the first half of 2008 was a twist in the plot — the fact that instead of pushing inflation down, the prospect of a sharp slowdown in the world economy came with a dose of high inflation. As the confusion about what was the bigger problem — slowing growth or high inflation — multiplied, risk aversion grew and markets sold off.

The prospect of stable if not lower commodity prices is helping to clear some of this confusion. The implication is that if the current business cycle goes back to a textbook template, the task of macroeconomic management becomes more clearly defined. Instead of toggling between the conflicting objectives of reining in inflation and propping up growth, governments and central banks can now focus exclusively on fighting the slowdown. Markets like this clarity.

In short, financial markets are not expecting a sudden reversal in the business cycle. Apart from the pathological contrarian, most market analysts are convinced that the next few quarters could see declining growth. What brings a glimmer of hope is the possibility that if commodity inflation abates, macroeconomic policy can now address this slowdown squarely without bothering about the inflationary consequences.

Let me make this less abstract and discuss the implications for India. If commodity prices stabilise globally, the effect is likely to seep into local headline inflation a few months from now. Thus while the inflation rate measured year-on-year could continue to move up, the rate of increase in prices month-on-month could slowly diminish. Thus, it is possible that the inflation rate will reach a peak of 12-13 per cent by October and then start moving down.

Banks have taken cues from the recent moves by the RBI and are hiking rates aggressively. This is bound to take a toll on credit demand and growth and my sense is that by the last quarter of 2008, most bottom-up indicators of economic activity would signal a palpable moderation. Companies’ bottom line will have sagged by then and analysts will start to pare their forecasts for the future considerably.

What does the RBI do if this situation indeed emerges? There are a couple of clues that the recent monetary policy statement provides. Let me quote two sentences from the policy. In the section on the stance of monetary policy, it says, “Slower growth in demand may temper commodity prices and ultimately inflationary pressures; however, the manner and period over which this adjustment would take place is highly uncertain.” A couple of paragraphs later, it says “while modulation of aggregate demand assumes crucial importance, it is also necessary to nurture and consolidate the recent gains in augmenting supply capacities and improvements in productivity and efficiency which accrue over a longer term horizon”.

What could the central bank mean by this? My take is that if the current trend in commodity prices sustains and there are growing indications that the monetary squeeze is hurting investment spending in the economy, the RBI could reverse monetary policy. It would first switch to a “neutral” stance and take a pause in hiking rates. It would then, depending on the degree of the growth slowdown, contemplate a reversal of the interest rate cycle. It is possible that by the end of this year or by early next year, the RBI starts paring interest rates or lowering reserve requirements. My assessment is that financial markets, particularly the bond market, are beginning to wake up to this possibility. The stock markets might need more to be convinced, but once they sense that interest rates are close to their peak, fear could easily give way to greed.

The other bit that is helping the markets seem to regain their confidence is the fact that the dollar is regaining some of the strength that it had lost against major currencies like the euro and pound over the past year. My understanding is that the health of the American currency is critical to global risk appetite the world over. A wobbly dollar is bad for riskier asset classes like emerging market equities and debt. This includes Indian equity and debt assets. A stronger dollar is a very basic signal that the world’s leading growth engine, the US economy, is on a path of recovery (however long that might take). This gives investors confidence.

It would be frivolous not to emphasise the associated risks. The US financial system is still not out of the woods and a couple of nasty shocks in the US banking system could send investors scurrying back to commodities. Local demand shocks in India could send prices of things like food soaring and the RBI might not want to relax its grip too quickly. However, the balance of risk and rewards seems a little more favourable now for asset markets.

Abheek Barua

The author is chief economist, HDFC Bank. The views here are personal.

172) Widening deficit

The trade numbers for June 2008, released last week, show that exports continue to do well, but also make it clear that the country continues to suffer a monthly trade deficit of $10 billion. A little over half of this is paid for by the surplus on trade in services and by remittances from Indians overseas, and the rest is covered by capital flows. There is also the cushion provided by $300 billion worth of foreign exchange reserves, equal to about a year’s imports. These numbers do not therefore warrant worry just yet, but watchfulness is certainly called for because of the negative trends. The trade deficit, for instance, is running at more than 40 per cent annual growth. The villain of the piece is oil.

Exports during the April-June quarter were valued at $ 42.8 billion, a healthy 22.3 per cent higher than a year earlier. The growth rate was slightly higher for June, suggesting acceleration, which is good news for exporters in a relatively sluggish global scenario. The rupee depreciation against the major currencies, during the past few months, has not helped much, though. The currencies of most countries that compete with India in the global market behaved similarly over this period, and domestic cost increases have offset the potential benefits of depreciation to exporters. Whether this relatively healthy performance will continue, though, is difficult to say. There are widespread expectations that the US economy will go into recession later in the year, which is likely to bring down the growth rate of Indian exports to a degree. In any case, the ambitious target of $200 billion for 2008-09 (which needs 30 per cent growth) looks unachievable, since even the first quarter numbers have fallen short of the implicit target for the period.

Imports during the quarter grew faster than exports, by 29.7 per cent over the corresponding quarter of last year, to reach $73.2 billion. Of these, oil imports accounted for $25.5 billion, just over a third. In fact, oil imports grew by more than 50 per cent over the first quarter of last year. Here, the depreciating rupee has clearly contributed to raising the bill, even as the long-delayed and still very incomplete pass-through of international oil prices to domestic consumers continues to encourage consumption.

The trade deficit therefore crossed the $30 billion mark for the quarter, 42 per cent higher than during the first quarter of last year. At these levels, it is likely to be more than 10 per cent of GDP for the year as a whole. As the deficit widens, something which is quite likely to happen if export growth slows down and oil imports continue to grow at their current rate, the vulnerability of the economy to any disruption in other inflows increases. This could happen for any number of reasons. Service exports could become sluggish because of market conditions, while remittances are vulnerable to any disruption in West Asia. Most importantly, the direction of capital flows has reversed to some degree. If substantial capital flows out, as has happened in recent weeks, it will reinforce the concerns about emerging balance of payments pressures. The large foreign exchange reserves obviously help tremendously to minimise such concerns, but it would be unwise to ignore the direction in which the external sector is heading.

171) Mildly bearish? How to profit from it

Placing option bets in highly volatile markets such as the present one may require derivative traders to exercise their grey cells more intensively. After all it is no easy task to make money in a market that appears to have a mind of its own.

So, if you are mildly bearish on the markets, don’t just buy a put or short the market blindly– remember volatility can kill your capital in no time.

Instead, use bear spreads that not only limit your maximum loss potential, but also give you an array of risk-return spreads to choose from.

When to use this strategy?

Consider using a bear put-option spread when you are moderately bearish on the underlying. However, if you are extremely bearish on an underlying, this strategy may not be best suited as it will limit your returns potential.

Options spreads, because they are essentially low-return strategies, are ideally suited for traders who have a lower appetite for risk.

How to set a bear put spread

You can set this spread by buying a put option with a higher strike price (in-the-money) and simultaneously selling a put with a lower strike (out-of-money) on the same underlying asset with the same expiration month.

This strategy, unlike the bear call-spread (discussed previously in this column) is a debit spread, since it will entail an initial outflow of money. This is because price of the purchased option will be higher than that of the option that will be sold and hence setting a bear put will involve an initial net debit.

For instance, if you are mildly bearish on Nifty and feel that it will trend down in the next few days, you can set a bear put spread by buying 4400 Nifty July put option (trading at Rs 112) and simultaneously selling 4300 Nifty July put option (trading at Rs 59). The cost of setting the spread will be the difference in the premium between the two options (in this case, Rs 53).

However, remember to execute both the legs of the strategy simultaneously as that will help you lower the margin money required for writing options.

Risk-return payoff

Essentially a low-risk and low-return strategy, this spread will deliver range-bound returns depending on the price movements of the underlying index or stock.

Maximum profit potential: The maximum profit for this spread will occur when the price of the underlying moves below the strike price of the option that was sold (option with the lower strike price).

Maximum profit potential however will be limited to the difference between the two strikes minus the net debit paid or the cost of setting the spread.

In this case, the maximum profit will be Rs 47 [(4400-4300) – Rs 53]. Breakeven point: The breakeven for the spread lies between the strike prices of the put options that have been transacted.

It can be calculated as follows – upper strike price minus net debit paid. (In this case, 4400-53). Maximum loss potential: When your spread is totally out of money i.e. when the underlying price is higher than the strike price of the purchased option, the maximum loss that you can suffer will be limited to the net debit paid – that is the money that was spent initially in setting the bear put spread. In our example, the maximum loss will be limited to Rs 53.

So, in essence as far this example is concerned you will be taking a maximum risk of Rs 53 to earn a maximum profit of Rs 47.

This risk-return payoff, however, can be changed to suit your appetite by tweaking the strike prices of the options involved. For instance, the same strategy when set using 4400 and 4250 puts will enjoy different risk-return potential. Since the maximum profit that can be earned though this strategy is limited, traders should consider booking profits and closing the positions as soon as the underlying trends below the strike price of the sold put option. On the downside, if you feel that the likelihood of the underlying moving down is low, you can consider a premature closing of positions before hitting the maximum loss scenario.

Bear put vs. bear call

Both bear put and bear call spreads in essence benefit from a downward movement in the price of the underlying. So, in order to decide on which strategy to use when you are mildly bearish, first compare the risk-return payoffs for both the strategies.

Depending on the time value of money and the volatility in prices, the two strategies will involve a different risk-return matrix. Besides that, since a bear call spread involves an initial credit at the time of setting it, the same can be chosen over the bear put if you are temporality tight on cash. That said, it primarily should be the risk-return payoff for the two spreads that should determine your final choice.

Srividhya Sivakumar

170) Trade set-ups: Options for the downturn

There are many who believe that the current up-move in stock prices will not last for long. Here are two option strategies to help traders who believe as much. The objective in both cases is to take advantage of the negative view and yet cap the upside risk.

The Indian stock market has been starved of positive developments for sometime now. It was, therefore, not surprising to some when the stock market climbed up, perhaps, as a response to the ruling party surviving the trust vote. There are, however, many who believe that this upmove will be short-lived. This poses some important questions. For one, should short sellers cover their positions? For another, can long-term investors take advantage of their negative view in the short term?

This article discusses two options strategies that these traders/investors can employ. The first strategy recommends taking profits on the short futures position and switching to puts or put-spread. The second is an income-enhancing strategy and employs covered call-write on an underlying that forms part of the core portfolio.

Covering shorts

Suppose a trader had short-sold Nifty futures at 4825. She is now wary of the up-move but is worried that her profits will be eroded if the Nifty spot index continues to move up. What should she do?

One alternative is to cover the short position and take profits. But the trader suffers from decision regret. What if she covers her shorts and Nifty declines thereafter? The pain from a wrong decision - to cover the short too soon - will be hard to bear. A trader knows upfront that she will suffer from decision regret. So, she will not want to cover her short position. Yet, running the naked short poses high risk.

The trader can draw some solace from the fact that the options market provides an optimal strategy. The trader can cover her short position and take profits. She can then use some profits to buy August Nifty puts. This way, her initial capital will not be at risk. And the puts will be set up to profit from her negative view on the market. The trader should choose the strike that is relatively cheap in terms of implied volatility.

Rolling into put spreads

Most traders may not want to pay 125-150 points to set up long put position. Such traders can consider rolling into a bear put spread. Such a spread is set-up buying a higher strike put and selling a lower strike put. This is done to subsidize the cost of the long-leg; the premium gathered from the short-put can be used to buy the long-put.

The problem is that the short-leg will not fetch sizable premium when Nifty is moving up. The reason is that the market will then price the up-move as more probable than the down-move.

The strategy would be to first buy puts but wait till Nifty moves down to sell a lower strike put. The short puts will then carry higher premium for two reasons. One, the turn in the Nifty index will increase the underlying volatility. The higher volatility makes options more valuable. Two, demand for puts will increase as more traders will now perceive a down-move more likely.

The trader should sell a strike that is close to the support level. That way, the short option will be worthless while the long option will expand to its fullest if Nifty closes at the support level on expiry date.

Income-enhancing strategy

Consider an investor who follows a core-satellite portfolio structure.

Suppose the core portfolio has exposure to large cap stocks. The investor can consider selling Nifty calls against this portfolio. Assume she sells the August Nifty 4700 calls.

If Nifty spot index moves up, the calls will also move up, resulting in mark-to-market (MTM) loss. But the trader’s core portfolio would have also moved up in value.

There are two ways to handle this process. One, the trader can pay the MTM in cash. Two, she can sell some underlying that she believes will pull-back after the near-term up-move ends and use the proceeds to pay the MTM loss.

If the trader decides to choose the second alternative, she will have to buy back the stock at a later date. Choosing not to do so will change the portfolio composition and may subject the portfolio to unwanted investment risk.

If the Nifty moves down as the trader expected, she can cover the short call at a lower price. Covered call-write is an income-enhancing strategy that wants the option to expire worthless so that the trader captures the premium.

This article discussed two strategies appropriate for those who believe that the current upmove will not last for long. It is important to understand that the cash-settled market design enables traders to set up a covered call-write without the risk of the underlying being called away. There is a caveat. As options carry non-linear payoffs, short-legs are more risky than long options. Traders should beware of this factor before setting up related positions.

B Venkatesh

(The author is an investment strategist. He can be reached at enhancek@gmail.com)