Singapore's Nifty Giraffe Beats India Stock Data Ban by a Neck

Singapore Exchange Ltd. has announced a new product that an excited hedge-fund manager described to me as the "most brilliant use of finance."

That's an exaggeration, of course, though with a large grain of truth.

SGX will launch three derivative products in June: SGX India futures; SGX India options; and SGX India bank futures. For 29 out of 30 days, these contracts won't be anchored by any underlying security or index; they will be whatever their buyers and sellers want them to be.

Read more here.

Sunday musings: Why Eklavya’s sacrifice should be a warning about trading in stock or index futures

The epic, Mahabharata, has many stories and incidents that reveal man’s inhumanity towards fellow humans. The well-known story of Eklavya’s sacrifice is a classic example.

For those not in the know, or have forgotten what they had heard from their grandmothers when they were small children, here is a quick recapitulation.

Eklavya was a low-caste hunter who had ambitions of becoming a warrior. So he sought to learn archery at Dronacharya’s martial arts ‘school’. Dronacharya was appointed by the king of Hastinapur to teach the Kaurava and Pandava princes.

The brahmin Dronacharya refused to teach the low-caste boy. The third Pandava, Arjuna, who was Dronacharya’s favourite pupil, shooed Eklavya away by saying that a low-caste person was not fit to learn along with high-caste princes.

Eklavya was disappointed but not disheartened. He built a clay model of Dronacharya and installed it in a forest clearing. He regularly practised archery in front of his model ‘guru’, and became an expert archer within a few months.

One day, a barking dog disturbed his practice. In a fit of pique, he shot a few arrows into the dog’s mouth. The dog wasn’t hurt too badly, but stopped barking. By chance, the Kaurava and Pandava princes were on a field trip in the same forest. Dronacharya and Arjuna came upon the dog with a mouthful of arrows.

Astonished by the sheer skill of the archer, they sought and found Eklavya practising. When asked who his teacher was, Eklavya pointed to Dronacharya’s clay model. Arjuna was very upset at finding an archer with better skills than him. Dronacharya was secretly happy but to pacify Arjuna, wanted Eklavya’s right thumb as ‘guru dakshina’ (teacher’s fees).

The young boy cut off his own thumb without hesitation. Dronacharya blessed him and said that Eklavya will still be a great archer – which he became by learning to shoot arrows with his forefinger and middle finger (much like modern archers do now).

Moral of the story? Entering into any venture may seem easy at the beginning. Skills can be learnt by perseverance and hard work. But future consequences often depend on the skills and mental acumen of competitors.

Does that mean avoiding any venture due to the fear of competition? Obviously not. But weighing possible future consequences and having an appropriate strategy before starting out can save you from financial disaster.

Most small investors lose their shirt in the F&O market because of their failure to weigh future consequences. Particularly in the futures market, the risk of making a huge loss far outweighs the easy margin entry and possibility of making some quick profits.

Remember that competitors in the F&O market are typically large institutional investors and HNIs with huge resources in terms of money, research and experience. They will beat you regardless of your skill levels.

Want to make money in the stock market the easy way? Read this post.

About taxation of Capital Gain/loss on equity shares, MFs and F&O transactions – a guest post

Many small investors enter the stock market without adequate preparation. Some resort to F&O trading in the hope of making quick gains. The consequences are often disastrous. Not only should one learn about how the stock market works and how to choose stocks/funds for trading or investment, one needs to know about the tax implications of various transactions.

In a guest post, Aashish explains the tax implications of profits and losses made in the stock market. If you find the post useful and/or have any questions, please leave a comment using the ‘comments’ link below the post. 

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Profits earned on sale of equity shares and equity-oriented MFs (65% or more of portfolio consisting of equity shares) are taxable as capital gains. Capital gains can be ‘long-term’ or ‘short-term’ depending on the period for which the equity shares/MFs are held.

Equity shares/MFs held for one year or longer are treated as ‘long-term’ for capital gains purposes. Any profit on sale of such shares/MFs is completely exempt from capital gains tax u/s 10(38) of the IT act - provided the transaction is processed through a stock exchange and Securities Transaction tax (STT) is paid. Any long-term capital loss has to be absorbed by the tax payer as such a loss cannot be set-off against a long-term capital gain, which is tax free.

If equity shares/MFs are held for less than one year, they are treated as ‘short-term’ for capital gains purposes. Any profit on sale of such shares/MFs is subject to capital gains tax @15% (+3% cess) u/s 111A of the IT act – provided STT is paid for the transaction. Any short-term capital losses can be set-off against short-term capital gains before calculating short-term capital gains tax.

In case STT is not paid – such as for a private transaction between two parties, or a share buyback by a company directly from its shareholders, or in the case of unlisted privately-held shares and non-equity oriented MFs (less than 65% of portfolio consisting of equity shares), capital gains tax on profit is computed differently.

Any profit earned on sale of such shares/MFs is taxed at normal capital gains tax rates. For short-term capital gains, the tax rate is as per tax payer’s individual tax slab (+3% cess). For long-term capital gains, 2 options for taxation u/s 112 of the IT act (whichever is lower) are available to the tax payer:

Either, the cost of acquisition of shares can be indexed according to the Cost Inflation Index published each year by the tax authorities; tax is assessed @20% (+3% cess) after taking into account the profit based on the indexed cost of acquisition; Or, tax is assessed @10% (+3% cess) without taking into account any cost indexation of such shares.

Futures & Options transactions are not delivery-based. There is no physical delivery of any capital asset. There is no question of any short-term or long-term capital gain or loss as F&O contracts are not treated as capital assets. Any gain or loss on such transactions is considered as regular business gain and loss.

Therefore, F&O profits are taxed as business profits as per tax payer’s individual tax slab (+3% cess). Any F&O losses are treated as business losses and can be set off against any other source of income (other than salary).

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(Aashish Ramchand is passionate about Indian taxation advisory and loves to write about the Indian tax system and its various nuances. A Chartered Accountant by profession, he is the Co-founder of Make My Returns.)

Was it a freak ‘error’ trade or a ‘short and distort’ scam?

For those who don’t have much experience in the stock market, the trading anomaly observed last Friday (Apr 20 ‘12) may have come as an unpleasant surprise - specially for those who prefer to trade in the F&O segment. Here are the facts, as already published in news media:

1. The Nifty (and the Sensex) were drifting along sideways in a very narrow range for the better part of 5 hours, when suddenly the bottom seemed to fall out.
2. Apparently Nifty’s future contract for April saw a freak trade that valued the contract 300 points lower than the Nifty spot price. Earlier, Infosys stock futures dropped more than 400 points in another freak trade.
3. The two freak futures trades taken together caused spot Nifty (and the Sensex) to plummet.

Several traders tried to explain away the anomaly by calling them trading ‘errors’. But the NSE authorities denied that there were any ‘errors’ and said that the existing systems have enough checks and balances. If there had been only one freak trade, it could have been attributed to an ‘error’. But two freak trades in the same day were too many.

So, what really happened? The answer will get revealed after the SEBI and/or the NSE authorities investigate the freak trades. But circumstantial evidence may be pointing to a well-planned ‘short and distort’ scam. This is a less known scam than the ‘pump and dump’, but the underlying logic is the same - to separate inexperienced investors from their hard-earned money.

How does the scam work? Scamsters first open short positions in an index/stock, and then spread unsubstantiated rumours or distorted facts through email, SMS messages and message board postings in investment groups. In this case, a message doing the rounds earlier in the week predicted that the market will crash on Apr 20. No reasons were given. Some hints about a negative astrological configuration were dropped. When the actual crash came, the short positions were quickly covered. The Nifty bounced up smartly, and closed higher on a weekly basis.

Some times, the scam is also used to get out of tight situations. If some operators had shorted Nifty prior to RBI’s policy announcement and had been caught unawares by the surprising 50 bps rate cut and the subsequent rally, how would they cover their losses? By pushing down the index level below their shorting level – by hook or by crook.

Those who panicked and sold off learned a painful lesson: Do not pay attention to unsubstantiated predictions about the market – even if such predictions turn out to be correct at a later date.

How to use Covered Calls – a guest post

Last month, Nishit wrote about the Short Strangle strategy to make money in a sideways market. Not too much has changed since then. The Nifty is still trading within a range - not giving a clear direction.

Individual stocks in your portfolio may be going nowhere also. Can you generate some profits without selling your stocks and losing out on dividends or bonus issues? Covered Call writing may be just the strategy for you, suggests Nishit.

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We continue with our series of F&O with an article on Covered Calls. Covered Calls basically mean we already own an underlying asset and sell Calls.

The Wikipedia definition is:

A covered call is a financial market transaction in which the seller of call options owns the corresponding amount of the underlying instrument, such as shares of a stock or other securities. If the trader buys the underlying instrument at the same time as he sells the call, the strategy is often called a "buy-write" strategy. In equilibrium, the strategy has the same payoffs as writing a put option.

Let us take an example of Infosys. Infy has been rallying from 2700 to 2950 from the June Series. That’s roughly a rise of 10% for the past past 3-4 weeks. Logic states that if a stock rallies before results, then any good news is discounted in its price. Same logic if it falls before results. This is based on the principle that markets discount all news in advance.

Assuming I have Infy shares constituting 1 lot in F&O, which is 125 shares. If I had written 1 lot Rs 3000 strike price Option of Infy on Tuesday, then I would have got Tuesday’s price of 52. This would entail a premium inflow of Rs 6500 (=125x52).

I have 125 shares of Infy in my account. Now, if my trade goes right and Infy falls, then I get to keep the shares as well as pocket the premium of Rs 6500.

Now if Infy rises, till Rs 3000, I don’t pay anything. This is because Option strike price is Rs 3000. At Rs 3050, I have to pay Rs 50. My inflow is Rs 50 from writing, so no loss no profit.

Above Rs 3050, I start having to pay up. This also means that when market price was Rs 2950, I was covered till Rs 3050 for losses and above that, I sell my shares which I hold and pocket the money. Suppose, Infy hits Rs 3100, then I sell off at a rally of Rs 350 from the bottom which translates to 13% gain in a span of 4 weeks.

A stock like Infy moves max 20% in a year in a range. Like from Aug ’10 to Jan ’11, Infy moved from Rs 2700 to Rs 3500. Not a bad deal.

This strategy is recommended for Long Term Investors who have shares in their demat accounts and want to earn some money on the side, without losing out on dividends or bonus.

Before entering any trade, one should have a clear idea of reward, risk and max loss and max profit.

Note: The figures at some times may be indicative or rounded off for example’s sake. The idea of this article is to try and explain the fundamental principle. True students of Option Strategies should try and grasp the basic principle. The strategy works best for stocks in which you are long-term bullish, but which may not be moving much in the near term.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

How to Short Strangle a sideways market – a guest post

In last month’s guest post, Nishit explained how options can be used to hedge your stock portfolio against potential losses. It can be a useful tool, provided you learn how to use it properly. The added advantage is that you need not sell off your holdings, if you are properly hedged.

What happens when a stock market is not going anywhere? Taking two steps forward and three steps back? Nishit presents a neat strategy that can make money in a sideways market. If you like what you read, or have a question, please leave a comment for Nishit.

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The markets are trading sideways for the past several days. How do Option Writers benefit from this?

As explained last month, Options are perishable commodities. They are a factor of price value and time value. For example, if Nifty is at 5550 and 5500 Call Option is trading at 110 rupees, 50 rupees is the intrinsic value and 60 rupees is the time value. Time value is value of time left till expiry when the Option will be squared off at the market price. The extra premium is with the expectation that the price will move up by at least 60 rupees till expiry.

Introduction on Options as below:

http://money-manthan.blogspot.com/2010/12/introduction-to-options-part-1.html

Options are bought by people and those people who sell Options are known as Option Writers. Why would people write options? Option Writers always make the maximum money and they are often big institutions.

In a sideways market, one can have a Short Strangle. What does this mean? The Nifty is now near 5400 and trading in a band between 5350 and 5600. The days to expiry are 2 weeks. One can write the 5300 put at say 60 rupees and 5600 call at 50 rupees. By writing these 2 Options we can get 110 rupees as premium.

Can we make a loss?

If the Nifty goes below 5300 or above 5600 we start making losses, in the sense that we will have to pay out money at expiry. We had received 110 rupees as premium so theoretically we are safe between 5190 to 5710. At the most we will make no loss and no profit.

Also, once the direction becomes clear we can either short Nifty or buy Nifty to cover the direction whether we are making a loss. Thus one side we take in the entire amount as profit.

Writing of Options should be done keeping the technical levels in mind and not in isolation.

One more way of deploying cash balance is at the end of the month. About 4 - 5 days from expiry, write Calls about 200 points above current market price. The price of each Call would be about 10 rupees after removing the brokerage.

Now, a margin of 1 lakh will allow you to write 4 lots which will bring in about 2000 rupees. Doing it every month for 12 months, will bring you 24000 or about 24% return on capital deployed.

The Caveat Emptor here is that one should keep technicals in mind and not blindly write calls. Also, calls are much safer to write than puts as sharp rise in price is never sudden as against a sharp fall due to news events.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

How to use Options as a hedge – a guest post

In Chapter 3 of my FREE eBook, I explained why small investors should avoid Futures and Options trading. The odds for success are too low, and the chances of making a loss are too great for my liking.

I belong to the old school of buy-and-hold investors who prefer to get rich slowly. For younger (and smarter) investors, who are not as risk averse as me, Options can be a useful hedging tool. Nishit explains how in this month’s guest post.

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Options are much misunderstood and much maligned. They are best used for hedging, and not as a gambling mechanism.

To read the basics of Options one can refer to this older post of mine:

http://money-manthan.blogspot.com/2010/12/introduction-to-options-part-1.html

How do we use Options?

Let us suppose we have a portfolio of stocks and feel that the market is going to take a beating. One approach is to sell our stocks and sit on the cash – which is the safer route. Another approach is to write calls and pocket the premium. E.g., when the Nifty was at 5900, we could have sold the 5900 call option at Rs 142 and pocketed the premium. One would have been at a loss only if the Nifty went above 6050, a gain of about 3%.

To buy options you need to pay a premium, and the seller gets the amount the buyer has paid. He is paid this amount in order to compensate the seller for the risk he is taking - the risk of markets rising.

If the markets rise, your portfolio would also have risen proportionately, provided it had blue chip stocks in it. One could do this month after month and earn extra money while at the same time keeping the portfolio intact. This requires a bit of effort in the sense that one needs to know a bit of technical analysis to understand the support and resistance levels.

What-if Analysis

One could come back and ask: why not buy Puts to hedge? The problem here is that Options are like mangoes, a perishable commodity. If the markets don’t fall, you lose your premium. In case of writing calls, you are getting a net inflow and you would only make less money and lose money if the markets rise more than 3%. If the markets rise more than 3%, then you have got your technicals wrong.

Is the converse true? When we feel the markets are going to rise, can we write Puts?

Writing Puts is one of the most dangerous things to do. Why? Most of the falls are sudden and unexpected. The triggers are something out of the blue. Consider the 9/11 events or some assassination or natural disaster.

Writing Puts and Calls leaves one open to unlimited liabilities. In case of writing calls, one has his or her portfolio as a hedge, but in the case of writing puts there is no hedge really. It should be left to big institutions to do.

Writing Puts can be indulged in, when one has bought another put as a cover. E.g., I know the market is at a support level and will bounce form that level. I write a 5700 put at Rs 150 and buy a 5500 put at Rs 60. My net inflow is Rs 90. The maximum loss I can suffer is if market closes on expiry at 5500, which would render the 5500 put worthless and for the 5700 put I would need to pay Rs 200. I have already got an inflow of Rs 90. So, my net loss would be Rs 110.

Options are great hedging tools but need to be handled very carefully.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.) 

What can small investors learn from the Put-Call Ratio (PCR)?

Before launching into a discussion about the Put-Call ratio, I need to make a disclosure. I strongly feel that small investors should stay far away from Futures and Options (F&O) trading. Most options contracts expire worthless and investors lose the premium amount that they had paid.

(I had made this point very clear in 'Chapter 3: What are your Future Options?' of my eBook. Haven't got your copy yet? Get your FREE eBook today!)

A put option owner has the option, but not an obligation, to sell the underlying security (a stock or an index) at a pre-determined price within a specified time. Likewise, a call option owner has the option, but not an obligation, to buy the underlying security at a pre-determined price within a specified time.

The Put-Call ratio (PCR) is calculated by dividing the total number of put options traded by the total number of all options traded. A ratio of more than 1 means more put options were traded than call options (i.e. more investors were feeling bearish). A ratio 1 or less means more call options were traded than put options (i.e. more investors were feeling bullish).

If small investors are supposed to stay away from F&O trading, why should they be interested to learn about the Put-Call ratio? The short answer is: the PCR is a short-term contrarian sentiment indicator.

As stock market indices drop near a bottom during a bear market, investors turn extremely pessimistic in panic and fear and expect to see further downsides. Many more put option contracts are traded than call options, and the PCR ratio keeps going higher.

How high is high? There are no fixed benchmarks. But a ratio of 1.5 or more means that bearishness is becoming excessive. As option traders are generally incorrect in their market sentiment assessment, a high PCR is taken as a contrarian 'buy' signal.

When stock market indices rise to a top during a bull market, investors become excessively greedy and euphoric and expect to see newer highs. More call options are traded than put options, and the Put-Call ratio drops below 1. This is used as a contrarian 'sell' signal.

Most business channels and pink papers make a big noise about the PCR. Just keep your eyes and ears open. Whenever the PCR gets to 1 or less, a correction may be close at hand. When the PCR gets near 1.5 or higher, it may be a good time to enter.

Like all technical analysis indicators, the usefulness of the Put-Call ratio (PCR) should be taken with a pinch of salt. It is not infallible. So never take buy/sell decisions based only on the PCR indicator. It should be used in conjunction with other indicators.

What are your future options?

A British schoolboy cricketer had once approached Sir Geoff Boycott to learn how to play the hook shot, because he was frequently getting out trying to hit a hook. Boycott told him that the best way to play the hook shot was not to play it! "But how do I score runs?", the boy had asked. Boycott's response was typical: "Don't get out! The runs will come."

Futures and options trading by small investors is akin to a school boy playing the hook shot. The chances of losing money overshadows the probability of scoring big. It is far better to buy quality stocks and wait for your wealth to grow.

Nowadays the lot sizes for F&O trading have been reduced, but the risks have not. Such trading is better left to professional and institutional investors who play for much bigger stakes and usually buy or sell in the cash market and hedge in the futures.

There is no harm in being aware of what F&O trading is all about, and some smart investors can get clues about the market from the difference in spot and future prices and volumes. But I get  confused when I hear talk about 'covered calls',  'strangles' and 'naked futures' and have stayed far away from F&O trading.

Seems like I'm not in a minority of one. The legendary Peter Lynch has made the following comments in his book 'One Up on Wall Street':

"I've never bought a future nor an option in my entire investing career.... Reports out of Chicago and New York, the twin capitals of futures and options, suggest that between 80 and 95% of the amateur players lose. Those odds are worse than the worst odds at the casino or at the race track, and yet the fiction persists that these are 'sensible investment alternatives'.... I know that the large potential return is attractive to small investors who are dissatisfied with getting rich slow. Instead they opt for getting poor quick .... Warren Buffet thinks that stock futures and options ought to be outlawed, and I agree with him."