Archive for August, 2007

A story about trading options

3 comments Written on August 30th, 2007 by
Categories: Options
Nifty closed at 4412 today. I'd mentioned to a friend on Monday, when the market was around 4300 or so, that the options data seemed to suggest that the market would move upwards rapidly in two days, and end near the 4400 levels.

What happened seems to have come through, but this just a thought that I haven't yet verified with past data. It seems to me that when is too much money riding on the fact that the market will go DOWN, it does the exact opposite.

The three options with the highest open interest on Wednesday were: the 4300 put, the 4400 put and the 4500 put. Together these accounted for an interest of around 99 lakh Nifty shares, an amount equivalent to 4300 cr.

My feeling was, when the put options have so much interest, they will make a lot of money when the stock price is below their strike price. In general, markets will move against where most people go - therefore, the price that looked most obvious from the data was 4400. The 4500 put traded much higher than Rs. 100 giving it a real value only when the Nifty was below 4400.

The upmove on Monday solidified that thought, since Friday was a bleak day for the US markets and we were supposed to follow suit. When Tuesday followed high, I took a position on the Nifty on Wednesday, writing a 4300 put, in my belief that the Nifty would end above 4300. A put-writer - or a seller of a put - is obligated to BUY at a certain price. My 4300 put-write gave me the obligation to buy the Nifty at 4300 on Thursday, one days later. Note that at this point, the Nifty was trading above 4300, so the premium I got was about Rs. 20. For one lot of 50 Nifty, I got about Rs. 1,000.

The margin I paid was Rs. 20,000 or so.

Now on Thursday the market rocketed upwards. It ended at 4412, nearly a 100 points up from where I had written it. Since selling me the Nifty at 4300 was useless, the option would be unexercised, giving me the Rs. 1,000 profit. What did I invest? Rs. 20,000 - the margin I put for writing the put.

Options are very risky; in fact, had I done this on Tuesday I would have been in some temporary trouble. Nifty ended up on Tuesday at 4300, and the put quoted at Rs. 20 then. The next day the market opened low, and the option was at Rs. 70 - a Rs. 50 loss. That means a loss of Rs. 2,500 per lot - a 13% loss in just one day! Yet the Nifty recovered and made the position a profitable one.

Most people who trade in options tend to buy them, but a lot of money can be made writing options, especially close to expiry. To me, it looked like the market would move against those that had bought options (because they have a limited risk - the option writers have unlimited risk), especially against the 4300 put because the open interest on that option was going UP when it should be declining (typically, option open interest in the last few days before expiry, declines)

So would I go and write all the top open-interest options the day before expiry? No. There needs to be a clear trend - increasing interest in a certain type of option and the direction of the top traded options. And I need to statistically analyse if such a strategy would have worked in the past - otherwise this is just co-incidence.

Note that commissions can put you out of business too. My commissions and taxes on my option was only Rs. 60, because I used Reliance Money. Had I used my account at Sharekhan I would have paid at least Rs. 250, a considerably lower profit.

If you have ABSOLUTELY no idea what this article was about, you probably want to read my Introduction to futures and options article.

Posted in Options

Firstsource acquires MedAssist

2 comments Written on August 30th, 2007 by
Categories: Stocks
Firstsource has acquired MedAssist for $330 million. Few salient points:
  • MedAssist makes about $100 million in revenue
  • 22-24% EBIDTA margins, so EBIDTA is $24 million or so.
  • Growing at about 10% annually.
  • Firstsource will take a loan of $275 million and fund $55 million from its internal kitty ($80 million). Loan comes at LIBOR plus 2.5-3 percent.
  • EPS accretive from fiscal 2009, says Firstsource.
Firstsource's share price has shot up from Rs. 71 to nearly 83 today, a stellar rise in a stable market. My view: this deal is not very EPS positive on its own
Mathematical analysis: $275million at LIBOR + 2.75%, where LIBOR = 5.1% for a year's term. That means 8.85% on the loan. That is $24.3 million in interest alone.

Consider then the loss of bank interest (6%) on the $55 million they put in. That's about $3.3 million. Total outflow = $27.6 million. Total inflow = EBIDTA grown at 10% = $26.4 million.

Cash flow hit = (negative) $1.3 million or Rs. 5 crores. This is not considering depreciation and taxes, which are likely to worsen the impact.

On it's own this deal will not be EPS positive; perhaps in 2009 there will be a marginal EPS credit, considering that the LIBOR stays where it is. In fact in 2010, three years from now, if things stay where they are today and revenues grow at 10%, this acquisition will yield an EBIDTA $3 million or so, about 12 crores. Post tax and depreciation this should be around 5 crores, in 2010. At the current equity of 42 cr. shares, the EPS impact is about 12 paise per share.

Firstsource made 97 crores in net profit last year, and by 2010 I don't think the EPS addition will be even 5%. The 10% rise in share seems to overvalue the deal.

Yet, there may be synergies that I cannot see on their balance sheet:

  • A US medical presence from which to expand, with an available track record.
  • Better efficiency (but I doubt it because Firstsource's current margins are about the same)
  • Entry into the med space with the HIPAA legislation may have been expensive had they tried to do it on their own.
  • Cross selling of other services to MedAssist's customers.
I don't know how much value to place on that (it's like saying "what is the value of a mangalsutra") so honestly I would say let's wait and see. On the financial end, this deal provides limited upside, but as an investor I see acquisitions as the only way to go forward. With a Rs. 2 EPS, Firstsource is valued at 40 P/E - a tad higher than one would expect - comparatively WNS (in the US) is valued at 30 P/E, and WNS is much bigger. I would personally wait and watch before buying.

Disclosure: I used to own Firstsource shares bought after the IPO earlier this year (average price 73). Sold all shares around May end, 2007. No current positions.

Posted in Stocks

News and views (28 Aug 2007)

5 comments Written on August 28th, 2007 by
Categories: Commentary
U.S. housing data isn't encouraging
The US markets are down on bad housing data. With house sales reducing every month (y-o-y) for the last five months, things look ominously bad. How does it affect us? Well, no home sales means defaults in loans. Loans are given by banks, packaged as mortgage based securities, and in turn sold to hedge funds. Hedge funds have fingers in every pie, including India. They may sell their profitable positions like India to make up for the housing losses.

This situation isn't improving anytime soon, even if the Fed cuts rates. There is simply too much silly lending that has happened to let it not affect us.

Dollar moves
The dollar's up to 41. Time to buy exporters? Not quite. In the face of the falling dollar, hedges were shored up to one quarters revenues in July, and as you might realise, the quarter still has a month to go. We'll have to see if the rupee slide is for real or temporary, but the going up indicates that FIIs are moving out (or at least, aren't coming in with gusto). But would you buy Infy and IGate? Not unless you read:

IGate and Infy hurt by subprime

So Infy and IGate fell prey to the subprime situation by losing a customer - Greenpoint. Not a very big deal for Infy, but could be for IGate. The P/Es of these companies are still 25 or so - fully valued for the near term if the dollar stays at this level.

The dollar upmove has another implication:

Forex gains of ECB holders to reverse
Tata Steel, Bharti Airtel, Reliance Communications etc. showed large forex gains (500 cr. types) in their Q1 results. With a fall in the rupee, the gains will reverse to a certain extent - and perhaps make their results less attractive in comparison. Airtel, without its forex gains, would have made just a 33% gain in profit over last year - high, but not as much as the 100% it did show. Again, for a company with a P/E of 40, even 33% growth isn't all that much.

There are other factors that may affect the market very soon: At the end of this month, hedge fund data will show us what kind of redemption pressure is around in the US. While all of this may sound bad, here's a few positive notes:

On a bullish front, US S&P 500 Puts are being bought by the dozen - a move that is bound to cause the market to rise because when a lot of people bet on the market falling, it usually rises.

In India, judging from just the sentiment on the TV channels, there seems to be an extremely high rate of caution. When people are cautious, the market rarely falls very much - as has been proved in the last month. Perhaps it's time to figure out what to buy; some candidates are in the small and mid cap spaces which have been battered much more than the top guys.

Posted in Commentary

No entry load if you buy directly from the mutual fund

10 comments Written on August 23rd, 2007 by
Categories: MutualFunds
Yay! You may never have to pay an entry load to a fund again.

SEBI has requested for comments on a proposal that says, essentially, that you need not pay any entry load when you invest directly with a fund (as opposed to doing it through a distributor/agent). This is fantastic.

What you need to do:

  • Write a mail to ruchic@sebi.gov.in saying that you completely agree with this proposal and that you support it wholeheartedly.
  • Wait till SEBI makes it a law.
After that funds will announce that you can invest directly without a load, and you should be happy.

Note that this process can take a lot of time. But at least it's a start. Also, be assured that distributors will gather all the support possible to veto this proposal. So if you're a reader, please write to the above email address with your consent. You will save 2.25% of your money later.

Posted in MutualFunds

Commentary that affects the market

3 comments Written on August 23rd, 2007 by
Categories: Commentary, Subprime
Lots of ups, downs, and sideways things happening in the broad market. Some news:

FIIs are selling.
FIIs have sold more than 8500 crores this month, till August 22. They invested around 24,000 cr. in July, so this isn't a panic situation. Yet. In fact,their net investment in 2007, even after these sales, is 34,000 cr.

Why are they selling? I don't know. People say it's the subprime problem, and that some funds have been forced to liquidate their assets. Perhaps they want to go to the US where the market has fallen to what may be attractive levels. The reasons always become apparent much after the fact - and the fact is: FIIs are selling.

The subprime problem is worse than we think.
What is the subprime problem? Here is a step-by-step recipe to create a subprime problem, for a new bank:

  • Interest rates are low, and people want to buy houses. But many of them can't get loans because they either don't have known sources of income, or have declared bankruptcy earlier, or have generally had bad credit history. How can we help?
  • Okay, let's give them loans at higher interest rates! "Er...but won't they default? They already have bad credit history!".
  • No, no, we have the house, right? We'll sell the house and recover our money! Anyhow housing prices are going up and up and up.
  • Okay, but they don't have income to pay the principal+interest.
  • no problem. Let's give them "interest-only" loans. They will pay only interest for, say 2 years, after which they'll pay back principal also.
  • Fantastic. Now we have hajaar loans. Homes are increasing in value, so some customers are selling their houses for 40% more, paying back the loan and taking another loan on a bigger house! Great stuff! But how can we give MORE such loans? We have not got enough capital!
  • I have a great idea: We have all these loans no? Let's package them as "mortgage backed securities" and sell them to other companies. They will give us money, which we can use to give more loans. Where they won't buy it, we'll borrow from them. Anyhow interest rates are low.
  • Great, now hedge funds have given us hajaar money for our securities and we have also borrowed more money, and are raking in huge amounts of money from the loan payments.
  • But interest rates are starting to move up!
  • Er...see, we will "reset" their interest rates only after two years, by that time they will be able to sell and give us back all the money.
  • Uh oh, the housing market is slowing down.
  • It's time for the loans to reset, but the customers can't pay higher rates, and they can't sell their houses.
  • Uhm. The default rate has reached 35%! One out of three customers is defaulting because instead of paying our "interest only" loan, they can get a new home for cheaper! How do we account for this now?
  • Let's go and get more money from the market.
  • Interest rates are too high and nobody wants to buy our mortgage based securities. In fact the people we borrowed from want their money back.
  • Uh, oh, the hedge funds who bought our loans can't recover them because of the default rate, and need to pay back their investors, so they are selling what they own - which is things like Indian stocks, Chinese stocks etc.
  • Uh, oh, but if we don't give more loans we will make no money! And how do we pay them back? Can we get some money from ANYWHERE?
  • ...
This is the story of many funds and banks in the US. First Magnus declared bankruptcy. HSBC, Lehman Brothers and Accredited have nearly shut down their mortgage operations. Countrywide just got a $2 billion funding from Bank of America, without which it would be finished.

The rest is starting to unfold. The Fed and the European banks have already thrown in more than $200 billion of money. The fed has cut rates by 0.5%. They want to save the economy by propping these big banks and funds up - the way they did in 1998 by saving Long Term Capital Management.

You can never really subvert a crisis like this. Eventually the lid will blow. But they can soften it for a few years; so don't go about selling everything, just the basic bits.

How does Subprime affect India?
Short Answer: You will only know after it hits us.
Long Answer:

  • IT outsourcers and BPOs can be hit badly if the banks stop giving them business. WNS recently announced a $26 million hit to its profits because they lost First Magnus as a customer.
  • Banks in India, which participate in consolidated funding or sourcing, may be hit. ICICI bank for instance takes loans from all over the world to fund its Indian operations.
  • If the US market is hit badly, FIIs will swing over, and the move will cause a slump in local markets (temporarily, but still, a hit).
  • If that happens the dollar will move up. Companies with ECBs will be forced to report losses on foreign currency gains, which as a line item made their growth seem fantastic this last quarter.
  • Subprime loans are in India as well. What we call "personal loans" or "pre-approved loans" are examples. Default rates on homes are moving up, it seems. Both ICICI and SBI have dramatically increased their NPA provisioning, and have both independently announced either slowing of credit growth or increase in defaults. Not good. ICICI, ever the smart financial cookie, has already taken on additional equity of 20,000 cr. and more loans to fight the obviously impending crisis. HDFC and SBI will follow shortly. The rest of the banking pack aren't yet responding.
All of the above is a short term problem. If you're investing for a ten year period, you should look at different things. If you ask me though, I would not invest in banks or IT till this drama settles down.

But interesting things are happening locally. Cement acquisitions: Holcim just bought a 15% stake in Gujarat Ambuja Cement. This may fuel more acquisitions in the Cement segment.

The political stage is also crazy; We may have fresh elections. My feeling is that elections will be good for us, because then we can vote out the Left parties. But if the Congress loses its enthu and pulls back on the Nuclear deal, all future deals will be seriously impacted. Then I will pull out whatever little I have from the markets.

On a personal front, I am still working hard with Kaushik to build Moneyoga. We are getting data on the markets and identifying patterns on them that will give us an idea of how good the odds are to invest in today's markets. We'll soon present that picture to you as well, in a form that is easily understandable.

And of course, it's raining in Bangalore. But before you go buy umbrella company stocks, note that it only rains for half an hour at a time.

Posted in Commentary, Subprime

Managing your portfolio yourself

9 comments Written on August 17th, 2007 by
Categories: Stocks
Does it pay to be actively involved with your investments? Rohit posted his comments on my earlier post ("Build Leverage"), and Prem has noted this too.

This got me thinking: So is it truly worth it to be involved with your investments? If you can eke out, say, 5% more than the market, on a portfolio of 50 lakhs you are only better by 5 lakhs. That's not much. Or is it?

The incremental cost of being actively being involved with your investments gives you a much higher longer term return. While the difference may not be visible now, it could be significant later.

Take 50 lakhs. Assume you have a 5% better return than the market. Just 5%. So the market gives you 12%. You can get 17%.

After 10 years, if you went down the market way you would have 1.5 crores. Your way would yield 2.4 crores. A 90 lakh difference.

Consider 6% inflation. Ten years later, the market investment is equal to 87 lakhs of today's money, and your managed funds is equivalent to 1.34 crores of today's money.

A 5% differential is worth 57 lakhs today. More than 100% of what you invested!

But how do you get a "better" return than the market?

You can manage your money better. There are just three things in investing.

  1. Money management: Some of your money should be in "safe" avenues (cash, debt funds etc), and some others in risky avenues like stocks. In stocks, you will allocate only so much money per stock that it does not take up more than x% of your portfolio (say 10%).
  2. Selection: You need to select stocks that will give you commensurate returns.
  3. Risk control: Have the discipline to control your losses. Meaning, if the market moves strongly against your trade, how do you react. Control your losses, ride your winners.
This is easier said than done. People are usually excellent at 2) above. But they get emotional about 1) and 3).

To get out of a losing trade requires cutting down your emotions. For instance, I had recommended SRF at 171. When I found it had bad results, the reason for my investing was over. I made an exit call at 146, a loss of about 10%. But had you held on to it, the price today is 127, a further 10% drop. (When things fall 10%, they tend to go on down another 10%)

Stop losses worked here. Even a risk control measure like booking profits helps. For instance my BHEL call was stopped out at 1650. It's at 1550 today. (And 1650 was at 40% profit) I owned (but had not formally recommended) L&T at 1950. It went to 2600+ and retraced to 2400 which was my exit point. It's sub-2300 today. It's not my calls that are important, it's the rules and the ability to stick by them.

Sometimes you can even book a 50% loss and still do ok. My Marksans Pharma post talks about how, since I got out at 128 - a near 50% loss from my buy price - the price has fallen to below Rs. 50 today.

Risk control does not have to be stop losses. It can be some other way, such as buying puts (or writing calls) to lower the risk of a stock going down.

Money management too isn't very complicated. You have to assess the amount of risk you can take (which has NOTHING to do with age, no matter what anyone tells you) and divide your money accordingly. In places where you can lose capital, please diversify enough to lower risk potential of an individual trade to less than 2% of your risk portfolio. Meaning, if you have 10 lakhs in stocks, your max loss on a single stock should be 20,000. If one of your stocks is worth 2 lakhs, set up a stop loss at 10% below its current value. If any of your stocks is worth 5 lakhs, the stop is at 4% below current price, which is quite small and you will get stopped out - so bring the weight of that stock down (either by selling some or adding more money into other stocks). That way you can always have 10% stop losses on your risk control while ensuring money management is sound as well.

All in all: Managing your own money, in my opinion, is a worthwhile exercise. For the long term. In the short term, there are bound to be disappointments but you will learn from them and be a better investor. Or even a better trader.

Posted in Stocks

Is Quantum right here?

6 comments Written on August 15th, 2007 by
Categories: MutualFunds
This one is a problem for you guys. Quantum AMC has an article in their July 07 newsletter saying thus:
Let’s take a normal school classroom. During the mid-term exams, two students Ram and Shyam scored 40% and 90% respectively. It doesn’t take a genius to figure out that Shyam (with 90%) is the better performer. Now comes the fun part. For the final exams, Ram scored 80% and Shyam scored 95%. Who would you rank as the better performer?

Shyam, of course! He scored 95 out of a possible 100 while Ram scored only 80. Yet, if Ram and Shyam were mutual funds, and were ranked in the way mutual funds are being evaluated, Ram (with 80%) would have shown up as a great performer while Shyam (with 95%) would have been an underperformer and the laggard!

The logic behind the ranking of Mutual Funds is that Ram, even though he has less marks, has improved by 100% (from 40 to 80) while Shyam has improved only by around 5.25% (from 90 to 95). By this argument, the “best” mutual funds could be those who have lost the most money for their investors initially and not done well, so that when they do recover lost ground – as Ram did when his scores jumped from 40% to 80% - they end up as the “best performers”. That, dear investor, is the potential flawed logic of ranking mutual funds.

I think there is a serious flaw in this argument. I've mentioned in an earlier post about Quantum that I think this is completely ridiculous.

Firstly, mutual funds aren't limited to 100%, are they?

Secondly, if the market moved up 35% in general, are we wrong to expect you to give us at least 35%? You are a no load, no commission fund, so the least I can expect is that you perform to the market's expectations, no?

What they really intend is that investors should look at a "risk/return ratio". There is something called the "sharpe ratio" which quantifies risk and return. Let me explain that in another post, but tell me if you also think the argument above is flawed, or if I'm just being silly.

P.S. I don't want to sound too harsh on Quantum, but it gets my goat when they charge you 2.5%, give sub market returns, and have the gall to say other funds are expensive and that they shouldn't be ranked.

Posted in MutualFunds

The futures opportunity

4 comments Written on August 14th, 2007 by
Categories: Futures
India is the world's largest single stock futures market, according to an article in FT. Meaning, nowhere else in the world do people trade stock futures than in India. This is confirmed by Andy Mukherjee in an article:
Indians, more than anyone else in the world, are crazy about single-stock futures. In January, the National Stock Exchange of India traded six times as many of these derivatives as Euronext.liffe, the world's No.2 market for contracts that oblige people to buy or sell a stock on a specified future date and price.
Single stock futures means futures on a stock, like Infosys or Reliance. Not all stocks have futures; Around 191 securities, out of the 1000 odd scrips traded daily, have futures and options that are tradeable.

What about the US? Well, options are traded there and there aren't any stock futures listed on the Nasdaq or NYSE. In stock options they beat the living daylights out of us - they trade about 100x our volume. Index futures wise, they again are about 15x our size.

Stock futures allow you to sell a stock without having to own it. In the US, you can do that in the spot market by "borrowing" shares. In India futures is the only real way to do it. Given that futures also gives you leverage - you can buy Rs. 100 worth of futures for Rs. 10 paid today as margin - there is a good reason to buy futures (or sell them) when the odds are on your side.

It's not an expensive trade, really. You can buy a Nifty future - lot size of 50 or multiples of it - for a margin of about Rs. 25,000 per lot. Each lot is equivalent to Rs. 200,000 or so (since the Nifty is at 4300), so effectively you get a position worth 10x your investment. You have to specify an "expiry date" - the date the future expires

That means that when the Nifty goes up 1% (40 points) you gain Rs. 2,000 - nearly 10% of your original margin. But if it goes down 1%, you lose 10% - that's the downside of leverage. You can "cover" this by taking the opposite position in the cash market - say by buying the stock and selling the future. The differnce is usually not large enough to make huge profits, but a reasonable 1% arbitrage is possible.

Once you buy (or sell) you can square off your transaction anytime before the expiry date by doing the reverse transaction in the futures market. Or, you can wait till expiry and reap the benefit (or loss) when the exchange squares it off at the closing price on the expiry day. If you have notional losses against the current market value of your position you may be required to place the loss as additional margin money.

One thing about stock futures though - they earn no dividends so none of that upside comes to you.

Posted in Futures

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