The markets have fallen: and we are apparently going into a bear market just today. This is just nomenclature – we’ve been in a bear market for a LONG time now and this 20%- fall-from-the-top commentary could just tilt things in favor of going bullish, at least temporarily.
But the point about this fall can be looked at in multiple ways:
1) At what point would you go long, saying there’s value in today’s market?
2) If markets might see further downside, but we think it’s at a good point today, can we build a strategy that benefits from the upside, but doesn’t hurt on the downside?
We have written – two years ago now – a post on how you can build your own Capital Protection Plan in three ways. The concepts there still apply, and we’re going to do one additional twist today. We will try and buy the Nifty at a lower level.
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Take a person who has Rs. 10 lakh. That’s two Nifty contracts now (each contract is of 75 Nifty).
Now, he could buy Nifty (either an ETF or Two contracts). That has disadvantages – if the Nifty falls, he loses money. This is not popular nowadays, since the Nifty isn’t exactly doing that well.
Buying Nifty at a Lower Level Than Today: Writing a LEAP Put
Can we construct a portfolio where, for the same Rs. 10 lakh, a person can “buy” the Nifty at a lower level than today’s 7300?
Remember, the Nifty trailing P/E is at 19.74 today. Perhaps you find the level of 18 more attractive? (Since earnings growth is slowing). That would be a 10% lower number today, around the 6,600 levels. If that sounds like the level you want to buy, can we somehow buy the Nifty at that level now, instead of waiting till it falls there? And perhaps profit a little if it doesn’t fall all the way till there)
Answer: Yes. We can write put options.
When you write put options, you are effectively buying the stock or the index at: Strike Price minus Premium received. If the stock stays above the strike you get to keep the premium (but no further upside). If the stock falls, then you pay out whatever is below the strike price. Your effective “break-even” price is: Strike Price minus Premium received.
The Nifty has “long term” options now, called LEAPS. And there is some liquidity in the December 2016 options. That’s 11 months away from now.
You could write the 7000 put option at Rs. 280.
This gives you an effective “buy” on the Nifty at 7000-280 = 6720. Effectively if the Nifty fell to 6720 before December, you would be buying the Nifty at that rate.
How would this work? What you would do with the money: Rs. 10 lakh – is:
a) Write two contracts (150) of the 7000 December put at Rs. 280. You receive a premium of Rs. 42,000, but you’ll need margin.
b) Assume you put this as margin, and the rest of the Rs. 10 lakh into a liquid fund (Liquidbees) which gives you margin enough to cover even if the Nifty loses 90% of its value.
c) You make Rs. 42,000 (4.2%) if the Nifty stays above 7,000 in December.
d) The 10 lakh will probably get a yield of Rs. 50,000 (5%) in the Liquid fund. Which means you make 9.2% if the Nifty stays above 7,000. This is the upside.
e) If the Nifty falls, you can hold on till December and effectively you will have bought the Nifty at 6720. (as in, if the Nifty falls to 6,000 you will have lost 720, for example).
Can We Buy Nifty Even Lower?
There is no liquidity in options below the 7,000 strike, so that may be useless.
But you could build a three way strategy that buys the Nifty at an even lower level if the Nifty falls, but continues to make some money on the upside.
1) You sell both the Nifty 7,000 call and the Nifty 7,000 put (December 2016) for a total premium of Rs. 907+280 = Rs. 1187.
2) You buy the Nifty 7500 call (December 2016) at Rs. 580.
The net premium you receive is: Rs. 607.
Again, using the formula – our breakeven point is the Nifty at 7000 (strike) minus 607 = 6393.
This corresponds to an even lower Nifty value than the above level! It’s like a P/E of 17. And on the upside the profit “flattens out” after 7,500 on the Nifty.
The Max profit is if in December the Nifty is at 7000 – a whopping Rs. 85,000 on the strategy, plus Rs. 50,000 on the liquid fund, which would give you a return of 13.5% on the capital.
Above 7500 on the Nifty, the profit on the strategy drops to Rs. 10,000 (plus 50K on the liquid fund means a return of 6%).
Below 7,000 the strategy behaves exactly like if you had bought the Nifty at 6393.
Which is better?
The second strategy is better for intermediate profit booking if, for instance, the Nifty begins to rise again. At that time, two things will happen – the VIX, which is currently at 22, will fall; the options that have been written, at a higher VIX, will lose time value due to both time decay and the drop in the VIX. Overall the strategy turns profitable faster.
We spoke of an unleveraged strategy; if you’re looking to lever them, the first one will be better as it requires lower margin (probably half of the second one). But if you allocate the full capital it doesn’t matter.
Writing puts is a strategy that works if you want to buy but believe the index or stock will fall even more – it offers a “cushion” to the downside. Writing a put is exactly like a covered call, only you don’t have to buy the stock, just leave the cash in there.
But you should also be confident about what you will do if the stock turns around and starts to rise rapidly – choosing a strategy that allows you to exit better when there is such a turn (so that you can buy back into it) will give you more flexibility.
Of course, remember that these strategies are not tax efficient (they will be classified as business income, and not long term capital gains) and there is a possibility that liquidity in these longer term options dries up, which reduces your flexibility for early exits. But it provides a one-time trading strategy (meaning: make these trades and you’ll need no maintenance till December) to ensure you can capture the index at a good value if it falls, but also benefit if the index hangs out right here and doesn’t go up. Such times don’t come often, but this sure seems like one of them!
Disclosure: We don’t have these positions and haven’t actioned them. But this is a specific strategy for a specific view point and we’ll revisit it in a few months.
Disclaimer
Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mind. This is educational or informational matter only, and is provided as an opinion.
Disclosure: The authors at Capital Mind have positions in
the market and some of them may support or contradict the material given above, or may involve a direction derived from independent analysis.
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