I am planning to start a new monthly post with the topic – what’s on my mind. It’s more likely to be a brain dump of my thoughts – more for myself – to check back in future as to what I was thinking (or smoking J ) at a particular point of time. This should help me cross-reference some of the investing decision I took at the time.

It’s a natural tendency to look at decision after they play out with a fair amount of hindsight bias. Like others, I too have a tendency to forget the key factors which played into my decision and color the history based on present information. Anyway, more on this bias in a later post.

Dollar depreciation

The US is now running a deficit of almost 1.4 trillion (that’s 1000 billion and 1 billion = 100 crores). That’s a lot of zeroes. The deficit is almost 10% of GDP and projected to continue for some time. A deficit of this proportion would land (and it did in 91) a country like India in serious trouble very quickly. If we had to borrow as much to fund our deficit, we would have a crisis (as we did in 1991).

Now the US dollar is a reserve currency and they get to print it and hence can monetize their debt. In addition, it’s a rich country, so other countries are ready to lend to the US. However there is finally a limit to everything and something which cannot go on forever will stop some way or other. In the usual case, a country incurring such a deficit could see its currency depreciate, cost of debt and inflation shoot up and contraction of its economy if it went too far. The US has been able to avoid all this as it is still the largest economy and other countries do not really have too much of an alternative.

That said, it is appear likely (atleast in the long run), that the currency will keep depreciating. That does not mean, that we will not have episodes (as in 2008), where the currency strengthened. However in the long run a country with a large deficit and growing debt can fix it in 3 ways – inflate, raise taxes and cut expenses. Inflation (via currency depreciation) is easier politically and hence looks more likely to happen.

All of the above is a conjecture, but still a probable scenario. Now, you may ask, how does it impact us? A few points come to my mind

• Our currency is still a managed currency and everytime the dollar has depreciated, RBI attempts to control the appreciation of the rupee. This has in general resulted in high liquidity in the domestic markets which results in asset bubbles – spike in real estate and Stock markets etc.
  
• Higher inflation due to higher commodity prices as most of commodities are priced in dollar
  
• Reduction in margins for IT and export oriented companies due to stronger rupee and weaker growth in export market such as US
  

The problem with macroeconomics is that you may be right in the long run, but in the short run be completely off the mark. In addition, it is easy to guess, but difficult to arrive at specific investment decisions based on these macro-economic mumbo jumbo.

All said and done, I am worried about the implied (based on current valuations) bottom line growth for IT companies and the head winds faced by them.

Automotive sector

The growth for the current quarter is likely to be high due to the base effect (dec 2008 was bad) and hence the market may still react positively. However in view of the valuations, I have already started reducing my position in maruti. Need to make up my mind on Ashok Leyland, which has appreciated quite a bit

Overall market levels

I am not sure if the market are overvalued at 22 times earnings, but at the same time I have started reducing my Index ETF positions. I do not look at chart and any other technical indicators. As I have said in the past, when the market has fallen below 12 times earnings, it has generally been a good time to buy the index and a market level of 23 and above a decent time to sell. Its not a precise approach, but makes decent sense from a valuation perspective.

Fixed income investing

I would prefer to buy short dated debt (short term deposits) or floating rate funds. I think that inflation is likely to go up and hence it would better to buy floating rate funds than fixed rate ones. Again, no specific analysis as to why I think that inflation will go up – only reason is that the government has a stimulus package and low rates. Once the inflation starts creeping up, RBI may have to raise rates again.

New ideas

Not many attractive ones. So I am currently just studying some companies such as Tata sponge and others from a learning perspective. This should help me pull the trigger when the valuations are right. I need to avoid trying to be too clever for my own good.

Aniruddha brought up a very good point in the comments and as a result, I decided to add it to the post as it captures the issue for a long term investor. My response follows the comment

Hi Rohit,
i also tried with options while ago. I realized that, i would never sell my portfolio. So even if it is hedged by options, it’s waste of money. If market falls you would earn money through options but that time you will not sell your entire portfolio. Option Profits would be offset against your virtual loss. Same thing with advances. The gain in the portfolio is offset with the option premium you pay, which would expire worthless.I found it good tool to earn money in volatile market for traders.

hi anirudha
As i said, for a long term investor, options will not make sense unless one plans to sell in the short term. Here again it may make sense to just sell and not get too clever with options. so options is still an area i am trying to figure as part of my portfolio.

If however one is managing money professionally, options can help reduce short term volatility, which is critical for clients who may not have the emotional fortitude to bear huge swings in the portfolio and may pull their money out at the wrong time.

Options work well as disaster protection too…end of 2008 if you thought icici was going down the tube and had deposits, then puts would have helped. I bought those options to protect my deposits with the bank and it was more of an insurance, than a trading position.
——————————————————————————–
I recently wrote on my purchase of options for hedging purposes and received several comments and emails on it. I discussed about the ‘what’ of the transaction, but did get into the ‘why’ of it. So let me discuss about it a bit here and then try to give a response to the various comments on the previous post

The why of options purchase
As I stated my previous post, the only scenarios where options would make sense for me are
· The market appears considerably overvalued and options are underpriced due to low volatility: This is a valuation and not a timing decision. However it is not a decision based on deep fundamental analysis. As the market gets more overvalued, I can reduce my long positions and the put option acts as a backstop for me. So in this case I am paying a small premium to protect myself from the downside, as I reduce my holdings and benefit from the upside in the interim.
· I wish to hedge a specific stock position which I plan to sell in the next few months: In such a case, I would prefer to buy a put option on the stock to hedge my open position. This is a hedging position and has no element of speculation in it. I am basically paying a premium for an insurance (against the stock dropping below the strike price)

In both the cases, I am paying a small premium for ‘insuring’ my portfolio for the short term as I sell the overvalued position. If I were to do this multiple times, I would expect to lose money on my options with the benefit of protecting my portfolio from downside while I am reducing my holdings.

In the past one month, I was lucky to have sold my open positions and then have the market drop a bit, due to which I was able to close out my options at a decent profit. I was lucky and not smart in this case.

Aren’t you speculating ?
I cannot deny that there is an element of speculation here. However I did not create a position with that in mind. As I said earlier, if I were to do this multiple times, I expect to lose money on my options positions with the benefit of being able to hedge the downside. If the market does crash, then the options positions would reduce my losses and thus reduce volatility of my portfolio. Speculation depends on the objective of a position and not on the nature of the instrument.
The cost of short term options is around 12-13% (annualized) for a downside protection for 10%. It would stupid of me to hedge my portfolio using options on a regular basis. Yes, the market is efficient in this aspect.

Why not buy long dated options
For starters, I looked for long dated options and was not able to buy them. The second key point is that the price of long dated options is very high. There is no point in buying a 10% downside protection for 1 year and pay 15% or more premium for it. In such a case, I am better off selling the open position itself. I see option protection useful only if I wish to buy short term protection in an overvalued market with clear plans of selling the overvalued positions during the same period

Imperfect hedge
Some readers pointed out that I bought an index put where as my portfolio is mainly midcaps. Well, my disclosed portfolio is mid-caps, but not necessarily my entire portfolio. I do have mutual fund holding and Infosys stock and hence an index hedge is good enough for me. I have disclosed my portfolio in the past and the associated disclaimers.

Educational experience
I am in a learning and exploratory phase in terms of options. Options basics and pricing is easy to understand. The difficult part is to build a sensible strategy around these instruments and use it properly. My positions in the past have been miniscule (<0.5 %) and a gain or loss is more or less a non-event.

I will continue to read and learn and may dabble in these instruments a bit in the future. I see the utility of these instruments in arbitrage positions, but continue to be doubtful in terms of their utility for my core portfolio.

The other day, as I was discussing my options plan with my wife, she summarized it well – All boys have their toys, in my case they are options.

Note : The position discussed in the post was closed sometime back and I do not currently hold any open positions in the instruments discussed in the post

I have a confession to make – I have moved to the dark side, figuratively speaking J. I have rarely written about options and derivatives. There is a simple reason behind it. I do not have as much experience in these type of instruments.

I have been reading on these instruments for some time now and have been dabbling in them a bit for some time now. My foray into derivatives has been mainly for hedging. I still firmly believe that trying to time the market is a waste of time (atleast for me). However that does not mean that I would not like to act when I feel the market may be overvalued.

There is a difference between the two points – time v/s price based action. Let me explain – lets assume that I hold a stock, which i assume is worth 100 and is currently selling for 60. Lets also assume that everyone thinks that the market is overvalued as a whole. If I believe in timing the market, I may decide to sell the stock assuming that market is likely to correct and so will the stock. When that happens, I may buy back the stock at a lower price.

If one approaches this from a price based view point and is agnostic about the market (it may or may not drop), then one may decide to do nothing as the stock is still undervalued. If the market drops, the stock has only become cheaper and one can choose to buy more. If however the market rises, and so does the stock, then well we have a nice profit on our stock.

The benefit of the above approach is one can focus on a single variable – discount of current price from the fair value of the stock and not worry about the market level, sentiment and other such factors. Ofcourse, if you think you can predict the market levels in the short term, then dancing in and out of stocks can be profitable. I however avoid these gymnastics and keep my life simple.

So how does a derivative – a put or a call option fit into the above approach ?

There are certain points of time when one can objectively look at the market valuation and conclude that the market looks fairly overvalued. One can look at the past history of the market and arrive at a reasonable conclusion that if the PE of the market is above 25, then the forward returns are likely to be low. One could look at the data and just ignore it or alternatively try to profit from it.

During the last 1-2 month, after the market hit 16000 and higher levels, I felt that the market was getting over priced. The number of attractive opportunities were reducing and the forward returns were likely to be low. At the same time, even if the market is overvalued, it does not mean that it will drop in the next 1-2 months.

At this point of time, I decided to hedge my portfolio with the use of a put option. Let me detail my thought process and strategy behind it

Buying insurance

In buying a put, I was looking at buying insurance for my portfolio. The objective of insurance is to protect your asset at the minimum cost and not necessarily profit from it. A put option is the right, but not the obligation to sell. So if I buy a put on a stock selling at 100 with a strike price of 80, I have to pay a premium for the option. The value of the option increases as the stock price drops below the current price. If the stock drops below 80 , I am fully hedged against any further drop in the price of the stock

The price of a put option depends on 5 factors – strike price, duration, current price, interest rate and implied volatily. I cannot go into option pricing in detail here, but in simple terms – lower the strike price (below the current price), lower is the price of the put (other factors being constant)

With the above point in mind, I had make a decision based on the following factors

• Strike price of the index put
  
• Duration of the put
  

The Strategy

At the time of the analysis, the index was in the range of 5051-5100 and I decided to pick a strike price of 4500. The maximum duration of the put which I could pick at that time was the December contracts. The reason for picking 4500 as the strike price was due to the fact the probability of the market dropping 15% or more looked low and at the same time a higher strike price required a much higher premium.

An additional factor in buying puts was the low implied volatility (read here for more details on implied volatility). As a result, the options seemed underpriced (I have bring a value angle into it J ).

I ended up buying the December contract for 100 with a strike price of 4500.

The result

After buying the options, the market continued to rise for some time. Options are brutal instruments, also called as wasting assets. Options lose value with time (called as theta or decay). In addition, if the price move in the opposite, then loss is almost exponential.

The above situation changed in the subsequent few days and with a 10%+ drop in the market, the options were almost in the money and had more than doubled in price. The end result is that they had achieved the objective of hedging my portfolio during the market drop.

Conclusion

Am I happy with success of my options strategy ? that would mean that I would be happy on making money on my fire insurance if my house burns down. I look at options merely to hedge my portfolio against short term drops. The cost of this insurance is high (almost 10-12% per annum of principal value) and hence it would be silly to buy puts every time one felt that the market is a bit overvalued.

I would personally buy options under two scenarios

• The market appears considerably overvalued and options are underpriced due to low volatility
  
• I wish to hedge a specific stock position which I plan to sell in the next few months.
  

I am looking at other strategies such as covered calls, collars, butterflies, rabbits (ok I made that up) and will post if I attempt these stunts in the future and survive J