Thursday 10 June 2010

Sensible Advise for Volatile times

Sensible Advise for Volatile times

My last post (Beware of Conmen) was about someone inviting you to take what could perhaps be perceived as "unduly high risk". A reader had forwarded this mail from HDFC Securities and asked me for my comments.

First, I'd suggest that you read the inputs from HDFC Securities:

Investors get perturbed when the markets are not moving up in a sustained manner. And rightly so, because most investors have a mindset of buy and hold. And when the markets frequently change their direction, investors find it difficult to cope with such volatility.
Changed environment calls for a change in the strategy we deploy to tackle the markets. Just as you adopt different strategies to face fast bowlers and spinners and play the ball on its merits similarly the strategies need to change to play different market condition.
The volatility could be a blessing in disguise, if you can acclimatize yourself with it.
1.Take your ones and twos
In a volatile market you should learn to take small gains and losses. Instead of yearning for a large gain, hitting a six in cricket parlance, you should settle for smaller gains and take them as they come.
A stock may not give you a 20% return in one go but may give you 25% returns in trenches.  Sounds impossible? Lets see.
We chose Tata Steel and studied how it behaved during the Months of April and May. The stock gave 5 upswings of 5% or more and 5 down swings of 5% or more during the period.  So whether you are a bull or a bear, you got ample opportunities.
The Tata Steel swings were larger than 5%. The 5% was only a filter mark. The upswings were to the tune of 18, 5, 10, 8 and 7% respectively. Even if you could catch any one of them and rode only 5%, it would have been a good return to post. 
On the downside, the swings were 9, 21, 20,10 and 6%. The magnitude of these downswings was larger than those of the upswings.
The best part of a volatile market is that you get to buy the same stock again and again at the same level or lower. The chances are that if you get this act once right, subsequent opportunities will be easier to spot and ride.
2.Create some cash
If you are sitting on a pile of cash, you will see the falling market as an opportunity to buy. But if you are fully invested you will be fearful. In that fear, you are likely to sell some of the stocks at a loss.
On a day like this, when the markets tumble sharply, the one with cash will confidently buy where as some one who is fully invested may end up selling his stocks at a loss.
I have always thought that sitting on a 20-30% cash is a good idea. The very fact that you have to maintain this kind of cash will make your investment decisions well thought out. You will research and then buy and that too when the valuations are compulsive.
And on a day when the markets open down sharply, this cash can be put to good use. The stocks that you buy with this cash will have to sell in a disciplined manner. The cash so generated will be used only when the markets tumble further or a really good investment opportunity is spotted.

If you are fully invested, sell a part of your stocks when the markets move north. Selling and creating  cash at leisure and when the markets move up is better than selling in panic. However, if you realize that the recent investment you made is not a sound decision, selling that stock at a loss is not bad idea for cash generation.
3.Buy Puts
Buying a Put in the stocks concerned protects your portfolio. Protection comes at a cost. In the beginning of the month, the costs are pretty high. So in order to reduce your protection cost, you may perhaps want to trade off writing a lower Put. Your portfolio is protected till the strike price for which you write or sell a Put. When you do such a thing, it is called constructing a Bear Spread.
4.Write higher Calls
When stocks are tumbling and you are not buying Puts, it may worthwhile to write a higher call for the stocks that you have. If the markets tumble you will get to keep the premium you earn. To that extent you are compensated. Should the markets reverse and move higher, what you do next will be a function what is your trading profit or loss in the call written. If the call is going in your favor, cover it. But if you are making a trading loss, don't book it. Hold your position till settlement. On that day, if the call premium is still higher than your buying cost, let it lapse and sell your existing stock (for which the Call was written) in the last 10 minutes of trade in the cash market.
5.Keep your stop losses tight
When you are playing for smaller profits, it is advisable to keep your losses even smaller. So keep tight stop losses. Decide on your stop loss before entering the trade and make it a trailing one as the market moves your way. Even in Puts and Call options stop losses can be kept.
6.Be Nimble footed
Expecting that the markets will tank, you by puts in the Nifty. And after going your way for some time, the market changes direction. While you have the choice of selling your Put option, you may consider buying a Nifty Future to make the best use of the Put that is already bought. If the markets recover to the level where you bought the Put, your buying of the Nifty future would have been justified.
There are further games you can play with this Put you had bought. If you think the Nifty is likely to lose momentum, book profits in the Nifty, still holding on to your put. This gives you another opportunity to enter the Nifty Futures again at lower levels. You can repeat this several times in a week.
The adept amongst you would have understood that with the protection of Put to support you get the full advantage of the range of futures movement. If the Nifty moves in a range of 50 points, you get the full advantage of trading in the Nifty. Where as trading in the option alone would give you only half the range.
Similarly, when the Nifty reaches the upper range of the range, buying a Call and then shorting the Nifty Futures and covering at lower levels will be helpful. Rinse and repeat as many times as you want, till the option you have bought remains relevant.
7.Buy in small quantities
If you hate trading and are not the like who will settle for smaller profits, the least you can do is, defer your buying over three stages. You may buy a third quantity of your researched share at the first go. The next third can be bought 5% or 10% lower depending on the volatility of the stock and the balance quantity still after another same percentage gap.
You may repent buying only a third of your desired quantity if the stock surges after your buying. In such a case, you would probably end up with notional loss, for the quantity you never bought. But if the market does go down, you will appreciate your foresight.
All said an done, if you plan your trading and investing assuming that the volatility will continue, you are likely to land on your feet. As you go through this experience, keeping your cool, you will begin to appreciate the opportunities volatility offers and may in fact begin to love it.
And in a few months you will also get to trade in Volatility Index (VIX) itself. So treat the current volatility as a practice session to master VIX trading.
HDFC Securities Limited

My comments:
  • First, the HDFC folks are not "directly soliciting business" - That by itself makes me positively inclined about the contents of their mail
  • Secondly, they do not give any "specific" tips nor any "vague" tips. Instead, they talk about a specific strategy to handle volatile markets. This makes me even more impressed, prompting me to seriously consider and evaluate their strategy.
  • Now, to the contents of the strategy:
    • First, by and large very sensible strategy.
    • Second, this is not for novices except the bit about staggered purchases and holding 20-25% cash levels - which, by itself, is an excellent recommendation for all. The typical novice MUST not be bothered about the "notional" or "real" opportunity loss due to funds lying idle. Typically, the interest lost is of the order of 3-11% per annum. This will possibly be "more than adequately compensated" by the very real "buying low" that would be feasible by patiently waiting for opportunities.
    • Third, dealing with futures and options, buying calls and puts, and, worse still, writing calls and puts - This is not for the faint hearted. As one of my favourite anchors on a business channel repeatedly says, "Remember that while you can make 40-100% returns in options in a couple of days, you can, and certainly will, occasionally (hopefully only occasionally and not frequently) lose your entire capital. That's a very real, live probability."
    • This is where the importance of stop losses becomes vital. The downside to stop losses in volatile times is that it is very common to be "whip-saw"ed both on the way up and on the way down due to these "strict stop losses".
All said and done, these inputs from HDFC Securities are very valuable with the following caveats:
  • Understand the inputs before even attempting to implement them
  • Applicable only for "seasoned players"
  • Start practicing with  "Throw-away" money, and gradually increase your exposure to the F & O segment.
  • Be prepared for "serious losses" in the initial several months before you "see green"
  • Make sure that "Greeed" & "Fear" are your servants and not your masters.

Take care!



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