Lachmandas Bhambwani's home page

The mechanics of risk management.

August 09, 2003

The markets have evolved rapidly in the last 3 years. I am consciously benchmarking the metamorphosis of the last 3 years only because that was the last time retail participation was high in equities. Now that the markets are rallying again, there is every likelihood of the retail participation returning back. Are we prepared to trade in the new regime ? Have we got our game figured out ? Are lessons of the past learnt ? I have serious doubts, I feel a large section of the investing populace are jumping in the fray without any upgradation of skills to trade in more complex markets. The current regime of margin trading, leveraged trades and high volume derivatives trading are a double edged sword and are capable of knocking out the un-initiated trader very rapidly due to heavy losses.

Should you abstain from the markets completely ? Should you miss the profitable opportunities just because the risks are high ?

I firmly believe in the age old sayings - "ships are safest in the harbour, but thats not what they were built for" and " nothing ventured, nothing gained". What is needed is implementation of risk management techniques that protect your capital and give you decent returns on capital employed and risks taken. In my view, the most welcome thing to have happened in the recent past in the Indian investment arena is the ushering in of derivatives trading. What is needed is the proper understanding of the subject and then exploitation of opportunities that are presented by the markets on a day-to-day basis. Whether you are a low risk profile investor, a fixed income middle aged investor or an aggresive trader, there are tailor made strategies for you.

Some of my favourite trading techniques are -

·         Nifty futures - trading in the Nifty futures is quite simple. Period. There seems to be a misconception doing the rounds in the investors minds that it entails huge margins and the exposure involved being higher, the risks are infinite. I beg to differ !! This index comprises of 50 stocks which determine the movement of the index. Since the volatility of 50 scrips determines this instruments volatility, the beta ( intraday movement in percentage terms ) of this index is low. Which means that you will make / lose small sums of money from trading this index. This instrument is very liquid ( largest traded futures), affordable - margin required is approx Rs 20,000 and a market lot of 200 units. Therefore, if you take a wrong view on the Nifty and do not maintain a stop loss, it will be a long time before the Nifty moves 10 points against you. In which case, you will lose ( 10 points x 200 units per contract ) Rs 2,000 only. On the flip side, your gains will be equally small. Imagine if you were to trade all 22 days in a month, go right on 16 days and wrong on 6 days, take a uniform profit / loss of even Rs 1000 per day as a cut off point, you still take home a semi assured Rs 10,000 per month. Suddenly, your fixed expenses can be covered by your short term trading and that provides you tremendous comfort. Investors who follow the CNBC channel avidly will recollect how the European sqawk box show mentions the "QQQ" trades ( index based instruments, like the Nifty ), which are some of the biggest value trades on the exchange floor. Forecasting the Nifty is quite simple actually - just get the weightage of the top 5 counters and take the short term peaks / troughs, factor in the weightage and you have the levels on the Nifty !! Any simple macro in an excel spreadsheet will do the trick.

·         Individual stock options - many traders think of buying options and making money. However, there is a slight catch here. 85 % or more of the entire open interest in any given month in the options segment expires useless !! Sure we derive silly and idle comfort in the thought that we lost only the premium that we paid and no margins or bigger losses were incurred. But pause to ponder and you realise that people who SELL options must be 15 - 20 % in numbers and yet collect money from 80 - 85 % of the options buyers !!! Is'nt it a better idea to sell options instead ? Marry technical analysis and guage the extreme points a stock can rise / fall upto, in worse / best case scenarios and execute synthetic buys / sells at deeply out of money options. Not only is the risk minimal, you also GET the premium, instead of paying premiums. The premium is your interest / vyaj on margins paid for selling these options. On the expiry day, you get your margins back and you are ready to roll over your capital again.

·         Options and futures hedging - this is a simple arbitrage wherein you take diametrically opposite views in the options and futures series. Since both their prices must converge with the cash price on expiry day, the differential will be your profits.

·         Covered calls - this is fast emerging as the most useful of the options gameplans. Investors having a large exposure on shares take positions in the options segment to hedge their risks in the delivery segment against the derivatives route to insulate capital even from notional gains. Since every options contract entered into is backed by delivery of shares, these are called covered calls. Institutional players normally take this route to manage risks.

·         Beta / RSC factor - it is common knowledge that some stocks tend to be stronger than broader markets and are insulated from short term shocks. Stocks with higher relative strength are called market out-performers. Whereas stocks with a high volatility in the short term perspective are called high beta stocks. They rise / fall faster than the indices in the short term, though they do not necessarily need to be trending anywhere in the long term. These high beta stocks are typically speculators favourites. My trading gameplan is to stick to high RSC and low beta counters. It gives a great degree of protection to my capital as short term shocks do not affect my portfolio.

·         Track record - try to trade stocks with some previous history. Technical charts, fundamental data and dividend records are available to make a scaleable comparison. The known devil is always better than the unknown devil.

In my view, lower returns with higher consistency is any day better than higher returns with great volatility. These strategies listed above should see you enhance your returns on capital invested by atleast 10 % per annum, if not more. Every investor / trader needs to protect capital first and look for returns later.

L. R. Bhambwani

The author is a Mumbai based investment consultant and invites feedback at lachmandas@bsplindia.com or 23438482 / 23400345.

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