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Introduction

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Topics 1

Introduction

Basics of stock market

• Induction
• Bull call spread
• Bull put spread
• Call ration Back spread
• Bear call ladder
• Synthetic long & Arbitrage
• Bear put spread

• Bear call spread
• put ration back spread
• Long straddle
• Short straddle
• Max pain & PCR ratio
• Iron condor

learning sharks stock market institute

1.1 Induction

Before we begin this module on options strategy, I would like to share with you an article I read in behavioral finance a few years ago. The title of the article was “Why winning is addictive.”

 

Here is the article written by B. Venkatesh, a consistent columnist for HBL:

To purchase and wager on a lottery ticket, a game you usually steer clear of because you know the chances of winning the jackpot are slim. If you do, however, win the ticket, you’ll probably feel pressured to continue purchasing lottery tickets in the future!

We behave similarly in terms of our investments as well. Why does this behavior occur? Our lives as humans are governed by anticipation. So both the anticipation of and fulfillment of a lottery win are exciting.

But according to neuroscience studies, dreaming about winning is more thrilling than actually succeeding! However, after experiencing the thrill of winning the lottery, you feel compelled to overeat. In other words, even though you know the odds of winning the second lottery ticket, your brain forces you to buy the first one.

The fact that we can lose money makes our experience of winning against such odds even more exciting! This is not so much true of lottery because a lottery is a game of chance while investments, we believe, require some degree of skill”

You might be wondering why I posted the aforementioned article at the start of this module. This article, however, takes some of my ideas a step further by putting them in the context of behavioral finance. One thing that I’ve noticed in all the conversations I’ve had with options traders, both seasoned and new, is that most of them view trading options as a hit-or-miss proposition. When one begins an options trade, there is always a sense of humor; however, many people are unaware of how fatal this naive humor can be.

Traders buy options (month after month) with the hope they would double their investment. Trading options with such a mindset is a perfect recipe for a P&L disaster. The bottom line is this – if you aspire to trade options, you need to do it the right way and follow the right approach. Else you can rest assured the gambling attitude will eventually consume your entire trading capital and you will end up having a short, self-destructive option trading career.

I do have to point out that the saying “limited risk, unlimited profit potential” is a silent P&L killer when it comes to options. This “theoretically correct” but practically disastrous fact disillusions new traders, who then slowly and steadily blow up their books as a result. As a result, in my opinion, trading options without a plan is a “dangerous but irresistible past time” (a quote from Pink Floyd).

learning sharks stock market institute

1.2 – What should you know?

Only a small number of strategies must be thoroughly understood by you. Knowing these strategies makes it simple to map the current market (or stock) situation with the appropriate option strategy from your strategy quiver.

We will discuss some tactics while keeping this in mind.

Besides discussing the above strategies I also intend to discuss –

  1. Max Pain for option writing – (some key observations and practical aspects)

  2. Volatility Arbitrage employing Dynamic Delta hedging

One options strategy will be covered in each chapter so that there is no muddle or confusion regarding the strategy. This means that this module will consist of roughly 20 chapters, though I suppose that each chapter won’t be overly long. I’ll go over each strategy’s history, execution, payoff, breakeven point, and perhaps the best strikes to make given the remaining time. If you want to use the strategy, I’ll also be sharing a working Excel model with you.

Please keep in mind that while I will discuss all of these strategies using the Nifty Index as a benchmark, you can apply the same principles to any stock option.

The most crucial thing I want you to know is that this module will not contain the Holy Grail. Nothing in the markets, including none of the strategies we discuss in this module, is a guaranteed way to make money. The goal of this module is to ensure that we discuss a few straightforward but crucial tactics that, when used properly, can generate income.

Consider it this way: if you drive your car safely and well, you can use it to commute and ensure your family’s comfort. However, if you drive rashly, it could be dangerous for both you and those around you.

Similar to how these strategies generate income when used properly if not, they can damage your P&L. It is my responsibility to make sure you comprehend these techniques so you can learn how to drive a car. I will also try to explain the ideal circumstances in which you should apply these techniques. But you have the power to make it work for you; this really depends on your discipline and market savvy. Having said that, I have a good feeling that as you spend more ‘quality’ time in the markets, your application of strategies will get better.

The “Bull Call Spread” makes its debut in the next chapter, which focuses on bullish strategies.

Remain tuned.

The Conscious Member of the Herd

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Do you ever just feel like you are acting mindlessly or like you are going through the motions? Are you shocked that your emotional responses cause you to sell when you should have planned to wait a bit longer? Or do you enter a deal too quickly without first carefully formulating a trading strategy? It’s possible that you’re succumbing to a natural tendency to follow the pack. Although it could appear normal, if you aren’t entirely aware of what you’re doing, you might find yourself forfeiting profits.

 

Even the masses who invest in the markets occasionally appear to behave without thinking. Once more, there is safety in numbers, and the masses find solace in doing as the throng does. They look for affirmation and attempt to follow the crowd. For instance, it is typical to observe the general public responding hastily to news headlines. Regardless of the underlying fundamentals driving the broader trend, traders in large numbers start selling as soon as they hear that a company has missed an analyst’s prediction. People start buying when a stock is hyped up, even if it is just due to unsubstantiated rumours.

learning sharks stock market institute
Source: oakridger

The disciplined trader adheres to a thorough trading strategy. Impulsive traders operate on the assumption that everything will work out as they go along. Trading automatically can work if you are a really experienced trader, but if you are a new trader, you risk making mistakes. You can succumb to regret, greed, hope, or terror. However, when you allow your emotions rule, you’ll often behave like the crowd, and when you trade like a mindless herd member, you’ll incur losses.

Having, doing and being

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Trading in the right frame of mind is frequently a need for success as a trader. Trading psychologist Dr. Van K. Tharp, founder of the Van Tharp Institute and author of numerous best-selling books on trading psychology, outlines three mental states that could influence your trading strategy. Traders transition from a “having” state of mind to a “doing” state of mind as they gain expertise trading the markets. But when they get to a “being” state of mind, they become profitable. Which mentality best describes your trading?

 

Many traders begin their careers with a mindset that prioritises “having.” They are preoccupied with profits and what they may buy with those profits rather than concentrating on how to trade in harmony with the markets. The primary objective is to make money, which can then be utilised to buy desirable items like a flashy red sports car, a roomy, opulent home, or a sizable collection of upscale clothing. They think that having enormous financial success will be the answer to all of their issues. Trading is more than simply a career; it is their last resort. Despite the fact that many traders are driven by financial gain, concentrating on what you might acquire as a result of your profits has drawbacks.

learning sharks stock market institute
Source: The new york times

A trader’s mentality eventually shifts from “having” to “doing.” When a trader is in a “doing” frame of mind, their attention is directed toward understanding trading strategies and when they work and when they don’t. Dr. Tharp asserts that traders in the “doing” frame of mind continue to prioritise performance problems. What can this trading strategy do for me, they enquire? They are worried about how the technique can make them wealthy. Trading in the “doing” frame of mind is about evaluating the strategy and pondering if it is “working” rather than becoming involved with the markets.

 

However, picking a certain approach and applying it at random is not how trading is done. Developing your trading abilities is necessary to become a successful trader. You must cultivate your intuition by engaging in trading using a number of strategies under a variety of market circumstances and figuring out how the right strategy fits with the ideal market circumstances. Trading in a “doing” state of mind is essential for achieving market mastery, despite the fact that it rarely results in long-term profitability. You acquire the knowledge necessary to trade naturally and with a top performance attitude throughout this phase.

 

The “being” state of mind is the ideal mental condition for successful trading. A trader in the “being” frame of mind is completely tuned in to the markets rather than concentrating on results. He or she trades in time with the movement of the market. Trading the market and accepting it on its own terms are firmly committed to. A trader who is focused on trading right now intuitively recognises successful setups and trades them with ease. You can trade with a “being” frame of mind with enough practise and experience, albeit it might not happen right away.

A healthy approach

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Successful traders pursue their interests. The statement “I love trading so much that I would do it for free if I could” is one that traders frequently utter. In fact, the story seems to be the same whether one looks into the backgrounds of outstanding traders: Any position, as long as it involved trading in some way, was sought after by everyone in the trading industry. The markets and the difficulties they presented attracted them; money was either unimportant or not a concern at all. However, if you ask the average non-trader what they think of traders, the response will be very different.

 

Many people believe that traders are out to make a lot of money, get great status, and flaunt it all with expensive homes and cars. Although they might be additional advantages of trading, they aren’t the main drivers. Successful traders see their profession as significant and like the challenges that the markets present. In other words, they approach trading success in a healthy way.

learning sharks stock market institute
Source: Coinnewsspan

The benefits of having a positive outlook on success are significant. Compared to those who used a traditional approach to achievement, people who adopted a healthy approach to success were better adjusted and more content with their lives. They also had stronger self-control, which allowed them to accept their limitations rather than have a propensity to exaggerate their skills and downplay their flaws. Additionally, they put in more effort at work and delivered better results.

 

A healthy attitude to success has several benefits that are worth noting. When compared to people who approached achievement the usual way, individuals who adopted a healthy attitude to success were better adjusted and more content with their lives. They were also better at managing their ego; that is, they were able to accept their limitations rather than have a propensity to overstate their skills and downplay their flaws. Additionally, they worked harder and produced better results because of it.

Head and shoulders pattern is psychological

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learning sharks stock market institute

Charts provide both a price history and volume history for a financial asset, but they also offer fascinating insights into how people behave. And if you learn to read them correctly, you may use them as a psychological map since they mirror fundamental human nature.

As technical analysts, we are aware that stocks, indexes, and futures markets frequently exhibit repeating patterns. Despite the fact that no two patterns are exactly alike, recognised characteristics reproduce themselves frequently enough for us to recognise and label these patterns and use them to forecast price movement. Understanding the underlying human behaviour and trading it accordingly is a key component of pattern recognition since these patterns reflect people’s thoughts and feelings.

Numerous indexes and stocks are forming—or have already formed—the head-and-shoulders reversal pattern on their daily charts. A head-and-shoulders pattern can be seen on a chart whenever a stock, for example, increases in price to a new high (on any time frame). High volume lifts the price movement to the apex, forming the top of the left shoulder.

The pullback happens next. Mass psychology is reflected in the downturn, which is when latecomers to the soaring uptrend enter the fray. They move in as soon as the retreat reverses, driving the price to yet another record high. But eventually, the worn-out tardy buyers cease “paying up” for the overbought stock. Fear sets in as they suddenly realise they are poised precariously on a mountainside that is eroding (head). When short sellers start to attack, panicked bulls flee at the mercy of the market. The stock drops to the previous support region created by the left shoulder’s completion. The head is now fully developed.

 

At the neckline (of the finished pattern), a select few eager purchasers drive the price up once again.

 

However, this time, the tepid optimism only raises the price as high as the top of the left shoulder. The top of the right shoulder is formed as volume decreases and the price rolls over.

Drooling and sharpening their claws, short sellers. The head-and-shoulders pattern is complete when the price retraced to contact the neckline. Some short sellers have already made an early (high-risk) entry while anticipating the upcoming fall below the neckline. The day after the head-and-shoulders pattern is complete, the stock may frequently gap down (on a daily chart) as anxious investors and short sellers rush to get out of the unsatisfactory equities.

Commitment to trading

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You’ve heard it time and time again: long-term trading success requires a solid commitment. We’ve all witnessed the unfavourable effects of those who lack commitment in other professions as well as trading. When a person is not dedicated, they waver, put things off, give up easily, and never seem to accomplish their goals. Whether it’s finishing college, starting a business, or obtaining a big promotion, achieving key life goals demands a strong dedication. Trading, however, seems to be a little different because it might be challenging for many people to commit fully. There are several valid explanations for this. It is beneficial to become aware of them and accept them.

 

Trading is unique from many other professions in that the work one puts in is not always immediately and clearly rewarded. In the majority of occupations, there is little doubt that the amount of time you invest in honing a skill and putting it to use will pay off. For instance, a mason building a wall would know for sure that laying brick after brick, hour after hour, will result in the wall’s completion (The wall may look unattractive if the mason is poorly skilled, but the wall will get finished, nevertheless). The relationship between effort and result is a direct one-to-one one.

 

However, even putting in countless hours of work, traders may still fail when it comes to trading. Trading requires a certain level of competence before returns, or profits, are reliable. Whether one has the talent to learn the skills is immediately evident to teachers and gatekeepers, and one is stopped from even trying to master the career (this may be true of other occupations). One may never make a dollar trading unless they reach a high level of proficiency. The likelihood that one’s time and effort may not pay off right away or at all makes it challenging to foster a strong commitment to trading.

learning sharks stock market institute
source: USAToday

How can one handle this situation? There are many approaches. First, realise that developing the abilities necessary to become a successful trader may take some time. Don’t believe that you HAVE to become profitable right away. Second, remember that “practise makes perfect,” as the saying goes. Give yourself time to acquire the necessary abilities. It’s important to practise, enjoy the learning process, and wait patiently to develop the essential skills, just like with other activity that involves skill-building, like playing music or sports.

 

Put your objectives in perspective third. Before deciding to trade full-time to earn your entire income, you might need to first set modest goals, such as mastering “paper” trading or successfully trading tiny positions. If trading is your passion and you like it, the concept that you need to put in the time to hone these abilities shouldn’t deter you. You might succeed as a professional trader, or you might have to settle with being a skilled amateur.

Being consistently lucrative at trading is difficult to do, which prevents one from committing fully. Many seasoned traders caution newcomers against expecting to become successful immediately because it is difficult, unrealistic, and demoralising.

 

It’s best to proceed incrementally. Educate yourself, hone your talents, and then progressively expand your position. Trading is so challenging over the long run, even seasoned traders admit, that they just take it “one day at a time” or “one deal at a time.” It’s simpler to create commitment if you focus on achieving modest goals initially before aiming for bigger ones. You can increase your long-term commitment to trading by heeding this advice.

Hedging with Futures

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Forward Market

• Forwards market
• Futures contract
• Future trades
• Leverage & payoff
• Margin & M2M
• Margin calculator
• Open interest

• How to short
• Nifty futures
• Nifty futures
• Futures pricing
• Hedging with futures
• Notes

11.1 – Hedging, what is it?

learning sharks stock market institute

Hedging is among the most significant and useful uses of futures. Hedging is an easy way to avoid suffering a loss on your trading positions in the event of any unfavorable market fluctuations. Let me try to explain the concept of hedging to you using an analogy. Just outside your home, let’s say you have a little patch of empty, barren land. Rather than letting it remain empty and bare, you decide to grass the entire area and plant a few lovely floral plants. You tend to the tiny garden, give it regular waterings, and watch it flourish.

 

Your efforts eventually pay off, the lawn turns a beautiful green color, and the flowers begin to bloom. As the plants develop and the flowers begin to blossom, unwanted attention begins to gather. You quickly discover that a few stray cows have made your small garden one of their favorite hangouts. You see these wandering cows happily grazing on the grass and trampling the lovely flowers. You decide to defend your tiny garden since you’re so irritated by this. What you envision is a straightforward solution—you build a fence (perhaps a wooden hedge) around your garden to keep cows out. By using this simple workaround, you can protect your garden while allowing it to grow.

 

Now let’s apply this comparison to the markets:

  • Imagine managing a portfolio by selecting each stock after thorough research. You gradually deposit a substantial sum of money into your portfolio. This is comparable to the garden you cultivate.
  • After investing your money in the markets, you eventually learn that the markets may soon enter a volatile phase that would cause portfolio losses. This is similar to a wandering cow ruining your lawn and flower plants by grazing there.
  • You build a portfolio hedge using futures to stop your market holdings from losing money. This is the equivalent of building a wooden fence to enclose your garden.

I believe the aforementioned comparison adequately conveyed what “hedging” entails. Hedging, as I had previously indicated, is a strategy to guarantee that any negative market movements won’t have an impact on your position. Please don’t think that hedging is just used to safeguard a stock portfolio; you may actually use a hedge to protect specific stock positions, albeit with some limitations.

 

 

11.2 – Hedge – But why?

Why genuinely hedge a position is a subject that comes up regularly when hedging is brought up. Think of this: A trader or investor has a stock that he paid Rs. 100 for. He now believes that both the market and his stock are going to drop. In light of this, he has the option of doing one of the following:

 

  1. Let his stock fall without taking any action in the hopes that it would ultimately rise again.
  2. Sell the stock with the intention of later purchasing it for less money
  3. Leverage the situation

 

Let’s first examine what actually transpires when a trader chooses not to hedge. Imagine your investment in the stock drops from Rs. 100 to, say, Rs. 75.

 

Additionally, we’ll assume that eventually, as time goes on, the stock will return to Rs. 100. The key question is: Why should one actually hedge when the stock eventually returns to its original price?

 

You would probably agree that the decrease from Rs. 100 to Rs. 75 represents a 25% decrease. But if the stock needs to move back from Rs. 75 to Rs. 100, it won’t be a scale back of 25%; instead, it will move back by 33.33 percent to meet the initial investment value! This indicates that while it involves less work to lower a stock’s price, it takes more work to restore it to its previous level.

 

Additionally, I can tell you from experience that equities do not typically increase that quickly unless there is a bull market in full swing. For this reason, it is usually wise to hedge positions anytime one predicts a pretty massive adverse market movement.

 

What about the second choice, though? The second alternative, in which the investor sells the stock and then buys it again at a later time, necessitates market timing, which is difficult to achieve. In addition, a trader who engages in frequent transactions will not profit from long-term capital tax. Naturally, frequent transactions also result in higher transaction costs.

 

Hedging makes sense for all of these reasons because it virtually insulates the position in the market, making it irrelevant to what actually occurs in the market. It is comparable to receiving a viral vaccination shot. Therefore, when a trader hedges, he may be sure that the market’s negative movement won’t have an impact on his position.

 

 

11.3 – Risk

It’s probably vital to know what we are aiming to hedge before moving on to understanding how we could hedge our market positions. We are hedging the risk, as you can probably guess, but which kind of risk?

In essence, you take on risk when you purchase a company’s shares. Systematic risk and unsystematic risk are the two main categories of risk. Purchase of a stock or a stock future exposes you to these dangers at the same time.

There are several reasons why the stock could decrease, costing you money. reasons like –

  1. declining sales

  2. declining margins of profit

  3. higher cost of financing

  4. maximum leverage

  5. management incompetence

All of these factors carry some level of danger; in fact, there may be many more factors that are similar, and the list might go on. You’ll notice that each of these risks has one thing in common: they are all company-specific concerns. Imagine, for instance, that you have Rs. 100,000 available for investment. You choose to invest in HCL Technologies Limited with this capital.

A few months later, HCL declares that its sales have decreased. It is apparent that the price of HCL stock would decrease. It implies that your investment will be lost. The stock price of HCL’s rivals Tech Mahindra or Mindtree won’t be  by this announcement, though. Likewise, Tech Mahindra’s stock price will decrease and not that of its rivals if the management engages in any misbehavior.

Unsystematic risk can be , which means you don’t have to put all of your money into one business. Instead, you can opt to invest in two to three different ones (preferably from different sectors). Unsystematic risk is significantly diminished when you do this. Going back to the previous scenario, imagine that you choose to purchase HCL for Rs. 50,000 and perhaps Karnataka Bank Limited for the remaining Rs. 50,000 instead of purchasing HCL for the entire capital. 

In such a case, even if the price of HCL stock drops (because to unsystematic risk), the investment will only suffer losses on half of it because the other half is  in a different firm. In reality, you can have a portfolio of five stocks, ten stocks, or even twenty stocks instead of simply two. Your portfolio’s diversification will be greater the more equities you have, which will reduce the unsystematic risk.

This brings us to a crucial question: How many stocks should a decent portfolio contain in order to completely diversify the unsystematic risk? According to research, a portfolio with up to 21 stocks will have the essential degree of diversification, and anything more than that may not significantly contribute to diversification.

As you can see from the graph above, diversification and adding more stocks significantly lower the unsystematic risk. The line begins to flatten out at 20 stocks, indicating that the unsystematic risk is not really diversifiable after that point. In fact, the “Systematic Risk” is the risk that persists even after diversification.

The danger that all equities share is  as systemic risk. These macroeconomic concerns typically have an impact on the entire market. A few examples of systemic risk are:

  1. decline in GDP
  2. increases in interest rates
  3. Inflation
  4. fiscal shortfall
  5. geographic risk

Of course, the list is not exhaustive, but I think you now have a good sense of what systematic risk is. Every stock is subject to systematic risk. A decrease in GDP will therefore undoubtedly have an impact on all 20 equities in a well- portfolio, and as a result, they are all likely to experience a loss. Because it is a part of the system itself, systemic risk cannot genuinely be . Systematic risk, however, can be “hedged.” Therefore, keep in mind that diversification and hedging are not the same things when we discuss hedging.

It’s important to keep in mind that we diversify to reduce unsystematic risk and we hedge to reduce systematic risk.

11.4 – Hedging a single stock position

We’ll start by discussing hedging a single stock future because it’s quite easy to do so. We shall also comprehend its limitations before moving on to comprehending how to hedge a stock portfolio.

Consider purchasing 250 shares of Infosys at a cost of Rs. 2,284 each. This amounts to an Rs. 571,000 investment. You are definitely “Long” Infosys in the spot market. You understand the quarterly results are due soon after starting this employment. You are  that Infosys might release some unfavorable financial data, which would cause the stock price to drop significantly. You choose to hedge the position in order to prevent suffering a loss on the spot market.

Simply entering a counter position in the futures market will allow us to hedge the spot position. We must be “short” in the futures market because the spot position is “long” at this time.

The short futures trade specifics are as follows:

Long Futures @ 2285/-

Lot size is 250.

Value of the Contract: Rs. 571,250

Though at separate prices, you are currently long Infosys (in the spot market) while we are short it (in the futures price). However, since we are “neutral” in terms of direction, the price variation is unimportant. You’ll realize what this implies soon enough.

The important thing to remember is that the position will not profit or lose money regardless of where the price is headed (whether it rises or falls). The general situation appears to be . In fact, the position loses interest in the market, which is why we say that when a position is hedged, it continues to be “neutral” with regard to the state of the market as a whole.

Hedging a single stock position is quite simple and hassle-free, as I had already said. To hedge the position, we can use the stock’s futures contract. However, one needs to have the same number of shares as the lot size in order to use a stock futures position. If they change, the P&L will change and the position won’t be ideal.

This raises the following crucial inquiries:

1. What if I hold shares of a stock that isn’t  by a futures contract? Does the absence of a futures contract, for South Indian Bank, imply that I cannot hedge a spot position in South Indian Bank?

2. The spot position value in the example was Rs. 570,000. However, what if I hold relatively minor positions, like Rs. 50,000 or Rs. 100,000? Can I hedge such situations?

In actuality, neither question’s answer is quite simple. Soon we shall comprehend how and why. We’ll move on to learn how to hedge several spot holdings for the time being (usually a portfolio). To begin, we must comprehend something referred to as the “Beta” of a stock.

11.5 – Understanding Beta (β)

Beta, represented by the Greek letter, is a very important concept in market finance because it is  in many different areas of that field. Given that beta is  to hedge stock portfolios, I believe the time is right to introduce it.

Simply said, beta evaluates how sensitive a stock’s price is to changes in the market, which means it can assist us to respond to queries like these:

  1. What is the in stock XYZ if the market rises by 2% tomorrow?
  2. In comparison to market indices (Nifty, Sensex), how risky (or volatile) is the stock XYZ?
  3. In comparison to stock ABC, how hazardous is stock XYZ?

A stock’s beta might have any value above or below zero. The market indices (Sensex and Nifty) have a constant beta of 1, nevertheless. If, for instance, the beta of BPCL is +0.7, the following implications are made:

  1. BPCL is to gain by 0.7 percent for every +1.0 percent increase in the market.
  2. BPCL is to increase by 1.05 percent if the market increases by 1.5 percent.
  3. BPCL is to experience a reduction of 0.7 percent if the market falls by 1.0 percent.

A stock’s beta might have any value above or below zero. The market indices (Sensex and Nifty) have a constant beta of 1, nevertheless. If, for instance, the beta of BPCL is +0.7, the following implications are made:

1. BPCL is  to gain by 0.7 percent for every +1.0 percent increase in the market.

  1. BPCL is to increase by 1.05 percent if the market increases by 1.5 percent.
  2. BPCL is to experience a reduction of 0.7 percent if the market falls by 1.0 percent.

2. It is thought that BPCL is 30% less hazardous than markets because its beta is 0.7 percent versus 1.0 percent, a difference of 0.3 percent.

  1. One may even claim that BPCL has a lower overall systematic risk.

3. BPCL is thought to be less volatile than HPCL, making it less risky, if HPCL’s beta is 0.85 percent.

11.6 – Calculating beta in MS Excel

Using the Excel function “=SLOPE,” you can quickly determine the beta value of any stock. Here is a step-by-step formula for doing that; I used TCS as an example.

  1. Download the Nifty and TCS daily close prices for the previous six months. This is available from the NSE website.
  2. Determine the Nifty and TCS daily returns.

1. Daily return is  as [Today’s Close / Yesterday’s Close]

-1

3. Enter the slope function in a cell that is empty.

  1. The slope function is as =SLOPE(known y’s, known x’s), where known y’s is an array of TCS’s daily returns and known x’s is an array of Nifty’s daily results.

4. 6-month beta for TCS (3rd September 2014 to 3rd March 2015) calculates to 0.62.

11.7 – Hedging a stock Portfolio

Let’s get back to the topic at hand, which is using Nifty futures to hedge a portfolio of stocks. Before we continue, you might be wondering why we should utilize Nifty Futures to hedge a portfolio. Why not another option?

Do not forget that there are two categories of risk: systematic risk and unsystematic risk. A diverse portfolio naturally helps us to reduce unsystematic risk. The systemic risk is what is left after this. The greatest strategy to protect against market risk is by using an index that represents the market, as systematic risk is the risk connected to the markets. The Nifty futures are a logical choice to reduce systematic risk as a result.

Initial Step: Portfolio Beta

Hedging a stock portfolio entails a number of stages. Calculating the total “Portfolio Beta” is the first stage.

  • The “weighted beta of each stock” is to determine the portfolio beta.
  • By combining the beta of each individual stock with its corresponding weight in the portfolio, weighted beta is.
  • By dividing the amount invested in each stock by the total value of the portfolio, the weighting of each stock in the portfolio is.
  • For instance, Axis Bank’s weighting is 15.6 percent (125,000/800,000).
  • As a result, Axis Bank’s weighted beta on the portfolio would be 15.6 percent * 1.4 = 0.21.

The overall Portfolio Beta is the weighted beta  together. The beta for the portfolio mentioned above is 1.223. This indicates that if the Nifty index increases by 1%, the portfolio as a whole are anticipated to increase by 1.223 %. Similarly, if the Nifty declines, the portfolio is anticipated to decline by 1.223 percent.

Calculate the hedging value in step two.

Hedge value is just the sum of the portfolio’s entire investment and its beta.

= 1.223 * 800,000

= 978,400/-

Remember that we bought these stocks on the spot market, and this is a long-only portfolio. We are aware that taking a counterposition in the futures markets is necessary for hedging. The hedge value recommends that a portfolio worth Rs. 800,000 should be hedged. We must sell futures contracts worth Rs. 978,400. Given that the portfolio is a “high beta portfolio,” this should be rather obvious.

Calculate the necessary number of lots in step three.

With the current lot size of 25, the contract value per lot for Nifty futures, which are currently trading at 9025, is equal to –

= 9025 * 25

= Rs.225,625/-

Therefore, there would be tonnes needed to short Nifty Futures.

= Contract Value / Hedge Value

= 978,400 / 225625

= 4.33

According to the calculation above, 4.33 lots of Nifty futures must be sold short in order to perfectly hedge an investment portfolio worth Rs. 800,000 with a beta of 1.223. As we can only short 4 or 5 lots, and fractional lot sizes are not available, it is obvious that we cannot short 4.33 lots.

We would be just a little under-hedged if we choose to short 4 lots. Similarly, if we sold five units, we would have over-hedged. We actually can’t always perfectly hedge a portfolio for this reason.

Now, suppose that after using the hedge, the Nifty actually drops by 500 points (or about 5.5 percent ). We will use this information to determine the hedge’s effectiveness in the portfolio. I’ll suppose we do it for the sake of illustration.

Position Nifty

the short started at – 9025

Value Reduction – 500 points

8525 is the Nifty value.

There are 4.33 lots total.

P & L = 4.33 * 25 * 500 = Rs.54,125

The short position has made a profit of Rs. 54,125. We will investigate what might have occurred with the portfolio.

Portfolio Place

Portfolio Value is 800,000 rupees.

Portfolio Beta equals 1.223

Market decline: 5.5 percent

Expected Portfolio Decline = 5.5 percent multiplied by 1.233 to equal 6.78 percent

800000 divided by 6.78 percent

= Rs. 54,240

As a result, as you can see, the Nifty short position has made a profit of Rs. 54,125, while the long portfolio has suffered a loss of Rs. 54,240. The net position in the market is therefore unchanged (please overlook the slight difference). The gain in the Nifty futures position cancels out the loss in the portfolio.

I hope this has helped you better understand how hedging a stock portfolio works. I would advise you to perform the same exercise with 4 or 5 lots in place of the 4.33 lots.

Let’s examine two outstanding questions that we posed when we explored hedging single stock positions before we conclude this chapter.

In order to make it easier for you, I’ll repost it here:

  1. What if I hold shares of a stock that isn’t covered by a futures contract? Does the absence of a futures contract, for South Indian Bank, imply that I cannot hedge a spot position in South Indian Bank?
  2. What if I have relatively minor stakes, say, Rs. 50,000 or Rs. 100,000? Can I hedge such positions? In the example taken, the spot position value was Rs. 570,000.

You can, however, hedge stocks that lack stock futures. For illustration, let’s say you own South Indian Bank stock valued Rs. 500,000. To find the hedge value, all you have to do is multiply the stock beta by the investment value.

Considering that the stock’s beta is 0.75, the hedging value is

500000*0.75

= 375,000/-

Once you’ve  this, divide the hedge value by the Nifty’s contract value straight to determine how many lots are needed (too short) in the futures market. With this information, you can properly hedge the spot position.

Regarding the second query, the answer is no—you cannot hedge tiny bets whose value is far below the contract value of the Nifty. However, you can use options to hedge such holdings. When we consider our possibilities, we shall talk about the same.

CONCLUSION

  1. By hedging, you may protect your market position from any negative market changes.
  2. Gains in the futures market are used to offset losses you incur when hedging in the spot market.
  3. Systematic and unsystematic risk are the two different categories of risk.
  4. The risk that is unique to macroeconomic events is called systematic risk. The risk posed by systems can be hedged. All stocks are subject to systematic risk.
  5. The company’s risk is known as unsystematic risk. Every business is different in this way. Although it cannot be hedged, unsystematic risk can be diversified.
  6. According to research, unsystematic risk cannot be further diversified after 21 stocks.

  7. We only need to take a counter position in the futures market to hedge a single spot equity position. But spot value and futures value must be equal in size.

  8. Beta for markets is always +1.0.

  9. The stock’s sensitivity is measured by beta.

1. Low beta stocks are those that have a beta of less than 1.

2. A high beta stock is one that has a beta greater than 1.

 

10. Using MS Excel’s “Slope” tool, one may quickly estimate the stock beta.

11. The actions below must be taken in order to hedge a portfolio of equities.

  1. Calculate each stock’s beta.
  2. Determine each stock’s individual weighting within the portfolio.
  3. Identify each stock’s weighted beta.
  4. To calculate the portfolio beta, add up the weighted beta.
  5. To calculate the hedge value, multiply the portfolio beta by the portfolio value.
  6. To determine the number of lots, divide the hedging value by the Nifty Contract Value.
  7. In the futures market, short the required number of lots.

12. Remember that creating a perfect hedge is challenging, thus we are obliged to either under a hedge or over a hedge.

Cold, hard facts: look at the facts

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There are times when analysing the icy, hard facts is the only option for assessing your performance. The bottom line is that if you are not profitable throughout a variety of trades, you will ultimately go out of business. It’s critical to evaluate your performance realistically. But if you’re a trader like most others, your insatiable need to succeed takes control. You only perceive what you want to perceive, yet an outsider would notice that you are on the verge of collapsing into the abyss but are unaware of it. Contrary to popular belief, traders are more likely to suffer from it. It might be quite difficult to evaluate our performance honestly since facing the cold, harsh truths can hurt one’s ego.

 

Focusing solely on performance outcomes isn’t always beneficial from a psychological standpoint. For example, developing your trading abilities takes time if you are a beginner trader. You’ll become frustrated if you have unrealistic expectations for performance results and deadlines. However, if you lose a lot of money trading, you can accumulate so much debt that it would be difficult for you to recover your losses. Realistically examining the cold, hard realities is a requirement, not an option. Let’s take a look at a few well-known statistics that show how successful you are.

 

First off, what is your hit rate? How often do you receive payment? Does it fall within the 20%, 10%, or lower bracket? It’s crucial to take into account your past success and establish a rough estimate of the percentage of transactions you close that are profitable. It gives you a feeling of how you are performing even if it is not the only metric you should take into account. The disadvantage of only using this indicator is that you might unintentionally want to execute a few little profitable transactions in order to increase your hit rate.

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Finally, it’s crucial to consider your account’s size and commission fees. Commissions will reduce your overall revenues if your account is modest. Although account size does matter, many novice traders want to hold onto the hope of becoming rich despite having a small account, so they avoid giving account size and commission fees their full attention. Don’t make oneself vulnerable to failure. To make money, you must have money. It’s a good idea to consider your trading expenses and modify your objectives if necessary. If your account size is too modest for your goals, you might need to take on a second job in order to accumulate investing funds, for instance.

 

People tend to be eternally optimistic. Realistic thinking must be used to temper optimism. Don’t be hesitant to evaluate your trading results objectively. You can correct your route midstream so that, in the long run, you will be lucrative by regularly and honestly evaluating your performance.

Going with your gut

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Traders with experience don’t hesitate to follow their instincts. A savvy trader’s gut, developed through years of experience, is the unconscious integration of all pertinent market data, the bare minimum of knowledge needed to formulate a smart course of action. All inputs are run through the experienced trader’s mental working models, examined, and then reflected as a hunch, which is still a feeling but a good, all-encompassing sensation. Trading professionals learn how to cultivate and harness their gut feelings. But first, it’s important to understand what a gut instinct is and how it should be cultivated before a rookie trader tries to employ it.

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Following your instincts when trading is odd at first. A common misconception about trading is that rational conclusions are reached after methodically analysing market data. When one initially begins trading, it is crucial to have a thorough understanding of the decision-making processes. The indications, market circumstances, and assumptions that were used to make a judgement should all be clearly stated. A new trader is likely to make poor choices at initially. He or she is ignorant of the many market circumstances that could exist or of the effective and practical uses of market indicators. But what was once purposeful and conscious becomes routine and unconscious after years of practise.

 

Trading involves deliberate and meticulous behaviour at first, just like acquiring any ability; nevertheless, with practise and a variety of situations, one can operate more naturally. It’s comparable to how you learnt how to play a sport or drive a car. Initially, you deliberated over each step to ensure that you didn’t miss any crucial ones, but now, you can perform flawlessly and without any thought. The same holds true for trading. At first, you must carefully consider the value and significance of a range of indications, but with time and practise, you will be able to take decisive action.

 

Having said that, it is crucial to understand that a trader cannot make precise, intuitive decisions unless they have gained years of expertise. You don’t want to presume that you can make experienced decisions without actually having enough experience to rely on, just as you wouldn’t want to make rash, ill-informed judgements.

Practice using your intuition when making decisions is helpful. The novice can develop an expert level of trading knowledge and trading perceptions that can be used later to make rapid and accurate decisions by engaging in as many trades as possible and getting as much market experience as feasible.

 

And if you learn to make judgments based on intuition, you’ll find it easier to trade in the zone and go with the flow. You can take advantage of uncommon market movements and respond promptly to ever-changing market conditions. You’ll trade more effectively, and the better you are at trading, the more money you’ll make.

Guilt: protection or distraction

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Rohan simply gave up on his trading strategy and wound up placing a lost trade. Why did I do it again? he asks himself. Why am I unable to adhere to my plan? He feels bad. He is furious with himself for his error. A typical emotion in trading is guilt. There are numerous reasons why we could feel guilty. Guilt keeps us from making stupid mistakes over and over again, but is it always useful? Similar to other negative feelings, shame can get in the way of enjoyable, simple trade.

 

Guilt is a protective sensation. When we were young, our parents instilled moral ideals in us; these values were absorbed and kept in what Freud called the “superego.” When we break a rule, we feel fear and guilt out of instinct. Shame holds us accountable. It prevents us from breaking a moral rule that is significant to us. Some traders report that they feel awful after every trade. Given that their family considers trading as a form of gambling, they may have grown up thinking that gambling was wrong. If you were brought up with these values, you may be more prone to feeling guilty.

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Is feeling guilty when you break your trading plan helpful? Frequently, it is not. Yes, guilt keeps us from betting a lot of money on a dubious scheme. Risking too much on a single deal is not a wise idea. It makes sense to feel bad if you trade with money you can’t afford to lose. In that instance, your guilt is shielding you from possible financial ruin. However, feeling guilty after a trading mistake can not be helpful. In these circumstances, you might wish to make an effort to reduce guilt. You won’t trade quietly and logically if you can’t manage your emotions.

 

Being guilty isn’t always helpful while dealing. When you feel guilty, you obsess about how awful everything is. You also have a propensity to believe that you are a “bad” person who needs to be punished. However, when you are actively dealing, there is no time for reflection. It does nothing. Instead of dwelling on your mistakes and feeling bad about them, you must always endeavour to find solutions if you want to stay ahead of the pack. You need to come up with imaginative solutions to difficult challenges, yet guilt prevents you from freely looking for original, novel alternatives. In light of this, if you feel guilty, tell yourself: “So I erred. That does not imply that I am unworthy or prone to repeating the error.

 

Sometimes guilt can serve as a form of protection, but when we trade, we frequently feel bad about the losses that come with the territory. Learn to manage your unproductive guilt if you are experiencing it. Long-term trading profitability increases with your ability to trade calmly and freely.