Stay the Course with Equities. Volatility isn’t the Time to Sell.
To make money in equity markets, selling price must be more than buying price for any investor / trader / speculator. Even if Buy and Sell rates are same, profit for investors in equity segment and derivative segments will be vastly different. Within derivatives, there is a difference between futures and options. Please look at the following to know how and why.
Let’s take an example such that the lot quantity in derivatives multiplied by equity price is equal to 10 lakhs. Let us also assume that investor is able to sell it with a profit of Rs 5,000. In case of options, let us assume the full contract value of the security is 10 lakhs.
From the above table, one can easily see that trading in equities is very expensive when compared to futures or options. While options look very attractive in terms of return on investment in percentage terms, liquidity is low for most options. Impact cost (loss due to low liquidity) and Volatility premium need to be understood before stepping into futures and options. You must also have reliable forecasting model to earn in trading volatile markets. Losses increase with expenses and profits reduce with expenses, as you can see from the table. Hence, to stay profitable, one must have a strategy of higher profit and lower loss model. We call it Risk-Return Payoff. Learn a bit more on each of them.
Impact cost is the cost you bear when executing large volumes in the market. Not all trades are executed at the same price in most cases. To effectively Buy or Sell, you must be willing to pay a tad higher price or offer at a tad lower price. If you want to trade only in futures and wish to have STOPLOSS in place, you will have to give enough room for the orders to be traded when price starts moving against you in quick time.
Volatility Premium: Common sense warrants future price to be higher than spot price. This is because there will be time to settle the trade for futures while spot prices needed to be settled in less than two days with money or delivery. But at times, when volatility is high, futures may be available at a discount to spot price thus defying logic. Everyone knows that the future and spot will have to converge by the expiry date. Yet, some people tend to sell future much below spot price. The following could explain such situations.
- Large investors, like FII or DII, may sell futures first to lock the rate and follow up with actual delivery trade. When the price seeks low levels following their delivery sales, they may close out their short positions in futures allowing the market to reflect higher future prices again.
- When traders anticipate steep correction in price, they may go short to book profits later. Usually, these are done in large quantities. In such cases, if the prices move up, against their view, they will have to cough up MTM losses forcing them to buy back and close sell positions. Prices surge very fast when panic sets in their mind of possible large losses, should prices further rise.
In options, higher volatility is synonymous with high prices of options. It is an established fact that deep in the money options carry less volatility premium and will return higher profits if the forecast works out well. Since investment is more, losses also will be more when their call is wrong. Based on strength of your forecast on likely direction of market, you should trade in positions that offer higher return for lesser risk.
Forecasting Model: Vivekam has built a model to help it forecast likely trends in prices of Indices and highly liquid stocks. To preserve capital in times of adversity, Vivekam suggests investors to limit their exposure to equity indices, to begin with. 100% hedging is essential at the end of any trading day, to ward off risks of shocks from intra-day variations. Vivekam’s model aims to capture a minimum of 2% on each signal. Since leveraging is allowed it works out to 10% gain. The following tables showcase the success rate of signals on Buy side and Sell side for the period 2015 – 2020 June.
The model has been able to generate enough successful signals to reward patient investors with handsome returns over time. If one considers that less than 50% success rate as sub-optimal, having a look at the Risk-Return Payoff details below will show why that is an incorrect assumption. If our return to risk ratio stands at 1.35% : 1.00%, we will stay ahead so long as Vivekam is successful 42% of all cases. Profits pour in from 43% onwards. Vivekam draws its strategies to build positions so as to ensure the above return risk ratio.
Risk-Return Payoff: The table below shows how one can gain, if return and risk are properly balanced. Returns with leverage of 3 and 5 times is presented. However, one must remember that to be in the game for longer periods, one must be with the strategy for a period of at least one year. On an average, there will be a minimum of 50 signals to initiate trades. Following table is for 100 signals and the likely result of STOPLOSS or Profits to be booked. You will realize that the critical percentage of success required stands between 42 and 43 percent. 43 percent generates positive outcome while 42 may put us behind by a small loss.
Considering the relatively high liquidity seen in Index Futures/Options, Vivekam suggests investors to be involved in Index futures and options. In the event of liquidity drying up, theory of stoploss may not be effective in individual stock futures or options there on. Anyone with a risk capital of 10 lakhs may contact us to know more about the FLOATER.
Selling unhedged options is not be encouraged by anyone, unless they have access to unlimited resources and very high risk appetite. Vivekam stays away from recommending selling unhedged options.
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