Fenil's Library

Treat tax-saving as investment, not as a perfunctory annual ritual

Suresh Sadagopan

Seeing is believing, they say, of the amazing wildebeest migration from Serengeti to Masai Mara. An estimated 1.3 million wildebeest participate in this migration, apart from 2 lakh zebras and other animals. Crocodiles lay in wait underwater, big cats wait across the river and hyenas chase and hunt young wildebeests. Reminds me of another landscape we are familiar with...

We have a stampede in the December-January period to complete tax-saving investments (Rs 1 lakh under Sec 80C). Saving tax is almost a pathological obsession. This holds so much significance to the tax payers that it has become a national obsession to hunt for schemes which "save tax" and complete the formality. The search is so single-minded that many lose track of the larger picture of investing wisely. We work for money. We never tire of talking of "hard earned" money. But we seem to invest without doing our homework. Just like in Masai Mara, there is an equally colourful & eclectic mix of crocodiles, big cats and hyenas to prey on the unsuspecting investors.

The agents/ advisors (some are called financial consultants too) have colourful brochures illustrating how the investors' monies have grown in the past several years. In spite of specific prohibition by the Insurance Regulatory and Development Authority (Irda) to desist from showing returns of over 10% in illustrations, there are many who will precisely do that, to give you the "real" picture. The 10% illustration is too bland and not evocative enough.

That of course must be truly enticing, going by the number of people who reach for insurance policies (mostly unit linked insurance plans, more popular by the acronym Ulips) for tax savings. Their decision making is of course egged on and eased by the goodwill gesture of cash gifts from the agents/advisors/consultants, for buying insurance policies through them. Investors are all for this - they get great returns, save tax and get some upfront cash too. It doesn't get better than that. Or, does it?

Reality hits them later, when they see the unit statements, in due course. They want to get out then. Many have come to me saying they were not aware of such usurious charges, nor the steep surrender charges. They then understand why the agent gave them the cash gift. It was a honey-trap.

Insurance plans are not the only point where investors falter. They are also bowled over by pension plans. Pension is a concept that talks to their deep-seated desire to get a monthly paycheque after retirement, is an assurance of security in their old age and a guarantee of 'sar utha ke jiyo'.

There is only one problem, however. The annuity they will get is taxable. No one mentions it to them, of course, and pension policies are a hit. No one tells them that once pension starts, they cannot get back their accumulated corpus either. Also, they also forgot to mention that the same pension can be structured in many other ways - like even through the other favourite — Ulips, whose maturity proceeds are tax-free — or that the pension could as well be arranged if one invested and accumulated wealth through the Public Provident Fund (PPF), equity mutual funds or direct equity.

Tax at maturity is a problem with National Savings Certificates, bank fixed deposits of five years or more, too. Talking of tax, investors have other options to invest, to save tax and regret at leisure. There are single premium policies which offer a life cover of five times or more in the first year, which falls to 2 times or less from the second year or later. So what's the big deal in this? Besides, as per Irda directive, the maturity proceeds become taxable if the sum assured falls to less than five times the premium, anytime during the policy term. That means, most of the single premium products which are being sold now will all be taxable. Was this made clear to them? Nope. Investors are not even aware that, there is such a catch.

I have read that 1/8th of the wildebeest do not reach the other side alive - a very sobering thought indeed. The toll among investors could match that - maybe worse.

What can investors do? They could simply invest in PPF or equity linked savings schemes of mutual funds - at least, they do not have to pay the charges, which are substantial in the initial years. Also, in these cases, it is a one-time payment — not a liability to pay for several years into the future. They save tax in the year of payment and do not create a tax liability on maturity. They could also prepay home loans (if they have one), for the principal amount so paid also saves tax under Sec 80C.

The great wildebeest migration has been happening for millions of years. And this is not even the only such spectacular migration. Monarch butterflies - hundreds of millions of them, fly some 2000 miles in an incredible intercontinental migration. By the end of October, the monarch butterfly population east of the Rocky Mountains migrates to the sanctuaries of the Mariposa Monarca Biosphere Reserve in Mexico. They have been doing this successfully year on year - the butterflies even reach the same tree and branch as their ancestors. Fancy that!

We keep talking about being evolved! Our tax-saving frenzy is at best decades old. We have a long way to go - we need to catch up with the butterflies first.

The writer is a certified financial plannerwho runs Ladder 7 Financial Advisories and can be reached at ladder7@gmail.com.

Remember, even in combination policies, insurance isn't free — you need to buy it

Sandeep Shanbhag
Last week, we analysed the Jeevan Aastha policy of Life Insurance Corporation (LIC) and ascertained that the maximum and minimum return from the policy, depending upon the age of the policyholder, would be in the range of 4.69% to 7.32% per annum Subsequently, several readers wrote in requesting an analysis or at least a view on a particular policy of their choice that they had identified. Not surprisingly, all such policies were either unit linked insurance plans (Ulips) or endowment related plans. I decided to address this issue through my column rather than reply to each person individually.

Debased dollar making gold glitter more

Vivek Kaul. Mumbai

"Stop staring at me," she said rather loudly as we walked to our umpteenth coffee session.

I kept looking.

"OK, tell me why everyone's talking about gold now," she said in an obvious bid to distract me.

"Well, the price of gold is inversely proportional to the value of the US dollar versus other currencies. If the dollar falls against other currencies, the price of gold goes up and vice versa. And I have already told you why I feel the US dollar will collapse in the days to come," I said, still looking at her, making it obvious that her ploy wasn't working.

I wonder if she sensed what I was up to, for she suddenly looked pretty serious about the issue at hand.

"I don't mind going over all that again, unless you do," she said.

"All right, you have it," I conceded, not sure if I had annoyed her or whether she was feigning it. "Let us go back in time. Gold coins were first used as currency in present day Turkey, way back in 600 BC. Over the years, people realised that using metals for currency made immense sense. So, gold, silver and bronze coins replaced other forms of currency such as sea shells, tea, slaves… for that matter, anything that could be exchanged."

"Interesting," she mumbled.

"I have been reading this book by James Turk and John Rubino titled The Collapse of the Dollar and How to Profit From It," I said, acknowledging the source of information out of habit. "The book offers some interesting insights..."

"I'll look that book up later, but I'd rather hear from you first," she said, goading me on.

"Well, metal coins were not really perfect either. They were noisy, heavy and they wore out with use, leading to a decrease in their value. So in the late 1690s, someone at the Bank of England had this brilliant idea of locking up all the gold and silver and issuing paper notes against it. Bank of England was the world's first central bank, set up in 1694. The paper notes it issued could be converted back to gold and silver coins at any point of time. But pretty soon, the weakness of the system started to come out. Can you guess what might have happened?" I asked.

"I think the bank started issuing more notes," she replied.

"More notes?"

"I mean the bank must have issued more notes than what was backed up by real gold and silver they had with them," she said.

"You are right. The bank had indeed issued more notes than it had gold and silver reserves for. People soon figured this out and wanted their gold and silver back. To manage the situation, Sir Isaac Newton, the famous physicist, was brought in as the Master of the Mint in 1699. He fixed the value of one ounce (around 28.35 gram) of gold to a little over three pounds. This was the most primitive form of what became famous as the gold standard in the years to come. What this did was to ensure that amount of paper notes issued at any point of time could not exceed the total value of gold that the bank had. This standard was followed for the coming years. As Niall Ferguson explains in The Ascent of Money - A Financial History of the World, "So restrictive was Bank of England that its bullion (gold) reserves actually exceeded the value of notes in circulation from the mid 1890s until the First World War." This ensured that paper money was always backed by gold, a physical asset," I explained.

"Interesting, but where does all this lead up to?"

"Have some patience. After the Second World War, European and American leaders met at Bretton Woods in the state of New Hampshire in the United States. Here, the value of one ounce of gold was fixed at $35. The values of other currencies were fixed to the US dollar. This effectively meant that the US Federal Reserve at any point of time was willing to convert the US dollars to gold. Since other currencies could be converted into US dollars, this effectively meant that the US Federal Reserve was ready to convert other currencies to gold as well. This is how the world worked for the next 20 odd years. Like all gold standards before, this gold standard too restricted the ability of governments to print paper currency beyond the total value of gold they had in their vaults."

"So what went wrong?"

"Well, by the sixties, the US had entered into a war in Vietnam. A cold war was also on with the erstwhile USSR. For all this, it needed a lot of dollars and the US government decided to print these dollars. And as they printed more and more dollars, the link between the amount of gold in their vaults and the amount of paper dollars in the market broke down. People soon found out and started to exchange their paper currency for gold. Now, there was only so much gold in the vaults of the US government. So on August 15, 1971, Richard Nixon, the then President of the United States, decided that the US would no longer convert dollars into gold. And that broke the last gold standard that prevailed."

"I kind of get what you are trying to explain. The gold standard essentially ensured that governments could not print money beyond a point. Like, now with no gold standard in place, the US government is simply printing more and more dollars to counter all the financial problems that are cropping up. As the US prints more dollars, the supply of dollars in the market is increasing and this over a period of time will lead to the value of the dollar against other currencies going down. Seeing this, investors and central banks of other countries seeing will start getting out of dollars and getting into other currencies and physical assets such as gold, so the price of gold will keep spurting up," she took off.

"Right. But the only worry is that a number of experts are talking about this now, and when experts talk about something, the opposite usually happens," I quipped.

"What makes you feel so?" she asked.

"I think theoretically the premise makes a lot of sense. But whether it will happen, I don't know. So the way to play it is to have 10-20% of your total investment in gold. So that if this investment theme does play out, you will be well-placed to cash in on it. And if it doesn't, you won't go down the tube either."

"Cool," she said. "But why have you been staring at the woman over there?"

 

(The example is hypothetical)

k_vivek@dnaindia.net

Beijing is seeking to pay for its own $600 bn stimulus as its economy slows

Keith Bradsher. Hong Kong

China has bought more than $1 trillion of US debt, but as the global downturn has intensified, Beijing is starting to keep more of its money at home, a move that could have painful effects for American borrowers.

The declining Chinese appetite for US debt, apparent in a series of hints from Chinese policymakers over the past two weeks, with official statistics due for release in the next few days, comes at an inconvenient time.

On Tuesday, US president-elect Barack Obama projected trillion-dollar deficits "for years to come," even after an $800 billion stimulus package. Normally, China would be the most avid taker of the debt required to pay for those deficits, mainly short-term Treasuries, which are government IOUs.

In the last five years, China has spent as much as one-seventh of its entire economic output buying foreign debt, mostly American. In September, it surpassed Japan as the largest overseas holder of US Treasuries.

Only now, Beijing is seeking to pay for its own $600 billion stimulus — just as tax revenue is falling sharply as the Chinese economy slows. Regulators have ordered banks to lend more money to small and medium-size enterprises, many of which are struggling with lower exports, and to local governments to build new roads and other projects.

"All the key drivers of China's treasury purchases are disappearing — there's a waning appetite for dollars and a waning appetite for treasuries, and that complicates the outlook for interest rates," said Ben Simpfendorfer, an economist in the Hong Kong office of the Royal Bank of Scotland.

Fitch Ratings, the credit rating agency, forecasts that China's foreign reserves will increase by $177 billion this year — a large number, but down sharply from an estimated $415 billion last year.

China's voracious demand for US bonds has helped keep interest rates low for borrowers ranging from the federal government to home buyers. Reduced Chinese enthusiasm for buying US bonds will reduce this dampening effect.

For now, of course, there seems to be no shortage of buyers for treasury bonds and other debt instruments as investors flee global economic uncertainty for the stability of US government debt. This is why treasury yields have plummeted to record lows. (The more investors want notes and bonds, the lower the yield, and short-term rates are close to zero.)

The long-term effects of China's using its money to increase its people's standard of living, and the US's becoming less dependent on one lender, could even be positive. But that rebalancing must happen gradually to not hurt the value of US bonds or of China's huge holdings.

Another danger is that investors will demand higher returns for holding Treasury securities, which will put pressure on the US government to increase the interest rates those securities pay. As those interest rates increase, they will put pressure on the interest rates that other borrowers pay.

When and how all that will happen is unknowable. What is clear now is that the impact of the global downturn on China's finances has been striking, and it is having an effect on what the Chinese government does with its money.

A senior central bank official, Cai Qiusheng, mentioned just before Christmas that China's $1.9 trillion foreign exchange reserves had actually begun to shrink. The reserves — mainly bonds issued by the Treasury, Fannie Mae and Freddie Mac — had for the most part been rising quickly ever since the Asian financial crisis in 1998.

The pace of accumulation began slowing in the third quarter along with the slowing of the Chinese economy, and appears to reflect much broader shifts.

China manages its reserves with considerable secrecy. But economists believe about 70% is denominated in dollars and most of the rest in euros.

China has bankrolled its huge reserves by effectively requiring the country's entire banking sector, which is state-controlled, to take nearly one-fifth of its deposits and hand them to the central bank. The central bank, in turn, has used the money to buy foreign bonds.

Now the central bank is rapidly reducing this requirement and pushing banks to lend more money in China instead. NYT

Rising prices are a scourge all right, but deflation would mean slow strangulation

R Jagannathan

As an agnostic, I am not much into prayer. But bad times are here, and there's no harm in a bit of almighty insurance cover. So, here's my contribution to the long list of wishes the world has written out for that Supreme Power in 2009: Dear God, please, please leave us some inflation this year.

Have I gone nuts? You judge. My reason for asking God to leave some inflation on the table relates to economics. We all know inflation as a scourge. But, believe me, depression is worse. Ask the Americans who lived through 1929-33. Ask the Japanese who lived through it in the 1990s.

If inflation is a slow killer that impoverishes before it kills, deflation is slow strangulation. In a deflationary scenario, prices and incomes keep falling - the former more quickly than the latter. As people keep buying less and start saving more, companies stop investing and keep laying off people. Banks stop lending and interest rates tend toward zero.

We are almost there in the US, where the Federal Open Market Committee set its target rate at 0-0.25%. This means, soon it will make sense for US citizens to keep money under the pillow. In India, our inflation has halved in less than six months and could fall to zero by June. Deflation and depression present a double danger: they penalise youth, and we are nothing if not a young nation. While the old have pensions which rise in value as prices fall, the young will have no jobs. Those who do have jobs, will find that all past borrowings will be doubly expensive.

Let's say I have taken a home loan and interest rates have fallen to 2%. I should normally be thrilled. My repayment burden comes down. But when prices are falling, the value of the EMI I am paying goes up. If I had kept the money with me, it would buy me more things than if I were to repay my bank. A falling price scenario helps lenders at the cost of borrowers. So, any sensible person should default.

But systemically, this is disaster as banks will stop lending and bring down economic activity — reducing my chances of retaining my job and real income.

In short, serious deflation in India will work against the young; our demographic dividend will become a demographic tax, with serious implications for law and order.

Of course, I have not addressed the more fundamental question of whether we are indeed headed for depression as in 1929. My answer is in two parts: the West is not too far away from 1929, but if it does end up in the ditch, India will be dragged down with it. This is why I suggest a one-year tax holiday for individuals.

During the great depression, US GDP fell by around 30%, stock prices by 90%, manufacturing output and imports by nearly 45-50%, and unemployment was up by 25% according to Ishwar Hegde, chief economist of Essar Steel. In the great recession so far, stocks and house buying have fallen by 45-50%, manufacturing by 19%. Joblessness is 7%. Since everyone is saying the worst is yet to come (GM, Ford and Chrysler are close to collapse), we are not really far from a depression.

And don't forget, the great depression of 1929 did not do us as much damage as the US, since we were already crushed under the colonial yoke. This time, with the US and Europe imploding simultaneously, we are bound to be dragged down with the rest. Our stock prices have fallen 65%, and home prices by 10-20%.

Actually, only China and India have the wherewithal to weather a depression, but China is overdependent on US imports (which fell 50% during the Great Depression) and India is not big enough to pull anyone out of the quicksand. In India, prices are falling and we could well hit zero inflation by mid-June, bringing us perilously close to the depressing scenario I described above.

On the bright side, we know much more about how to cure depression: print notes, shovel money into the economy. The world has begun to do that already, with both the US and Europe pouring trillions of dollars to get the economy out of the muck.

In India, our reflexes are still slow - for two reasons. One, we were blowing money up even before we got into the ditch (oil subsidies, farm loan waivers, et al). So we have less room for manoeuvre. Second, we have an overcautious government that is more vulnerable to special interest lobbying in an election year. Why do you think every manufacturer is heading for Delhi with a laundry list of concessions? It is far more sensible to give everyone who pays tax 100% relief so that there is no economic distortion in the way the money is spent.

The first sign that things are looking up will show up in the inflation numbers. So God, please see that inflation doesn't hit zero or stay there for too long. We have a few mouths to feed in these parts.

 

r_jagannthan@dnaindia.net

Caught in spiral of debt, the US govt has little choice but to print more currency notes

Vivek Kaul. Mumbai

"Where have you been?" she asked, as I ran into her in the elevator.

"Everywhere," I replied, trying to sound funny.

"I've been looking for you. See I have a doubt. Why don't we have coffee at my place?"

"Okay. Coffee with Kiran can't be all that bad."

"I read in a recent interview in DNA Money that the US dollar is the world's biggest Ponzi scheme. What does that mean?" she asked as she opened the door to her flat.

"You know what a Ponzi scheme is, of course?" I shot back, making myself comfortable on the sofa.

"Yeah, it's named after Charles Ponzi, an Italian immigrant to the United States of America (US), who promised investors in 1919 that he would double their money in 90 days, which he later reduced to 45 days. At its peak, the scheme had 40,000 investors who had invested around $15 million in the scheme. Ponzi had no business model in place. All he ended up doing was using the money brought in by the new investors to pay off old ones. He ran his scheme till the money coming into the scheme was greater than the money leaving the scheme. One fine day, that stopped and the scheme went bust."

"And what makes the US dollar a Ponzi scheme?" I asked.

"I think I asked you that…"

"Did you? Well then I should answer that. See, over the years, the US and its citizens have been on a consumption and borrowing binge. The US is the world's largest debtor nation. As on November 19, 2008, it owed a whopping $10.6 trillion to others," I said.

"But how did they get around borrowing so much in the first place?"

"The advantage with the US is that its currency is the international reserve currency. Countries buy and sell goods in dollars. They also have a major proportion of their foreign exchange reserves in US dollars. And where do they get all these US dollars? A major portion of this comes from selling goods and services to the US. The US GDP is around 25% of the world GDP of $55 trillion. So the US is a major market for anything and everything. Once a country has earned these dollars, what does it do with them? It can either keep these dollars in its vaults or invest them somewhere. And where does it invest them? It invests them in financial securities issued by the US government as they are deemed to be safe and at the same time earn some return," I explained.

"But why does the US government issue these financial securities?" she asked.

"Well, for the simple reason that it spends much more than it earns. So to make good the deficit it needs to borrow money. And in order to borrow money it issues these financial securities. Most countries in the world have a good portion of their reserves in the US dollar, which they in turn invest in financial securities issued by the US government. You'd know that China and Japan are the two biggest exporters to the US; they are also the two biggest investors in financial securities issued by the US government. So what does that tell you?"

"You tell me."

"Well, it means there is significant demand for these financial securities. Thanks to the demand, the returns offered on these securities are low, which in turn ensures that interest rates in the US are also low. This encourages more and more people to borrow and buy goods and services that the Chinese and the Japanese have to offer. And when that happens, China and Japan earn US dollars. These dollars are again invested in the financial securities issued by the US government."

"But why is the US dollar and the economy a Ponzi scheme?"

"Oh, I thought you would have known by now. Well, let us say you have a credit card and you go on a spending binge. How will you return that money?"

"Well. I will return it when I get my next salary."

"What if you have spent much more than what you can realistically repay through your salary?"

"I will probably borrow from my parents."

"And how will you return money to your parents."

"I might borrow from you," she replied smiling.

"Well. The point is, if you cannot earn it and repay it, you will have to keep borrowing and playing pass-the-parcel. Similarly, to put it in a very simple way, that's exactly what the US government is doing. When one set of financial securities becomes due for repayment, it issues new financial securities to repay the investors holding the old financial securities. So, money brought in by the newer investors is used to pay off the older investors. That's what makes it a Ponzi scheme. And they can keep doing this because countries which export majorly to the US are ready to keep recycling the dollars they earn through the US economy and reinvest in the US government securities. Worst come worst, the US government can print more dollars to repay," I explained.

"Hmmm… interesting."

"If you and I run a Ponzi scheme, we get labelled as fraudsters. But when the government runs a Ponzi scheme, it is said to be financing a deficit."

"But isn't the Government of India also doing the same thing? They also spend more than what they earn and borrow the remaining?" she asked.

"Yes it is. And I can smell milk burning. Ponzi has spoilt my coffee with Kiran, too."

(The example is hypothetical)

A sharp drop in interest rates is almost a certainty now

Sandeep Shanbhag

The rate of inflation should decline to zero sometime in the next six months, going by the chief economist of a leading private sector bank I was talking to the other day. Part of it would be due to the high base effect, of course, but an equally significant part would be on account of the sharp decline in prices of almost all commodities, especially of oil, which augurs well with regard to the inflation expectation of a commodity importing country such as ours.

With inflation no longer a threat, the government can pull out all stops to encourage growth and limit the collateral damage the recession-ravaged West can wreak on our economy. Indeed, the ball is already in play.

Last week, the Centre and the Reserve Bank of India (RBI) announced a coordinated stimulus package - monetary easing complemented with fiscal sops is expected to release a huge amount of liquidity that would hopefully ease the flow of funds through the financial pipelines of our economy.

Key amongst the various measures announced were a cut in the rate at which banks borrow from the RBI (repo rate) to the lowest ever of 5%. Simultaneously, the rate which RBI pays banks to park their idle funds (reverse repo rate) was also slashed to 4%, thereby sending a very strong signal to banks that the RBI is going to systematically disincentivise them from using it as a safe-keeper of their money. With bond yields dipping to as low as 4.86%, banks spooked by counter party risk will at last be forced to use their assets for productive purposes such as lending, thereby kick-starting the credit cycle in the economy. At the same time, the cash reserve ratio, which is the share of deposits that banks need to park with the RBI, has been brought down in five successive cuts to 5%. The aggregate liquidity that has been released into the system due to monetary actions undertaken so far is expected to be in the region of Rs 3 lakh crore.

What does all this mean for us retail investors?

Well, first and foremost, it is almost a given that such strong measures will without any doubt see a sharp drop in interest rates. In fact, K V Kamath of ICICI Bank has gone on record saying he expects interest rates to fall up to 5 percentage points over the next six months. Therefore, investors who intend to park their money in bank deposits should hurry, if they haven't invested already.

With bank deposit rates coming off, alternate investments such as company fixed deposits (FDs) would suddenly start seeming attractive.

Though monetary policy is being eased, some corporates, especially in the real estate and construction sectors, would find raising money from traditional sources difficult. Offering the retail investor a higher rate on corporate FD would be the immediate recourse adopted and it is here that a retail investor should take care. An attempt to earn marginally higher return could well prove to be one in which the capital itself may get unstuck. Realise that company FDs are unsecured loans and not subject to a charge on the fixed assets of the company concerned. There is a reason why banks are chary of lending to corporates and investors must undertake the necessary due diligence.

If I were you, I would prefer to put my money in gilt and long-term bond funds. Over the next 12 months or so, this is the space that offers the highest potential for safe yet attractive returns.

This is because interest rates and prices of fixed income instruments share an inverse relationship. When the overall interest rates in the economy rise, the prices of fixed income earning instruments fall and vice versa.

To illustrate how fluctuations in interest rates affect the returns, let us take the example of an income fund.

We assume that the current NAV of the fund is Rs 10 and its corpus is Rs 1,000 crore. This means that if the fund sells all the assets of the scheme and distributes the money on an equitable basis to all the unit holders, they will receive Rs 10 per unit.

Now, suppose the interest rate falls from 10% to 9%. Immediately thereafter, you wish to invest Rs 1 lakh in the scheme. Realise that the entire corpus of the fund stands invested at an average return of 10%. If the fund sells the units to you at its current NAV of Rs 10, you will be allotted 10,000 units. This will benefit you immensely. You will be a partner in sharing the benefit of the higher returns of 10%, though the fund will be forced to invest your Rs 1 lakh at the lower rate of 9%. This is injustice to the existing investors. Therefore, something has got to be done to protect their interest.

Here comes the 'mark to market' concept. The fund raises its NAV to Rs 11.11. You will be allotted only 9,000 units and not 10,000. The return on 9,000 units @10% would be identical to the return on 10,000 units @9%.

In other words, the NAV rises when the interest rates fall.

Indeed, this has already started happening and the one-year return on most funds is already in the region of around 20% p.a. Going ahead, as the yield on government securities has already come off substantially, funds investing in corporate bonds as against gilts are expected to earn better return. The credit spread between gilts and corporate bonds still exists and a 15% annual return in a well-managed income fund of a good pedigree would be a very reasonable expectation.

sandeep.shanbhag@gmail.com

Here's a look at six half-truths that pass for timeless wisdom

R Jagannathan

What do you do when your entire stock market investment suddenly halves in value - as it has for many people since January last year? Curse fate? Rail against market manipulators? Abuse the government for failing to protect your wealth?
You can do all that, but none of it will bring your money back. The best thing you can do is to look back and learn from it all. The world's best investors have done just that and made tons of money in the process. They then proceeded to write books on their successes, and made even more moolah.
Good for them, but not for you. Peter Lynch's bestseller, One-Up On Wall Street, earned him good money, but don't assume you will achieve the same success by following his methods. Success can never be copied.
The best way to start is by exploding a few myths and questioning the half-truths that pass for timeless wisdom. Let's start by examining them one by one.

The strategy involves buying two call and one put options on the same underlying stock

Hiral Thanawala

A derivatives strategy that can help investors make the most of a bullish trend is called 'strap', just as there's one called 'strip' for the bears.

A bullish adaptation of the straddle strategy, strap involves buying a number of at-the-money puts and twice the number of calls of the same underlying stock, strike price and expiration date.

This strategy will help earn good profits from equity/ commodity markets when our GDP numbers are stronger; the signs of micro and macro economic stabilisation are prominently visible; profits and sales of companies improvement; and there is increasing participation by the FIIs and HNIs in our markets again.

That's difficult to imagine in the near term, of course, and there's no saying how much longer the bear grip will hold. But, economists expect a clearer picture of economic growth to emerge by the middle of this year, at least for BRIC economies.

So, it is better to understand this strategy now in order to be able to use it when a bull market is upon us again.

This strategy has the potential to create huge profits when the underlying stock price makes a strong move either upwards or downwards at expiration, with greater gains to be made with an upward move.

Risk:

The risk is limited in this strategy. The maximum loss for the strap occurs when the underlying stock price on expiration date is trading at the strike price of the call and put options purchased. At this price, all the options expire worthless and the options trader loses the net premium and commissions paid to enter the trade.

Computation of breakeven points:

There are 2 breakeven points for the strap option strategy. The breakeven points can be computed as given below:

Upper breakeven point = Strike price of calls/puts + (Net premium paid /2) Lower breakeven point = Strike price of calls/puts - Net premium paid Example: Consider, ABC stock is trading at Rs 1,000 in December. An options trader implements a strap by buying two January calls for Rs 60 per share as premium for a strike price of Rs 1,000 and a January put for Rs 50 per share as premium for a strike price of Rs 1,000. The net debit taken to enter the trade is Rs 17,000, assuming a market lot size of 100 shares.

If ABC stock price reduces to Rs 500 on expiration in January, the January calls will expire worthless, but the January put expires in-the-money and possesses intrinsic value of Rs 50,000 (Rs 500 decline in stock price x 100 lot size). Reducing the initial debit of Rs 17,000, the strap's profit will be Rs 33,000.

If ABC stock is trading at Rs 1,500 on expiration in January, the January puts will expire worthless, but the two January calls expire in the money and have an intrinsic value of Rs 1 lakh (i.e. Rs 50,000 x 2 call options). Reducing the initial debit of Rs 17,000 the strap's profit will be Rs 83,000.

However, if on expiration in January the ABC stock is still trading at Rs 1,000, both the January put and the January calls will expire worthless and the strap will suffer the loss of Rs 17,000, which was paid as premium to enter the trade.

The 2 breakeven points in this case will be:

Upper breakeven point = Rs 1,000 (strike price) + Rs 85 (net premium paid /2) = Rs 1,085.

Lower breakeven point = Rs 1,000 (strike price) - Rs 170 (Rs 60 x 2 call premium + Rs 50 put premium) = Rs 830.

In this example, the stock has to break the price band of Rs 830 to Rs 1,085 to be profitable, i.e. decline below Rs 830 or appreciate beyond Rs 1,085. If the stock price fails to break the price band between the upper and lower breakeven points, the investor will end up losing the entire premium paid for executing this strategy.

Thus, the strap strategy is the right options trading approach for investors who are bullish on the market and expect it to move upwards in near future.

 

This piece first appeared on theApna Paisa Blog, an independentpersonal finance forum.

The derivative strategy involves buying one call and two put options on the same stock

Hiral Thanawala

The state of affairs in the equity markets needs no reiteration. The steep fall seen in 2008 has been unprecedented. Retail investors in particular have been badly singed and are wary of entering the markets again, leave alone playing, what with the bears at large.

For all that, however, a bear market isn’t all bad, if one knows how.

One strategy that can help investors actually benefit from the ongoing bear reign is known as ‘strip’.

This is a bearish adaptation of the straddle strategy, developed on the concepts of at-the-money and in-the-money.

Let us understand a few terms before attempting to understand the strip strategy.

Strike price

This is the price at which a holder of stocks can sell to, or buy from, a writer the item underlying an option.

Example: An ABC 50 call option gives the holder the right to purchase 100 shares of ABC stock at a price of Rs 50 per share. On the other hand, an ABC 40 put option gives the holder the right to sell 100 shares of ABC at a price of Rs 40 per share.

At-the-money

Options are at the money when common stock price is equal to the strike price.

In-the-money

A call option is in the money when the strike price is less than the market price of the underlying interest.

A put option is in the money when the strike price is greater than the market price of the underlying interest.

Now that these terms are clear, let’s move to our main plot.

Strip strategy basically involves buying a number of at-the-money calls and twice the number of puts of the same underlying stock, strike price and expiration date.

Investors can benefit from this strategy whenever the market witnesses a bounce-back. Consider that the Reserve Bank of India has effected cuts in the cash reserve ratio, repo rate, reverse repo rate, prime lending rate and statutory liquidity ratio to increase the liquidity in the hands of banks and investors, while the government has announced stimulus packages for certain sectors.

This would be the right time to execute the option trading strategy (strip) if an investor is convinced that it is a bear market relief rally and the direction of the market in the near term would remain south.

Profit potential

This strategy has the potential to create huge profits when the underlying stock price makes a strong move either upwards or downwards at expiration, with greater gains to be made with a downward move.

Risk

The risk in this strategy is limited. The maximum loss for strip occurs when the underlying stock price on expiration date is trading at the strike price of the call and put options purchased. At this price, all the options expire worthless and the options trader loses the net premium and commissions paid.

Computation of breakeven points

There are two breakeven points for the strip option strategy. The breakeven points can be computed as below:

Upper breakeven point = Strike price of calls/puts + Net premium paid

Lower breakeven point = Strike price of calls/puts - (Net premium paid/2)

Example: Say the ABC stock is trading at Rs 2,000 in December. An options trader implements a strip by buying two January puts for Rs 120 per share as premium for a strike price of Rs 2,000 and a January call for Rs 100 per share as premium for a strike price of Rs 2,000.

The net debit taken to enter the trade is Rs 34,000, assuming a market lot size of 100 shares.

If the ABC stock is trading at Rs 2500 on expiration in January, the January puts will expire worthless, but the January call expires in the money and has an intrinsic value of Rs 50,000 (500 rise in per stock price x 100 lot size).

Subtracting the initial debit of Rs 34,000, the strip’s profit will be Rs 16,000.

If the ABC stock price reduces to Rs 1,500 on expiration in January, the January call will expire worthless, but the two January puts expire in-the-money and possess an intrinsic value of Rs 1 lakh (i.e. Rs 50,000 x 2). Reducing the initial debit of Rs 34,000, the strip’s profit will be Rs 66,000.

However, of on expiration in January the ABC stock is still trading at Rs 2,000, both the January puts and the January call will expire worthless and the strip will suffer a loss of Rs 34,000, which was paid as premium to enter the trade.

The two breakeven points in this case will be:

Upper breakeven point = Rs 2,000 (strike price) + Rs 340 (Rs 120 x 2 put premium + Rs 100 call premium) = Rs 2,340.

Lower breakeven point = Rs 2,000 (strike price) - Rs 170 (Rs 340, i.e. net premium / 2) = Rs 1,830.

In this example, the stock has to break the price band of Rs 1,830 to Rs 2,340 to be profitable, i.e. decline below Rs 1,830 or appreciate beyond Rs 2,340. If the stock price fails to break the price band upper and lower breakeven points, investors will end up losing the entire premium paid for executing this strategy.

The strip strategy seems to be right option trading approach for investors who are bearish on the market and expect it to correct in the near future.

 

This piece first appeared on the Apna Paisa Blog, an independent personal finance forum.