Monday, 22 June 2015

How to make your portfolio GROW in a FALLING market?

8f722-w704Markets moves in trend, but trends exhibit different degree of strength in different market conditions. Sometimes, the trending market has greater strength while at other times, it may just move sideways or downwards.  In such a scenario, fluctuating paper returns on the portfolio holdings is one of the main problems faced by investors/traders, alike. If you are an investor, who aims to hold the portfolio for long term and still wants to negate the downside fluctuations in the market, then options can be used as ‘the alternative’.

Options writing against the portfolio holdings, commonly know as, Covered Call strategy is one of the best way to neutralize the downside risk on portfolio holdings.If done along with proper understanding of technical analysis, it can be a very fruitful way of drawing consistent income against your portfolio.The added benefit with this strategy is that you do not require any extra margin/cash to initiate this call.
How does it work?

Lets say, you have have 1000 shares of ITC in your portfolio bought at 360/- a couple of months back and you intend to hold it for long term. On 01st April 2015, the stock trades at 330/- and your holdings are at a paper loss. Looking at the short term scenario, you concluded that the stock will still remain under pressure in short term and the short term resistance of 350 wont be taken out till April expiry.

Since you know, that the holdings have little chances of appreciation in near future, you might sell the call of 350 which is trading at lets say, 2.50. The trade is taken in order to draw an income from a depreciated portfolio holding.

The trade would look like this:

Call Shorted= 350 CE @2.50

Lot Size: 1000

Margin required: NIL

Premium collected= 2.5*1000= 2500/Lot

Cost of holding ITC holdings reduced by = 2500/-

Now, let’s look at various possible result scenarios possible, if ITC expires at different price levels:
Scenario 1:  ITC expires below 350, at 345

In this case, total premium will be kept by the shorter. The premium collected may be considered as the income generated on the portfolio.

ITC  price on 1st April      =   330
Price at Current expiry     =   345
Price of 350 CE at expiry =   0.00
Premium collected against holdings = 2.5*1000=2500/-

Total Paper profit on portfolio on Expiry = ((1000*(345-330))= 15,000/-

Profit realized by selling 350 CE= 2500

Profit increased by =2500/15000*100=  16.6%

If the short term outlook of the stock still looks bleak, the trader can still opt to short the further month call options and keep on collecting premium thereby deriving a consistent income on the portfolio holding without spending an extra penny.
Scenario 2: ITC expires below 350, at 320

ITC  price on 1st April      =    330
Price at Current expiry     =   320
Price of 350 CE at expiry =   0.00
Premium collected against holdings  = 2.5*1000=2500/-

Total paper Loss on portfolio on Expiry= ((1000*(320-330))= -10,000/-

Profit realized by selling 350 CE=2500/-

Loss decreased by: 2500/10000*100= 25%
Scenario 3: ITC expires above 350

This is where the problem arises! If your analysis about the levels goes wrong and ITC rises above 350/- (strike price) the call option will start accumulating intrinsic value and the contract may expire In-the-money.Though, there is a very high probability that shorters will win in 80 out of 100 cases, there is still scope of going wrong and if that happens, the profits on holdings can take a beating. The question, how wrong it can go and what can be potential losses on the holdings. Lets look this with the following real cases.
This is how it will look like!

If ITC closes above 350 at expiry, the shorted call option will appreciate in value. But unlike naked call writing, there is NO unlimited loss to the shorter. However, the profit will always be limited to 350, even if the stock rises to 380 or 390. Here is how the trade will work:

Buying price                   =    360
Price at Current expiry     =   370
Price of 350 CE at expiry =   20.00 (Current Price- Strike Price)
Loss in 350 CE           =   2.50-20.0  (2.5 = Price at which 350 CE was shorted)

= -(17.5*1000)=  -17,500/-

Loss in portfolio= ((1000*(370-360)+(-17500))= -7500/-
What if the stock expires at 380?

Buying price                   =    360
Price at Current expiry     =   380
Price of 350 CE at expiry =   30.00 (Current Price- Strike Price)
Loss in 350 CE          =   2.50-30.0  (2.5 = Price at which 350 CE was shorted)

= -(27.5*1000)=  -27,500/-

Paper Loss in portfolio= ((1000*(380-360)+(-27500))= -7500

***(LOSS Remains CONSTANT irrespective of stock movements!)
How it can be amended?

If the stock prices rises above the strike price, and you are convinced that the analysis has gone wrong, just act on ‘cutting your losses’ so that it does not limit the paper profits on your holdings. Place a stop loss at the strike price and close out the short position before it erodes the paper profits on your holdings.

Hope this article helps you in building insight in options trading. If you need any clarification on the subject, just drop in your comments in the box below.

Good Luck!

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