I got the following comment from abhijeet on my previous post. Instead of replying directly to the comment, I thought of putting my thoughts on options in a separate post.

I have been studying options and futures on and off for sometime (read a few books on it). However I am still not an expert or anywhere close to it to commit a meaningful amount of money to a position. However as a start, I have started looking at options as a defensive strategy. Let me explain

For various reasons I do not have a firm opinion on the valuation of IT firms. One can argue that the future is bright (see the latest issue of business today for no. of IT deals coming up for renewal this and next year), but at the same time there are several known factors which could upset the applecart. In the end there is little margin of safety in the true graham sense.

So if I hold IT stocks and have a fixed time horizon to sell the stocks, then buying put options is good strategy to limit the losses (and still have an upside). However this strategy is not a costless strategy. It may not be a strategy with a positive expected value. But buying puts acts like an insurance. In the end it would prevent something truly bad from happening to my portfolio, but it is not strategy to make money.

I still look at using options as a defensive strategy as I am not comfortable with an approach which could have an unlimited downside.

Covered call writing as mentioned in comment could be strategy to make money, but I have not tried it at all and not sure how much I could make (net of all the commissions, spreads on the options) unless I had a strong opinion on the stock on which I am writing the covered call. The other risk which I see in options is that not only one has to be correct on the stock, but one has to get the timing right (which I am very bad at – have been wrong more than 50 % of the time whenever I have tried timing)

In the final analysis, even if I am not planning to put any significant money in options, I see a definite value in learning about it.

A strange topic to write on and that too after a gap of almost 15 days. Not sure if anyone missed my posts, but I surely missed posting something on my blog.

I was away mainly due to my regular job demands. So during the last few weeks I did not have much opportunity to analyse any new companies or look at any new investment ideas. But I did have a chance to reflect on time as a key constraint.

Although time is a constraint for anything you do in life, I tend to think of time as a constraint or limitation on my much effort I can devote to investing and reading. Having a job, family and all other assorted interest puts a limit on what I can or cannot do in investing.

Thinking in reverse, I more or less know that I cannot do the following due to my time constraints

• options trading: It’s a specialised field, requires day to day supervision and lots of effort. Other than the fact that I am no way an expert in it, it is too risky for me as I just do not have the time or the stomach for it
• Deep value investing: This is the quantitative mode of value investing. I understand this form investing fairly well (atleast I think so), but this form of investing require more effort as one has to churn the portfolio more often. Also tempramentally, I am not comfortable with these ‘cigar-butt’ companies which are lousy companies, but may give a decent return. Also to practise this kind of investing, one has to diversify into a decent number of companies and then track them atleast quarterly
• Day trading: No time and no temprament for it at all. It looks like easy money these days. But long time back I made a promise to myself to invest into opportunities which I understand and avoid the ones I don’t. In the end I may miss some easy money, but avoid the pain too
• Gold/ Commodity trading: No time, special knowledge or temprament here

So by this reverse exclusion approach leaves me with searching for good companies with sustaniable competitive advantage which I can hold for long term. It may seem to be a very small area to work in, but it is not. For the size of my portfolio, if I can find 1-2 good companies a year, it is good enough.

Going forward (time permitting) I plan to expand my investment activity to special situation and deep value investing. But that is still some time off.

Also those of you who would have invested in reliance as an arbitrage situation, the bet would have paid off. Pre-split reliance was selling around 850 – 900 a share. Post spilt it is around 1140 a share. A 25 % return in 2 months.

Now I would like to boast that I made a killing and had some terrific insight …blah blah !!. That’s not true. I tried doing a sum of parts analysis before the split and read some articles on this arbitrage situation. Eventually I got stuck on two points

• How to value reliance infocomm. Conservative valuations (v/s bhart telecom) showed back of the envlope value of 275 per share (300 now). In the end I was not sure of how to value it
• If reliance infocomm could be valued at 275 per share, the value of the core business was at around a PE of 12 on current year earnings. Again I was not a 100 % sure if that was undervalued as the petrochemical business is on an upswing and the earnings were at a peak

In the end, as I was not very confident on my analysis, I did not make a big commitment. I am not regretting it though. I would rather do nothing if I am not sure than do something just because others are doing it (does not pay to have others think for you). However I am trying to reverse engineer the arbitrage and see how I could have analysed it better and ‘forseen’ this opportunity.

In anyone has an insight or did this in dec/jan before the split, please share with me. I would like to learn from you

There is generally no shortage of recommendations, tips, or get rich – schemes which are pedelled to the general public. You will notice that the number of such ‘schemes’ (for want of better word) increase almost proportionately with the rise in the corresponding asset or the market. So if there is bull market in gold, you will find more of such tips for the gold market. If the stock market is up, then you will get such schemes for the stock market.

Just think about it, how many recommendations or tips did you see for gold in 1999 (gold was 3900 at that time) or for the stock market in 2003.

And now gold is being touted as an investment and so are a lot of low grade stocks. Mutual funds who are supposed to be for the small investors are no better. Try to check on the number on new launches in the last one year versus 2003. I don’t blame the industry for more launches now, because the subscription would be low if the fund gets launched during the bear market. What irritates me that these funds play on your greed. Now you can argue that if one is greedy then one deserves to be punished for it (well , I definitely was for all the IT funds I bought in 2000). But is the behaviour of the mutual funds not that of a drug dealer who supplies the drug to an addict (rather than a doctor or counseller who prevents it)

So what is the antidote to all of the above. The starting point of this post was this comment from abhijeet . If you know that there are people trying to part you from your money, either by preying on your greed or fear or through fraud, how does one protect himself? Here is what I think

No. 1 protection is knowledge. Learn how to invest. I have mad
e it a point never to invest money in any opportunity if I don’t know what are the risks in it (rewards will take care of itself). Now, I have lost a number of opportunities by that, but have also avoided severe losses.

In my case, I tend to remember the losses far more (I think my pain for loss is far more than average) than an average person. It is not the loss of money which has hurt (that hurts too) as much as loss of faith on my own skills. In cases where I have made a bad decision, I tend to remember that very long, even if I may not have lost as much.

As a result, I am extremely cautious in making my investment. That is not same as avoiding it though. The difference is that I try to do as much homework as possible on an opportunity. I try not to make a decision immediately if I find a good opportunity. I make my notes and wait for a couple of days. Then when the intial excitement of finding an undervalued stock is gone, I tend to be more rational.

Finally, I never go any one recommendation. I read a lot of broker reports, blogs etc. but never accept any recommendations on face value. So if I find a recommendation, I try to analyse it on my own and reach my own conclusions.

In some areas which are out of my circle of competence or interest, I don’t even bother. They include gold, commodities etc. Does not mean that one cannot make money on them, just that I am not competent to do it.

Finally, my thinking is derieved from this quote from warren buffett

‘Risk is not knowing what you are doing’

ps: by the same logic, please do not base your decision on stocks which I post here.