Aniruddha brought up a very good point in the comments and as a result, I decided to add it to the post as it captures the issue for a long term investor. My response follows the comment

Hi Rohit,
i also tried with options while ago. I realized that, i would never sell my portfolio. So even if it is hedged by options, it’s waste of money. If market falls you would earn money through options but that time you will not sell your entire portfolio. Option Profits would be offset against your virtual loss. Same thing with advances. The gain in the portfolio is offset with the option premium you pay, which would expire worthless.I found it good tool to earn money in volatile market for traders.

hi anirudha
As i said, for a long term investor, options will not make sense unless one plans to sell in the short term. Here again it may make sense to just sell and not get too clever with options. so options is still an area i am trying to figure as part of my portfolio.

If however one is managing money professionally, options can help reduce short term volatility, which is critical for clients who may not have the emotional fortitude to bear huge swings in the portfolio and may pull their money out at the wrong time.

Options work well as disaster protection too…end of 2008 if you thought icici was going down the tube and had deposits, then puts would have helped. I bought those options to protect my deposits with the bank and it was more of an insurance, than a trading position.
——————————————————————————–
I recently wrote on my purchase of options for hedging purposes and received several comments and emails on it. I discussed about the ‘what’ of the transaction, but did get into the ‘why’ of it. So let me discuss about it a bit here and then try to give a response to the various comments on the previous post

The why of options purchase
As I stated my previous post, the only scenarios where options would make sense for me are
· The market appears considerably overvalued and options are underpriced due to low volatility: This is a valuation and not a timing decision. However it is not a decision based on deep fundamental analysis. As the market gets more overvalued, I can reduce my long positions and the put option acts as a backstop for me. So in this case I am paying a small premium to protect myself from the downside, as I reduce my holdings and benefit from the upside in the interim.
· I wish to hedge a specific stock position which I plan to sell in the next few months: In such a case, I would prefer to buy a put option on the stock to hedge my open position. This is a hedging position and has no element of speculation in it. I am basically paying a premium for an insurance (against the stock dropping below the strike price)

In both the cases, I am paying a small premium for ‘insuring’ my portfolio for the short term as I sell the overvalued position. If I were to do this multiple times, I would expect to lose money on my options with the benefit of protecting my portfolio from downside while I am reducing my holdings.

In the past one month, I was lucky to have sold my open positions and then have the market drop a bit, due to which I was able to close out my options at a decent profit. I was lucky and not smart in this case.

Aren’t you speculating ?
I cannot deny that there is an element of speculation here. However I did not create a position with that in mind. As I said earlier, if I were to do this multiple times, I expect to lose money on my options positions with the benefit of being able to hedge the downside. If the market does crash, then the options positions would reduce my losses and thus reduce volatility of my portfolio. Speculation depends on the objective of a position and not on the nature of the instrument.
The cost of short term options is around 12-13% (annualized) for a downside protection for 10%. It would stupid of me to hedge my portfolio using options on a regular basis. Yes, the market is efficient in this aspect.

Why not buy long dated options
For starters, I looked for long dated options and was not able to buy them. The second key point is that the price of long dated options is very high. There is no point in buying a 10% downside protection for 1 year and pay 15% or more premium for it. In such a case, I am better off selling the open position itself. I see option protection useful only if I wish to buy short term protection in an overvalued market with clear plans of selling the overvalued positions during the same period

Imperfect hedge
Some readers pointed out that I bought an index put where as my portfolio is mainly midcaps. Well, my disclosed portfolio is mid-caps, but not necessarily my entire portfolio. I do have mutual fund holding and Infosys stock and hence an index hedge is good enough for me. I have disclosed my portfolio in the past and the associated disclaimers.

Educational experience
I am in a learning and exploratory phase in terms of options. Options basics and pricing is easy to understand. The difficult part is to build a sensible strategy around these instruments and use it properly. My positions in the past have been miniscule (<0.5 %) and a gain or loss is more or less a non-event.

I will continue to read and learn and may dabble in these instruments a bit in the future. I see the utility of these instruments in arbitrage positions, but continue to be doubtful in terms of their utility for my core portfolio.

The other day, as I was discussing my options plan with my wife, she summarized it well – All boys have their toys, in my case they are options.

Note : The position discussed in the post was closed sometime back and I do not currently hold any open positions in the instruments discussed in the post

I have a confession to make – I have moved to the dark side, figuratively speaking J. I have rarely written about options and derivatives. There is a simple reason behind it. I do not have as much experience in these type of instruments.

I have been reading on these instruments for some time now and have been dabbling in them a bit for some time now. My foray into derivatives has been mainly for hedging. I still firmly believe that trying to time the market is a waste of time (atleast for me). However that does not mean that I would not like to act when I feel the market may be overvalued.

There is a difference between the two points – time v/s price based action. Let me explain – lets assume that I hold a stock, which i assume is worth 100 and is currently selling for 60. Lets also assume that everyone thinks that the market is overvalued as a whole. If I believe in timing the market, I may decide to sell the stock assuming that market is likely to correct and so will the stock. When that happens, I may buy back the stock at a lower price.

If one approaches this from a price based view point and is agnostic about the market (it may or may not drop), then one may decide to do nothing as the stock is still undervalued. If the market drops, the stock has only become cheaper and one can choose to buy more. If however the market rises, and so does the stock, then well we have a nice profit on our stock.

The benefit of the above approach is one can focus on a single variable – discount of current price from the fair value of the stock and not worry about the market level, sentiment and other such factors. Ofcourse, if you think you can predict the market levels in the short term, then dancing in and out of stocks can be profitable. I however avoid these gymnastics and keep my life simple.

So how does a derivative – a put or a call option fit into the above approach ?

There are certain points of time when one can objectively look at the market valuation and conclude that the market looks fairly overvalued. One can look at the past history of the market and arrive at a reasonable conclusion that if the PE of the market is above 25, then the forward returns are likely to be low. One could look at the data and just ignore it or alternatively try to profit from it.

During the last 1-2 month, after the market hit 16000 and higher levels, I felt that the market was getting over priced. The number of attractive opportunities were reducing and the forward returns were likely to be low. At the same time, even if the market is overvalued, it does not mean that it will drop in the next 1-2 months.

At this point of time, I decided to hedge my portfolio with the use of a put option. Let me detail my thought process and strategy behind it

Buying insurance

In buying a put, I was looking at buying insurance for my portfolio. The objective of insurance is to protect your asset at the minimum cost and not necessarily profit from it. A put option is the right, but not the obligation to sell. So if I buy a put on a stock selling at 100 with a strike price of 80, I have to pay a premium for the option. The value of the option increases as the stock price drops below the current price. If the stock drops below 80 , I am fully hedged against any further drop in the price of the stock

The price of a put option depends on 5 factors – strike price, duration, current price, interest rate and implied volatily. I cannot go into option pricing in detail here, but in simple terms – lower the strike price (below the current price), lower is the price of the put (other factors being constant)

With the above point in mind, I had make a decision based on the following factors

• Strike price of the index put
  
• Duration of the put
  

The Strategy

At the time of the analysis, the index was in the range of 5051-5100 and I decided to pick a strike price of 4500. The maximum duration of the put which I could pick at that time was the December contracts. The reason for picking 4500 as the strike price was due to the fact the probability of the market dropping 15% or more looked low and at the same time a higher strike price required a much higher premium.

An additional factor in buying puts was the low implied volatility (read here for more details on implied volatility). As a result, the options seemed underpriced (I have bring a value angle into it J ).

I ended up buying the December contract for 100 with a strike price of 4500.

The result

After buying the options, the market continued to rise for some time. Options are brutal instruments, also called as wasting assets. Options lose value with time (called as theta or decay). In addition, if the price move in the opposite, then loss is almost exponential.

The above situation changed in the subsequent few days and with a 10%+ drop in the market, the options were almost in the money and had more than doubled in price. The end result is that they had achieved the objective of hedging my portfolio during the market drop.

Conclusion

Am I happy with success of my options strategy ? that would mean that I would be happy on making money on my fire insurance if my house burns down. I look at options merely to hedge my portfolio against short term drops. The cost of this insurance is high (almost 10-12% per annum of principal value) and hence it would be silly to buy puts every time one felt that the market is a bit overvalued.

I would personally buy options under two scenarios

• The market appears considerably overvalued and options are underpriced due to low volatility
  
• I wish to hedge a specific stock position which I plan to sell in the next few months.
  

I am looking at other strategies such as covered calls, collars, butterflies, rabbits (ok I made that up) and will post if I attempt these stunts in the future and survive J

Now that I have managed to irritate some of you, by rejecting stocks which you hold, let me push it still further J

Torrent cables: Erratic performance in the past. Loss in the current year and some years in the past.

TRF ltd: Negative cash flow. High accounts recievables being funded by supplier debt

Bharat bijlee: Poor cash flow. Rough estimate is 20% of net profit, hence the valuation is double the current PE. Fairly valued.

Allied digital services ltd: Raised new capital, majority of which has been used in accounts receivables

Ganesh housing: Fully valued or overvalued. Constantly raising capital for growth

Supreme industries: very low free cash flow and low margins.

UB engineering: Negative networth. Business turned around in the last 2-3 years.

Some quarterly results

Some of the companies, I hold currently have declared their quarterly results. A quick review and some thoughts

VST industries: The company reported a 40% increase in topline and 50% improvement in bottom line. Volume growth seems to be driving the top and bottom line in case of this company. I do not have access to the reasons behind it and hence it is difficult to evaluate the sustainability of the performance. I need to analyze if the growth is being driven by some new products as it is unlikely that the existing products would suddenly do so well.

Asian paints: The company is now firing on all cylinders. The company has reported a 100%+ growth in net profits. This has been a long term holding for me and as I have written in the past, I am also an ex-employee of the company. I am not surprised with the performance of the company. The company has a long history of good performance and has increased its market share and competitive advantage substantially in the last few years. The valuations of course reflect the strength of the company

NIIT tech: The company reported a 12% decline in topline and similar decline in the bottom line. The key reason behind it are the hedging losses. The company has been able to improve its operating margin during this period. There is nothing much to get excited in the current quarter results and with rupee appreciation, it is likely that the negative impact of the hedges will be reduced. I do not expect much in terms of the performance, which has clearly been a disappointment for me. I have marked down the intrinsic value of the company accordingly.

Maruti Suzuki: The company reported a 45% increase in topline and 90%+ improvement in net profits. The topline has been driven by domestic growth and major increase in exports. The bottom line has been driven by moderation of various commodity prices. The performance has been as expected in view the good monthly sales numbers and the stock price has already factored in this performance. As I have written earlier, I have started exiting this position.

I will be posting on the results of the other companies in the coming weeks as they are published and I am able to complete my review of the numbers.