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Hedging With Derivatives | An Advanced Stock Investment Strategy

This article is of little use to those investors who are expert derivative traders and know, how to use hedging for their portfolio against market risk. But, of utmost know to factor to the investors, who are away from the derivative segment and are likely to know about. Let’s read.


What is Hedging and Who is a Hedger

A strategic trading strategy in the derivative market, to protect the value of equity portfolio against price fluctuations is called hedging. When there is an uncertainty in the price movement of any stock, stock investors can hedge the price of a stock from a fall, by participating in the derivatives market. And, such investor is then called to be a Hedger.

Hedging is nothing, but securing the price of a stock by speculating market movement. In other words, it’s an advanced equity investment strategy, where the equity investments are protected in the market fall /fall in the price of a stock scenario. Hedging gives a sort of ‘peace of mind’ to the equity investors, by ensuring a more predictable outcome.

Hedging of a Stock doesn’t give more outcome, but it definitely gives a more predictable outcome.

What Are The Types Of The Risks Associated With Any Stock

While buying a stock every investor thinks and hopes that, it will move forward and there will be a hike in the stock price. But, nobody can make sure that the price hike is definite. There are certain risk factors, that may restrict the stock price, and push it down.

The stock price is always a function of many risk factors, which will decide its future. Some are specific to the particular stock and sector. And some are global. Market risk is considered as an external risk factor that will equally affect the entire industry. For example, currently the Diamond Industry, is facing such a type of Market Risk. Which is unavoidable by all the stocks of various companies that belong to this industry.

How To Hedge A Stock

Hedging is an art of ensuring the return of an equity investment apart from market risk. This is done by participating in the derivatives market, and execute exactly the opposite trade. That means, the trade which  opposite to the trade in equity segment. By doing so, one can ensure the return from either the equity /derivative market, as the two segments move in opposite directions. In this form, one can bypass the risk to those who are willing to bear it.

There are two types of derivative contracts, that help the investors to hedge their investments in the cash segment, that is equity. They are Futures and Options.

For example Mr. A holds 100 shares of a company XYZ. If the buy price is Rs. 10 per share, and the stock price is hovering around Rs 10 and Rs.12, for a month. Then Mr. A speculated the price movement towards negative direction. And, he decided to liquidate his holding predicting its future fall. But, his advisor and friend, Mr. B suggested him to hedge his holding  to ensure his future earnings at the cost of the premium to be paid to buy a contract in the derivatives segment. So, Mr. A postponed the idea of selling the shares at the current market price. And, decided to sell the stock at the expected Rs. 15 after 3 months.

Even though there are many contracts to hedge the stock value in derivative segment, the best one is the PUT Option, which he can utilize to sell his stock after 3 months and at the strike price.

Put Option gives the buyer to sell the stock  during a predetermined period and at the predetermined strike price, which is usually above the market price.

The cost of buying a Put Option increases with strike price. That means, higher the strike price, the higher the cost. So, it is always advisable to choose the strike price moderately to hedge the stock.  So, Mr. A chose to buy the 1 ATM Put of 100 shares with the 3 month expiration period.  He paid Rs. 100 towards premium and his strike price was Rs.11

As per his expectation the price of his stock fell to Rs.10. And, Mr.A exercised his option to Put his quantity of 100 shares at Rs. 11 each. The amount he received was Rs. 1100. So, the loss is only the amount that was paid towards commission while buying the stock. In India the Futures and Options, of all the listed stocks expire on the last Thursday of the contract month. If that Thursday is declared to be the holiday, the expiry day will be the preceding Wednesday.

If you like my article, leave your comment. I value your comments, and try to rectify my defaults.

Happy Investing!

 

Indiabulls Ventures | A Growth Stock

CMP: 27


Formerly known as Indiabulls Securities, Indiabulls Ventures is one of the group companies led by Indiabulls Private Limited.

‘Indiabulls’ is one of the India’s foremost diversified conglomerates with businesses spread over Real Estate, Financial Services, Securities and Power.

The company is currently active and performing well in the following sectors.

  • Equity/ Commodity/ Currency Broking
  • Marketing and Distribution of Residential Properties
  • Developing and Leasing of Commercial Properties

Bagging the highest quality grade BQ1 for its quality brokerage services, assigned by CRISIL, the company has a very loyal customer base. This is one of the indicative traits of a growth stock. Quality service assurance is a signal for its great future prospects. Currently the stock is available at its best to buy price. Just buy and hold for your future prospects.

Click here to check the Target Price of Indiabulls Ventures Ltd.

Indiabulls Ventures – Financial Ratio Analysis

Technical Analysis

 

CMP: Rs.27

Has tested the low of Rs. 20 levels, thrice. Has a clear indication that soon going towards the second highest level. Tested its 29 level for the first time since 6 months, currently trading at 27 levels, along with strong fundamentals, ‘Indiabulls Ventures’ is my pick for all the long-term investors, seeking exceptional growth rate.

Fundamental Analysis

 

Good dividend paying companies are ought to have good earnings. Have the capacity to earn and distribute the profits. A defined signal of its future growth.

The company has not paid any dividend since from the last payout of 25% interim. Can be considered as a positive sign towards its capital growth. In other words the company might have has employed the profits in its growth, expansion of the business or its service quality improvement. Fine sign of our capital growth.

Current P/E is 16.45. Before two quarters it might have been definitely less than this. Improvement in P/E along with other fundamentals is a clear sign of its future growth prospects.

With P/B of 2.5, the market is estimating its future prospects as positive and constant.

 

FMP’s | Are Not Guaranteed Return Schemes?

Fixed Maturity Plans /FMPS are also known as ‘Fixed Term Plans‘. These are ‘Close Ended Schemes’ floated by various Mutual Funds. The maturity period ranges from 1 month to three/five years. The tenure is fixed. Even though, almost all the FMPs are predominantly debt oriented, some of them may have small equity component. The objective behind this is to protect the investor’s investments from market fluctuations and to ensure the guaranteed returns over a predetermined fixed tenure /maturity period.


How Do Fund Managers Manage The FMPs

Fixed Maturity Plans are passively managed by the Fund Managers in the favor of investors to generate a fixed income over the fixed investment tenure. Fund Managers lock the investments in the debt securities, whose maturity period coincides with the maturity period of the plan.

As said before, FMPS are the closed ended debt mutual fund schemes with fixed tenure. So, these closed end schemes typically invest the major portion of about 80% in risk free debt instruments like AAA rated bonds, and the remaining 20% is routed towards the riskier avenues like equity.

It is the very structure of FMPs, that ensures the protection of capital as well as the expected return. By the end the stipulated period, the debt portion of the total investment grows to give back the principal along with its interest return. The return on the equity portion is related to the existed market situation. And the return fluctuates as per the fluctuations in the market. In the up market condition the return is good and the equity portion brings the potential upside. Similarly unfortunate market crashes may bring back the minimum, but the corresponding unfortunate loss.

Where Do The FMPs Make Their Investments

The debt portion of FMPs usually invests in commercial papers (CPs), money market instruments, certificate of deposits (CDs), corporate bonds and sometimes even in bank fixed deposits. Depending on the tenure of the FMP, the fund manager invests in a combination of the above mentioned instruments of similar maturity. Say, if the tenure of the FMP is about a year, then the fund manager invests in paper maturing in one year. The expense ratio, usually varies from 0.25 to 1 per cent.

Why FMPs Are Not ‘Guaranteed Return Schemes’

It’s true that FMPs offer many advantages over other fixed income products. But, at the same time, there are several risk factors that need to be concerned. These risk factors, sometimes may adversely affect the returns. That’s why FMPs are ‘Not Guaranteed Return Schemes’. In other words, the returns that the plan promises at the time of investment is only indicative.

To get back the indicative returns, we need to avoid those risk factors anyhow. Few risk factors that we need to be concerned are mentioned below.

Default Risk

Bank Certificates Of Deposits are the safest debt instruments with zero default risk. Whereas Commercial Papers offer higher interest rates with more risk. So, indicative portfolios with the major portion 0f corpus in less /zero risk instruments like Bank CDs is best to choose to avoid the default risk. If, one has the capacity to bear the default risk, then indicative portfolios with predominantly invested in Commercial Papers are best to invest. One can expect more returns.

Credit Risk

You should also check the scheme’s offer document for the minimum credit rating of the securities the fund intends to invest into. The investors should also note that the higher the credit ratings of their securities, the lower the returns would be for the FMPs and vise versa. However lower credit rating securities have higher credit risks; hence investor should keep in mind the same.

Expense Ratio

The higher the expense ratio the lesser are the returns. The high costs will eat up the total returns, reducing the overall return benefit.

So, FMPs with lower expense ratios are preferable over the FMPs with higher expense ratios.

Growth Or Dividend Option

There are two options to choose between while investing in FMPs. They are the growth and dividend options. Investment tenure is the main criteria to choose between these two options.

Growth option is good for long-term investment, that’s most probably more than a year. Because, the capital gains taxed @SST, if the tenure is under 1 year. For more than 1 year tenure period, the investor can be benefited from the long-term capital gains tax rate. Which is @10% without Indexation benefit, and @20% with Indexation benefits.

Dividend option is best for, under one year investment tenure. Under this option returns are in the form of dividends. These dividends are charged by the dividend distribution tax, which is @12. 5% for retail investors.  This, along with education cess and applicable surcharges are paid by the fund. And are tax-free in the hands of individual investors.

Maturity Of  The Scheme And Indexation Benefit

Some of the FMPs launched between January and March every year, offer double-indexation benefit. As the scheme is purchased in one financial year and the matured after two financial years, these schemes are benefited by the double indexation.

Under double indexation, the overall tax liability gets reduced, as the long-term capital gains are adjusted for inflation. That means, for two years the capital gains are adjusted @rate inflation and only the pure capital gains are taxed. Thus, the overall tax liability is reduced.

For example, a scheme is launched in March 2011 i.e. FY10-11, it will mature in April 2013 i.e. FY12-13. While the investment is made in FY10-11, the redemption takes place in FY12-13. Thus, by investing in FMPs with the maturity of a little over a year, the purchase and sale years are spread over two financial years, called double indexation, which effectively reduces one’s tax liability.

 

Return On Debt (ROD) | Its Impact On The Company Performance

‘Return On Debt’. Spells short. But it’s as important as any other financial ratio, and also tells a  lot about the financial health of a company. Especially when there are big number of debts that peeps out of the balance sheet. So easy to analyze, but difficult to manage, ROD ratio has its own impact on any company’s performance.


Let’s try to have a few important points – What it may otherwise indicate the impact of ROD on any company’s performance as well as on our returns.

What Is ‘ROD’ Or The ‘Return On Debt’ Ratio

The ROD is a financial ratio, that compares the company’s net earnings to its long-term debt.

‘Return On Debt’ = Net Earnings / Net Long Term Debt

Here, debt means either taken /issued by the company. And sometimes the both the cases. And this ‘long-term-debt’ is in various forms and in distinctive interest rates depending on the creditor or the issuer. Anyhow, what we need to calculate is the ratio of the net earnings of the company to its net debt.

This ratio shows the amount of net earnings that is generated, for each coin that a company holds in debt. And, this ROD can either be positive /negative.

A positive ROD has been always beneficial to the company. And, it indicates that some income is being generated by the debt issued /taken by the company. Where as a negative ROD is a threat.

We can locate the long term debt data on the balance sheet as well as the notes to financial statements. The information explains the amount of debt taken out /issued and the number of years related to it.

How Important Is ‘Return On Debt’ In Any Company’s Financial  Analysis

Mostly, the ratio of ‘ROD’ is not used in the simplest financial analysis. But, it’s an important calculation that needs to be performed, while evaluating company’s solvency. It is generally used by the owners of the company while making a decision on, which financing sources would be better for the company.

It’s common to carry a certain amount of debt by any company. But, the amount should be limited. The more the debt to its earnings level, the more the credit risk’ is.

Moreover, companies carrying a significant amount of debt related to capital and/or assets are more prone to economic downturns during a decline in earnings.