Salesmen hurry you to take a decision!

I recently had to visit a bank and being a long time customer they took me to the manager's room for a quick chat; a chat to get me to buy some new insurance/savings product. Later during the chat I came to know that they wanted to reach their year end targets and so were forcing me to buy this before year end - I guess it's performance appraisal for them and some bonus perhaps!

When salesmen start pitching their product it all sounds rosy; they throw in terms like guaranteed benefits, maturity benefits, assured bonus, regular addition and what not. Even if you say that you will get back to them, they'll say that it will be good to take it right now!

Analysis

Back home, I looked closer into the product - out of the 3 amounts that they promised, 2 are dependent on what they announce at the start of every year! So it's not really a guarantee! Anyway, assuming that it is, I compared of what we would get if we were to take the traditional route: regular fixed deposit (FD) in the same bank along with a term insurance (insurance where you don't get back your premium).

And lo behold - it turns out that even after considering tax deductions on the FD interest, you would still do better to take a FD and term insurance rather than their new product. It confirms to the age old advice I've heard from people who analyze investment products - "Don't combine insurance and wealth generation; keep them separate - take 2 separate products." 

But it is disheartening that many people still buy these products; and those in a lower tax slab will feel a bigger pinch - because the lower you're tax slab, the more money can make by going with the traditional route of FD + term insurance.

I wonder what the salesman would say if I showed him my calculation; I didn't have the time to sit with him, put a spreadsheet and do a comparison in the manager's room. 

Well, I'm still tempted to do it - perhaps he would say that, "This reduces hassles because it is a single product" or perhaps he hasn't given this a thought.

The 'buy and hold' policy!

It'll take me a while to get into the grove of writing travelogues - so till then, I'll ramble about a few other things.

Recommendations

I was talking to an elderly middle class man who takes care of carpentry work (he employs a few guys) was asking me what stock to buy; it's a little worrying when you recommend a financial investment to someone - especially if they don't have surplus money. What if your recommendation goes wrong? In that case, just because of you someone else loses their money! A frightening thought due to which I hardly give a stock reco; another reason is that without giving such tips, people can't judge whether you are a good stock picker - and when there is no data to look at, they assume that you are very good at it :-)

Buy and forget

So rather than flatly say 'no, I don't give recommendations', I moved our conversation away from that area. He told me about how he he buys stocks and then forgets about it. And then after a few years, he will take a look at his portfolio. And to his surprise he saw that a few companies have completely disappeared from the market! 

It made me wonder about the policy of 'buy and hold'. Does it really pay off? Well, maybe and maybe not - if you had bought an Infosys 15 years ago and forgotten about it, you will be sitting on a nice little fortune today. 

But for every such multi-bagger stock (stocks which increase your wealth) there are plenty of multi-beggar stocks (stocks that wipe out your wealth). I just went back through our stock market index (the Nifty which tracks some of the 50 biggest companies in India) - in 2007 December, the Nifty was at 5900. And now in 2012 December, the Nifty is again at around 5900! 

So that means that if you bought a mutual fund that tracked the Nifty or a combination of stocks that closely resemble the Nifty, then in a period of 5 years your wealth has increased by Rs.0! 

Yikes - alright, I know that a few of you will say "Hey, you can't just look at a 5-year period. Give it some more time." Well, maybe in another 5 years the Nifty goes to 12000 and in that case your returns aren't that bad. But if you take a look at some of the company stocks, you will find that the price of many have gone down by 80% or so - and it doesn't seem like they will ever regain their old highs.

And at this point, those of you who have never invested in the stock market will say, "Gee... this is exactly the reason that I stayed out of the market"!

Anyway, in the end I avoided giving any recommendations and told him to look at his holdings at least once a month to see how his portfolio is doing and take decisions based on that.

How did he make 15k in two days?

Puzzle we left off with in the last edition:

A colleague made a whopping Rs. 15,000 in one day by trading in options. He did so without exercising the option. Any guess as to how he did it?

Before answering that we missed one term in the last edition.

Strike price: In our example of land, the strike price was Rs. 5 lakhs - we told the seller that we are paying this premium to buy the land for Rs. 5 lakh at a later date.

So how did my colleague do it?

Let's say we have a stock which trades at Rs. 3800. My friend feels that this price is surely going to rise in a month - possibly to somwhere around Rs. 4100 and so he checks on what options are available for that stock.

He finds one with a 1 month duration with strike price of Rs.4000.

There are people who are willing to take a risk and sell options - they feel the opposite - that the stock price will go down further - so they want to make some money through premiums. Now there are a group of potential buyers - and they would kind of bid against one another to buy the option. It is all based on supply and demand - many people want to buy means that many feel the price will go up - and since demand is more the premium price will also go high.
Let's say the premium was Rs.50 per share (not many people expect that it will go up by 200).

Options are sold in lots (i.e. in bulk amounts of 100 or 200 shares). So my friend buys the option for 200 shares at a premium of Rs. 50 per share. Total money he pays is Rs. 10,000.
So he has bought options for a stock at a strike price of Rs. 4000 with a premium for Rs. 50 - which means he expects the stock price within one month to rise above Rs.4050 (only then will he make some profit).

On Monday due to some positive news in the market the stock price climbs up to Rs.3900 ?(up by Rs.100). Now more people start realizing that this stock could well cross the 4000 mark and so they scamper to buy the option at strike price of 4000. Since buyers are more the premium goes up. It might have gone up from 50 to 150 per stock since people now feel it might really shoot up.

My friend now has two options - wait till the price crosses the 4000 mark and then exercise the option. So if at the end of the option duration the stock price is 4001 then he makes a profit of Rs.1 per stock. Total profit = Rs.1 * 200 = Rs.200

Or he could square off his position - meaning that he now sells the option to someone else; since the premium is now 150 (while he gave a premium of only 50) he makes a profit of 100 per stock. Total money made = Rs.100 * 200 = Rs. 20,000.

Wow you say; that's a quick way to make huge amount of money. Everything is not rosy of course - on the downside; suppose my friend sells his option and at the end of the duration of the option the markey price might have become 4500.
Now the person who bought the option from my friend will think, "I paid 150 as premium for a strike price of Rs. 4000. So effectively I will make profit when the market price crosses 4150 mark. Now it is 4500 which meanuls I make a profit of 350 per option for a total of Rs.350 * 200 = Rs. 70,000". So the guy sees that he can make a huge profit and will enforce (exercise) the option. Since my friend was the seller of the option he has to either buy 200 stocks from the market and give it to the buyer at the rate of 4000 or he has to pay the Rs. 70,000 difference between current market price and strike price.

ERRATA (21 August 2007): There's a catch; in the above case my friend will not have to pay the other guy - instead it will be the first guy who sold the option who will be held liable. Whenever one does a buy and sell of an option (square off) then you are not considered as being the creator of the option. If you sell an option without having bought it then you are the initiator of the option - this is possible and this is how options originate. How can you sell without buying? An option just means that you are telling a person "give me an advance now and I shall guarantee to give you the stock in future at the strike price irrespective of the market price at that time". So you can sell an option without ever buying one but in this case you end up with unlimited liability. If my friend had sold the option without having bought it he would've been exposed to unlimited liability and will need to pay the 70k.

So you can see that the losses are unlimited for the seller of options but for the buyer the worst case would be losing his premium if he finds that the prices are going in an unfavourable direction.

And that is similar to what my friend did to earn a large sum in 2 days.

What is the option in options? How options work?

Just thought of writing a series on the stock markets, finance and related concepts - hope you enjoy the series...Stock market terminologies are bolded

What is the option in options? How options work?

You must've heard of derivatives with respect to te stock market; Futures and Options (F&O as they are called) are a form of derivative. We'll take a look at that later.

So let's say there is a piece of land up for sale. Owner demands 5 Lakhs. You really want to own that property but can't afford it right now. You want to buy it after a couple of months. But the owner is bound to sell it to someone else by then - after all, everyone is into real estate business now. So you talk to the owner and tell him, "I really want to buy this land in a couple of months".
Owner: I can't keep waiting for two months; what guarantee do I have that you will buy it after 2 months. Two months is a long way away.
After a long pause the owner says, "Ok, we'll do one thing. You pay me an advance amount now - like a reservation fee to block the land for you. If you don't buy it then at least I would get the reservation fee".

"And if you do buy the land, then I'll give it to you for the same price of Rs. 5 lakhs itself irrespective of the market price at the end of two months".

This sounds a fair enough deal. We pay a non-refundable advance to the owner and at the end of the second month we have the option to buy the land at the current price. We have a gut feeling that the price of the land will most likely shoot up by 2 months.

Note: It is an option given to us by the owner and not a compulsion for us to buy the land at the end of two months. Let's say the advance amount is 10% of the total value = Rs. 50,000

This amount is the the premium.

Now at the end of the second month two scenarios can arise because of various factors:
1.) Price of land shoots up (say to Rs. 6 lakhs).
2.) Price drops to Rs. 3 lakhs.

Case I: If case 1 happens, then we will gladly buy the land at the promised rate of Rs. 5 lakhs - we don't need to pay the current market price because the owner promised to give it to us at the old rate of Rs. 5 lakhs.

So now we can buy the land at the old rate and resell it to make a profit of Rs. 50,000.

Profit = Selling price - (premium paid + price of land)
= 6,00,000 - (50,000 + 5,00,000) = Rs. 50, 000

The owner who gave us the option has actually suffered a loss. If he hadn't sold us the option, or if he had charged a higher premium he could have made more money because the land price now has shot up.

Case II: Now if we buy the land then we stand to lose Rs. 2,50,000.
Loss = 3,00,000 - (50,000 + 5,00,000) = Rs. 2,50,000.
Here the owner actually make a good profit while we suffer a loss. But wait; we never promised the owner that we will surely buy the land after 2 months - it was just an option. So now we will decide not to enforce the option in which case we won't buy the land and we will lose the premium we paid for the option - a loss of Rs. 50,000 only. Land owner earns Rs. 50,000 because the land price went down.

So we were the buyer of the option and the land owner was the seller of the option (called the writer). The buyer of the option has limited liability (maximum loss is the premium paid) but the seller has unlimited liability (the higher the land price goes at the end of the second month the greater the loss the seller suffers).
At the end of the second month we had the choice to either enforce the option (called exercising the option - in which case we buy the land at the promised rate) or ignore the option (in which case we lose the premium).

Apply the same concept to stocks and you'll understand what are "options" in terms of stocks. Instead of the land here the underlying asset is the stock of a company. Typically stock options are traded in lots - one lot is usually 100 stocks but it could vary depending on the price of the stock (sometimes a lot is 3000 stocks).

Note: Seller of the option feels the price will go down while the buyer feels the price will go up.

We'll end with a puzzle:

A colleague made a whopping Rs. 15,000 in one day by trading in options. He did so without exercising the option. Any guess as to how he did it?