Stock Market at an all time high – Participate in the Ride but Don’t Forget to Wear Your Seat-belts!
Nifty Index’s All-Time-High (ATH) is 15,916 which was made on 28-06-2021. Today, Nifty index closed at 15,879 – not very far from ATH. There is a very good chance that Nifty may surpass 15,916 and make new ATH soon. But will it sustain there? Nobody can say for sure. What’s important is to participate in the rally but make sure that you don’t get carried away.
Global as well as Indian Stock Markets have been consistently going up in the last 12-15 months. Almost all stocks, irrespective of underlying business fundamentals, have been on an upward surge. This may have led to some complacency in traders and investors. Of course, there are few exceptions like ITC, Bharti Airtel, Coal India, etc. which are under-performing.
What are the factors that the stock markets are tracking?
- Inflation, Interest Rates and Tapering
On inflation, the jury is still out. The Federal Reserve believes Inflation is transitory but the surge in commodity prices tells a different story. Metals, Crude Oil, agri-commodities, chemicals, wages in the USA, etc. have risen significantly compared to pre-Covid levels. If the Federal Reserve is wrong then interest rates will be increased sooner than projected and liquidity infusion will have to be tapered. History suggests that markets react negatively to such events in the short-term. If other factors like recovery/growth are still intact, then these events are forgotten and markets continue their original path.
High PE stocks may suffer the most when interest rates are increased. In India, FMCG, mid-cap IT, etc. fall under this category.
- Economic recovery / Earnings Growth
More than June Quarter results, the management commentary and outlook on future growth will be more important. For example – TCS, Infy, HCL Tech all corrected after decent March 2021 quarter results because the managements said that revenue growth in FY 2021-2022 will be lower than what was projected earlier.
Currently, bulk of the earnings increase is being contributed by Metals companies. Other sectors will also need to start contributing. Personally, I believe that today’s prices are discounting good results over the next 2 years and there is no margin of safety in stock prices.
- Covid – Vaccine Roll-out, new variants and possibility of a new wave
A successful vaccination roll-out will help in avoiding a severe third wave. Till now, the available data suggests that vaccines are effective on new variants. What remains a concern is that the third wave should not strike before majority of the citizens are vaccinated. Any fresh lockdowns will impact the stock markets as well as the economic recovery.
- High Valuations, upcoming marquee IPOs and low implied volatility
Valuations in almost every sector are at a premium to their historic averages. The market expects swift earnings recovery. Any negative surprise in earnings will lead to a sharp correction in share prices. There is no room for error / no margin of safety.
Having said that, the flush of liquidity is and can keep taking the markets higher.
Marquee IPOs like Zomato, PayTm, Policy Bazaar, LIC, etc are expected in the next few months. Large IPOs suck the liquidity out of markets. It is anecdotally said that the activity in the IPO market increases as the bull market nears its peak.
Though, there are large intra-day fluctuations in the stock market, the trading range has been very narrow. The Nifty is oscillating between a 300-400 point range.
India Volatility Index (VIX) is around 13 levels which is very close to the lower range. Remember that it was almost 80 in March 2020 but that was an exception. A more normal range for India VIX is 10-40. A lower VIX implies that the market is expecting neither a significant upside nor downside in the market. But you may have observed some sudden, sharp selling in some big stocks for various reasons – Adani group, Reliance and most recently, Tata Motors.
Lower VIX presents a great opportunity for hedging as the option premiums are much lower. Thus, your hedging cost can be relatively lower.
How to approach Hedging?
- Decide how much drawdown is acceptable to you.
In my view, a 5-6% drawdown in equity markets is normal. Thus, Nifty 15000 strike price is a good option. It’s a ~5.5% drawdown from current Nifty levels.
- Buy a Put Option with a distant expiry.
You can opt for 30th September, 2021 expiry as that is the most distant contract currently trading. This Put Option can be sold anytime on or before 30th Sep 2021.
- How many lots to choose?
If you are investing mostly in Large caps, it is safe to assume that portfolio beta is ~1 (relative to Nifty). Lot size of one Nifty contract is 50. At current Nifty levels, one Nifty contract can hedge a portfolio worth ~7.5 lakhs. Thus, if your equity portfolio value is worth 30 lakhs, you will need to buy 4 lots.
- What is the cost of Nifty 30 Sep 2021 15000 PE contract?
Today’s closing price is 110.
Lot size is 50.
Amount paid for 1 lot = 5500 (110*50).
Cost as % of portfolio = ~0.75% (5500/7.5 lakhs)
- What does this achieve?
For a cost of 0.75%, it protects your portfolio for any fall below 15000 in Nifty.
You will still be exposed to a 5.5% fall in Nifty – from current Nifty level to 15000.
In case the fall is greater, then the increase in the value of the Put Option will offset this fall to a large extent.
Below examples are for illustrative purposes and actual position may differ to some extent. Also, taxes, brokerage, STT and other charges will eat into your gains.
Scenario 1 – Nifty is between 15000 and 15870 on 30th Sep 2021
Portfolio drawdown = Market drawdown (+) Cost of hedging.
Scenario 2 – Nifty is above current levels (15870) on 30th Sep 2021
Increase in portfolio = Increase in Market (-) Cost of hedging
Scenario 3 – Nifty is below 15000 on 30th Sep 2021
Portfolio Drawdown = Cost of hedging (+) Acceptable Drawdown
As you can see, the Put Option helps in avoiding big drawdowns. However, it comes at a cost of 0.73%.
Questions that may arise in your mind –
Why not choose a strike price closer to 15870, let’s say strike price of 15900? Will it not help in avoiding 100% drawdown from current levels?
The cost of a 15900 30 Sep 2021 Put option is 3x of the 15000 30 Sep 2021 Put option. Thus, your cost will increase from 0.73% to 2.2%. Anyways, the idea is not to completely avoid drawdowns but to avoid big drawdowns.
Do I have to wait till 30 Sep 2021 to square off / sell my Put Option?
No, the put option can be sold anytime before 30 Sep 2021.
Why not sell the shares, sit in cash and buy after a correction?
Because its impossible to predict market movements correctly. Put options allow you to avoid a big drawdown but they also let you enjoy the ride if the markets go higher.
Let’s say the market has a big correction, then what?
Sell the Put option and use the proceeds to buy your preferred stocks at the lower prices. This will bring down your average cost and increase the quantity of shares.
Its similar to Health Insurance. You pay premiums but you don’t complain that your premium was wasted because you didn’t get sick. You may not want the markets to go down but the low VIX gives a good opportunity to hedge your risks at such stretched market valuations.
Disclaimer – Qrate Capital LLP does not provide investment recommendations or advice. We merely present the facts that are based on research and analysis. Additional analysis should be done by individuals prior to making any investment decision, we are here only as one form of a resource. This is not a tip/recommendation. Please consult your financial advisor before making any decision.