There's money to be made in these uncertain times

There's money to be made in these uncertain times
24 Apr, 2008, 0725 hrs IST,Parag Parikh,

Markets by nature are uncertain. The current news headlines make them
appear even more uncertain. In these uncertain times, there are heads-
I-win-tails-you-lose opportunities available. One of these
opportunities is given below.

Let us say you invested Rs 5 lakh in a Nifty index fund. The Nifty is
currently trading around 5,000-levels. Assume you did not see the
stock prices for 3.25 years and opened you newspaper to check the
prices only on July 1, 2011.

The portfolio value you would expect would depend on the Nifty level
then prevailing. If the Nifty closed at 3,500 on June 30, 2011; you
would expect your portfolio to be worth Rs 3.5 lakh. On the other hand
if the Nifty closed at 8,000, your portfolio should be worth Rs 8
lakh.

An alternative to the above strategy is available in the markets,
where the downside is completely eliminated and the full (and
sometimes more than the full) upside is captured. As I write the Nifty
is trading above 5,000-levels and the Nifty call options with expiry
of June 30, 2011 have sellers at 1,100.

Say you wish to invest Rs 5 lakh. Do the following two transactions:

Buy 100 call options at a price of Rs 1,140 per option. Total cost
would be Rs 1,10,000. Invest the balance amount in a bank FD with a 9%
interest rate till June 30, 2011 that would amount to Rs 3,90,000. The
total reads Rs 5,00,000.

On July 1, 2011, the money kept in bank FD would have grown to approx
Rs 5,20,800 (assuming quarterly compounding). The call option will
give the full upside on Rs 5 lakh worth of equity. Thus if the Nifty
were to close at 3,500, you would have a portfolio value of Rs
5,20,800. On the other hand if the Nifty closes at 8,000, your
portfolio would be worth Rs 8,20,800. A guaranteed outperformance over
the Nifty!!!

So where is the catch? There is no catch other than taxes. If the
markets were to go up, long-term capital gains in equity would be tax
free, where as long-term gains in equity options may not be. Further
bank interest would be subject to taxation. One could invest in fixed
maturity plan mutual funds instead of bank FDs to save on tax, but the
rate of return would vary slightly.

A question may arise as to why these opportunities are available in
the market. The reason is that market participants have very short
memories and tend to extrapolate recent events far into the future.
Just as demand for earthquake insurance goes up immediately after an
earthquake, currently there is huge demand for put options (implied
volatility of 40%-50% for the academically inclined). In such a
scenario, call options are being sold at ridiculously low levels
(implied volatility of 0% !!!).

So for someone who is not bothered about paying taxes on the gains,
this strategy would be heads I win, tails you lose.

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