There's money to be made in these uncertain times

24 Apr, 2008, 0158 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.

(The author is chairman, Parag Parikh Financial Advisory Services)

Source: Economictimes