Short Selling and Short Squeeze

At any given point, only a certain amount of a publicly traded company’s stock is floating freely in the market. The rest is held in various portfolios, funds, and investment vehicles. Now, everyone’s familiar with the basic idea behind the stock market: you buy stock when it costs little, and you sell it when it costs a lot, profiting on the difference.

But that assumes a company’s value is going to increase. What if, instead of betting a company will go up, you want to make money betting the company will go down? You can — by selling stock you don’t own.

Say you borrow a certain amount of stock from someone who already owns it. You pay a fixed fee for borrowing the stock, and you sign a contract saying you will return exactly the same amount of stock you took after some amount of time. So, you might borrow a thousand shares of Apple stock from me (I don’t actually own any, but play along), pay me $100 for the privilege, and sign an obligation to return my stock in 3 months. At the time, Apple stock is worth $10 per share.

After you borrow the stock, you immediately sell it. At $10 a share, you get $10,000. Two and a half months later, another rumor about Steve Jobs’ health sends AAPL crashing to only $6 per share for a few hours, so you buy a thousand shares, costing you $6,000. You give me back those shares. Because you successfully bet the company would go down in value, you earned $4,000 minus the borrowing fee. This is called short-selling or shorting the stock, and the downside is obvious: if your bet was wrong, you would have lost money buying back the shares that you have to return to your lender.

When Volkswagen’s share price exceeded the point where it made sense for Porsche to buy the company, a number of hedge funds realized that Volkswagen shares have nowhere to go but down. With Porsche out of the picture, there was simply no reason for VW to keep going up, and the funds were willing to bet on it. So they shorted huge amounts of VW stock, borrowing it from existing owners and selling it into circulation, waiting for the price drop they considered inevitable.

Porsche anticipated exactly this situation and promptly bought up much of these borrowed VW shares that the funds were selling. Do you see where this is going? Analysts did. According to The Economist, Adam Jonas from Morgan Stanley warned clients not to play “billionaire’s poker” against Porsche. Porsche denied any foul play, saying it wasn’t doing anything unusual.

But then, last October 26th, they stepped forward and bared their portfolio: through a combination of stock and options, they owned 75% of Volkswagen, which is almost all the company’s circulating stock. (The remainder is tied up in funds that cannot easily release it.)

To put it mildly, the numbers scared the living hell out of the hedge funds: if they didn’t immediately buy back the Volkswagen stock they were shorting, there might not be any left to buy later, and it isn’t their stock — they have to return it to someone. If their only option is thus to buy the VW stock from Porsche, then the miracle of supply and demand will hit again, and Porsche can ask for whatever price it wants per VW share — twenty times their value, a hundred times their value — because there’s no other place to buy. They’re the only game in town.

And that, my friends, is called a short squeeze.

Market Dynamics: is it the right time to buy

This information has been sourced from economictimes article,
http://economictimes.indiatimes.com/Markets/Analysis/Equity_-_Is_It_The_Right_Time_to_buy/articleshow/msid-3845314,curpg-2.cms

There are several metrics which can be observed to get a fair guesstimate about the direction market is heading towards. They are:

Earnings Approach

The current level of Sensex implies 10.0 x – 9.4 x P/E of FY09 earnings and probably around 12.5x – 11.3x of FY10 earnings.
Historically, since 1991, Sensex has traded in the range of 10-30 times one year forward earnings. So, currently the Sensex is certainly at the lower range of the historical P/E band.
Even if things are likely to be different this time due to a worldwide recession, we do not expect more than 20% downside from these levels.

Book Value Approach

The current P/BV (Price to Book Value) of Sensex is hovering around 2.3 which is in the range of historic lows of 2-2.4.
In last 18 years, whenever the P/BV ratio had drifted to around 2, it has been followed by a smart pull back. For example, in November 1998 when Sensex fell to around 2800 levels (P/BV of 2), the next six months witnessed a strong pullback rally of more than 40% pushing the index to 4000 levels.

Conversely during last 15 years, markets have fallen sharply every time the P/BV ratio has crossed 6.5. January 2008 was no exception to this rule.

Falling Yield in Equity

Historically, it has been observed that whenever Equity yield has crossed the G-Sec yield, it makes sense to invest in equities.
On the other hand, whenever G-Sec yield has reached higher than equity by 4% or more, it has been a good opportunity to sell out of equities.
In January 2008, the G-Sec yield was higher than equity by this threshold margin. Since this indicator was very accurate in predicting the peak of the bull market, it may be used as a good sign to determine the trough of this bear market. Since Equity yield has already crossed the G-Sec yield, we may conclude that we are near the bottom of the cycle as far as equity markets are concerned.

Futures and Options -- Let us Know

Derivatives are products that obtain their value from a spot price, called the “underlying”.In India, F&Os are the two popular derivatives instruments traded on stock exchange. While in a futures contract, you agree to buy or sell shares at a certain price in the future, the option contract gives you the right, but not an obligation, to buy (through a call option) or sell (through a put option) the underlying scrip at a specified date and at a specified price.To start trading in futures contract, you are required to place a certain percentage of the total contract as margin money.This feature of futures contract makes it a leveraged instrument since you can make a larger profit (or loss) with a comparatively small amount of capital. In India, futures contracts are available on equity stocks, indices, commodities and currency.

In options trading, you pay the premium for buying the rights to exercise your option. To take the buy or sell position on index and stock options, you are required to place a certain percentage of order value as margin money.An option can be a ‘call’ option or a ‘put’ option. A call option gives you a right to buy the asset at a given price or before a given future date. This ‘given price’ is called ‘strike price’.Similarly, a ‘put’ option gives you a right to sell the asset at the ‘strike price’ to the buyer. Thus in an options contract, the right to exercise the option is vested with the buyer and the seller has only the obligation but no rights.Since the writer of an option bears the obligation, he is paid a price known as ‘premium’.

Before venturing into unknown waters, analysts advise that you must fully understand the implications arising out of trade in F&Os. “It is trading on margin with a leverage of four-six times. You should know that in leveraged trading, the market fall is magnified to the extent of the leverage availed by you.Understanding your risk appetite and risk tolerance is important in F&Os trading,” says Sandeep Nayak, senior vice-president and head, private client dealing, Kotak Securities.The golden rule — never trade anything that you don’t understand — believe analysts, has a special significance for F&Os trading since the risk in them, with all the leverage and complexity, comes in multiple dimensions. “Unlike the cash market where your risk is limited to the amount you deploy, you can lose much more than what you’ve put in and in much more ways than a simple price move in the F&Os segment. Always think risk first and then think about returns,” cautions Nilesh Shah, CEO of Ambit Capital.

According to Shah, a first-time investor must not trade in F&Os due to the associated risks. Only after having invested in stocks for over three years, an investor should try to become a trader.“However, you must start with very small ticket sizes initially and only once you’ve gained confidence about the nature and working of these instruments should you look to increase your ticket size.You should try to seek expert advice at least in the initial part of your trading journey,” he feels. Nayak, too, feels that a first-time investor trading in F&Os is akin to an individual trying to swim in the deep end of the pool on day one of swimming class.

According to Shah, a first-time investor must not trade in F&Os due to the associated risks. Only after having invested in stocks for over three years, an investor should try to become a trader.“However, you must start with very small ticket sizes initially and only once you’ve gained confidence about the nature and working of these instruments should you look to increase your ticket size.You should try to seek expert advice at least in the initial part of your trading journey,” he feels. Nayak, too, feels that a first-time investor trading in F&Os is akin to an individual trying to swim in the deep end of the pool on day one of swimming class.

Example: On November 1, an investor feels the market will rise Buys one contract of November ABC Ltd futures at Rs 400 (market lot: 200) November 12 ABC Ltd futures price has increased to Rs 480 Sells off the position at Rs 480. Books a profit of Rs 16,000 (200x80).Options Example: On November 1, an investor is bearish on the market Current Nifty is 2,980. You buy one contract (lot size 50) of Nifty near month puts for Rs 20 each.The strike price is 2,940. The premium paid by you: (20x50) Rs 1,000.Your breakeven Nifty level is 2,920. If at expiration Nifty declines to 2,890, then Put Strike Price 2,940 Nifty expiration level 2,890 Option value 50 (2,940-2 ,890) Less: Purchase price 20 Profit per Nifty 30 Profit on the contract Rs 1,500.

Technical Risk Ratios for Portfolio Planning

There are five ratios referred to while creating and maintaining efficient portfolios.

1. Alpha,
2. Beta,
3. Standard deviation,
   
4. R-squared, and
   
5. The Sharpe ratio.

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Alpha
A measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund's alpha.

A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would indicate an underperformance of 1%.

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Beta
A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

Beta is calculated using regression analysis, and you can think of beta as the tendency of a security's returns to respond to swings in the market. A beta of 1 indicates that the security's price will move with the market. A beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security's price will be more volatile than the market. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market.

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Standard Deviation

Standard deviation is a statistical measurement that sheds light on historical volatility. For example, a volatile stock will have a high standard deviation while the deviation of a stable blue chip stock will be lower. A large dispersion tells us how much the return on the fund is deviating from the expected normal returns.

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R-squared

R-squared values range from 0 to 100. An R-squared of 100 means that all movements of a security are completely explained by movements in the index. A high R-squared (between 85 and 100) indicates the fund's performance patterns have been in line with the index. A fund with a low R-squared (70 or less) doesn't act much like the index.

A higher R-squared value will indicate a more useful beta figure. For example, if a fund has an R-squared value of close to 100 but has a beta below 1, it is most likely offering higher risk-adjusted returns. A low R-squared means you should ignore the beta.

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Sharpe Ratio

The Sharpe ratio tells us whether a portfolio's returns are due to smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio's Sharpe ratio, the better its risk-adjusted performance has been.

A variation of the Sharpe ratio is the Sortino ratio, which removes the effects of upward price movements on standard deviation to measure only return against downward price volatility.

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Financial health of a company: some tips

We started off by eliminating all those companies that had recorded less than 15% growth in net sales and PAT in any of the past three years.

Further, we filtered companies on the basis of debt-to-equity ratio and return on capital employed (RoCE). While a high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations, a low leverage ratio increases a company’s potential to raise funds.

Hence, we selected companies which had a debtto-equity ratio of less than 1.5. In order to carry sustainable operations, it is necessary for a company to operate at an RoCE which is well above its cost of capital. Only those companies with an RoCE of more than 15% could make it to the next stage.

The final criterion was to do away with all companies whose three-year average net cash flows from operating activities was less than 50% of their reported cash profit.

Short Term Capital Loss

According to Section 74 of the Income Tax Act, 1961, you can offset your losses and even carry forward them for eight assessment years immediately succeeding the year in which the loss was first computed.
As per the act, any loss related to a short-term capital asset (like the sale of equity funds/shares within one year), can be set off against income under capital gains in respect of any other capital asset (be it short-term or long-term). This means, you can even offset this loss against any long-term capital gain. For instance, let's say you invested in a debt fund. After a year, you sell the units and book a profit (long term capital gains). You can offset this gain with your short-term mutual fund investment loss.