Post Office Savings Scheme: Investments and Risks

Here is some more news on my previous post of Post office savings schemes (Tax Planning). In that article, I had questioned about the safety and security of your money that you invested in post office savings scheme. Some readers had left the comments mentioning that the liability of the money that we invest in post office schemes for tax-planning lies with the government, hence our money is safe.

However, here is a news item that might give you a glimpse of what can go wrong with such inefficient process and low safety investment options. Here is a new item from a leading newspaper: Unsafe savings: Rs 153 cr vanishes from post offices. (Opens in a new window). Please read through this article and see how the post masters and the agents willing to offer services with a smile are charged of duping people with millions of money, all the hard earned savings of investors vanishing.

In a way, it’s always easy to find a justification for what we have done. We simply end up by saying that the government is running the post offices, so it is the government’s responsibility to take care of the safety of my money which I am depositing in the post office schemes – be it for saving taxes, or for long term investments to earn attractive returns. However, what we tend to forget is that once a problem starts, it’s not easy to get out of it in a simple and straightforward way.

It is the investor’s money that has been taken for a ride. The government can simply appoint an investigation committee to look into the matter. It will take months and even years for the investigation committee to come out with results. Even if everything goes well, then also it will be the investors who will have to face the consequences. Even if the government identifies that there has been a genuine scam and they need to repay the money to their investors, it will take ages for the investor to justify their claims. The money that they have invested was being taken by giving them forged receipts. How can the investor really claim that he has really given the money to the post master or the agent? That too to a government official in India?

There was a big tragedy in Bhopal – the famous and notorious Bhopal Gas tragedy. Till date the victims are fighting for their compensation. The real victims may have received nothing, but the middlemen and other people who were not even remotely related to the victims have managed to harvest a big amount with their connections. Let’s not forget that the bureaucratic process in India will make you run round and round for your own money! How about getting the tax refund from the Income tax department?

If I know correctly, then another case was with the famous Indira Vikas Patra or the Kisan Vikas Patra, launched in the 1980s. It promised to double your money in 5.5 years or so. However, at the maturity, the government did not have sufficient money to pay back. So it offered to extend the savings to another term of 5.5 years. Investors were left helpless!

It’s not only in India, but across the globe. The Russian Government default on Russian Bonds in the late 1990s led to the collapse of LTCM - “Long Term Capital Management” , the company which was run by the Noble prize winner. There is a famous book on this collapse – titled “When Genius Failed” . The root cause of the fallout was the default on Russian government based securities, bonds and currency. Then the South American countries like Argentina and Brazil also defaulted on their government based bonds, which was the precursor of the economic doldrums of late 1990s.

Simply trusting the government is one of the dumbest things an investor can do.
Simply putting the blame and responsibility on governments or any other agency is a big and highly faulty assumption that a person makes. The government itself is running by the support of more than 25 parties. It is unclear about its own future, how can one keep on trusting such a setup? There is nothing hindering the growth rate and future prospects of this country, but only the instability of the government. A typical example that can be quoted is that of Gujarat. The moment Modi won, all the Gujarat based shares went for a sky rocketing performance. Is this possible at the center? Looking at the situation, I don’t think so. Readers may differ in opinion, so please feel free to Post your Comments at the end of this article.
It’s always better to think twice before finalizing your investments and savings. Anyways, 153 crores or 15.3 million is not a small amount of money. I can only sympathize with the investors who have been duped by the post masters, the post office employees and the post office agents. May be it is just the tip of the iceberg and lot more may be unearthed. Table of Contents

Mutual Fund (NFO) Investments on Loan

There is a new investment option coming in to lure the investors in mutual funds – better to say another circus is going to start in the mutual funds investment arena.

Last month, there were as many as 11 different mutual funds launched. All good pretty good response. Banks are now trying to cash in this mutual fund euphoria and earn their income.

Banks have now offered to give special loans exclusively for investments in the new fund offers, or NFO, for Mutual fund investments. People who are not having sufficient money, or they want to invest in the stock market by buying units in the newly launched mutual funds can now avail a loan from these banks. Buy stocks, buy units, buy anything, the bank is there to help you with a loan. No need to have that extra money, just apply for a loan by calling the bank and you will get the money and you can make an investment in the mutual fund of your dreams.

As per the offers, the banks are now willing to fund as much as 80% of the money for investments in mutual funds that will be launched soon through a NFO or new fund offer.
The way it is going to work is as follows:

You have 200,000 or 2 Lakh to invest in a mutual fund that will soon be hitting the stock market. You are certain that the mutual fund will be a good investment in the near or long term future. So you are willing to invest more, say 1 million or 10 lakhs. But the problem is that you have only 2 lakh. Now, you have the option to take a mutual fund loan or a NFO loan as offered by various bank.

As per the conditions, the bank can offer you as high as 80% of the investment value as loan. So if you want to invest 1 million, then all you really need to have is only 2 lakhs, remaining 8 lakhs or 80% will be provided by the bank as a loan.
So, you take the loan, invest the entire 1 million in the NFO and wait for the fabulous returns.

The NFO loan or mutual fund loan that is offered is being charged around 12% rate of interest. Hence, suppose that you take the above mentioned loan at 12%. In 6 months time, your mutual fund investment of 1 million has grown by 20%. Therefore your 1 million is now 1.2 million.

However, you will have to repay the in interest on your mutual fund loan or NFO loan of 8 lakhs. For 6 months, at 12% interest rate, the interest comes to 48,000. So you make a fair amount of profit. You receive 2 lakhs from the 20% increase in your mutual fund investment, you repay 48,000 from that, and hence you keep around 152,000 with you as your profit – fair and square.

But what the catch? Actually there are no catches – directly or indirectly. You must be aware of what you are doing!

In the above calculation, we have not accounted for the entry load charges that may be as high as 3%. Then the exit load charges that may be 1.5%. So your investment of 1 million will reduce to 0.97 million and your 20% assumed return will come down to 194,000. Then, when you exit from this fund, you will pay 1.5% on this 1,194,000 – which comes to around 18,000. Hence, your net return comes down to 176,000. Still a good bet because you will still carry 176,000 – 48,000 = 128,000 as net profit, after paying the interest.

But the biggest problem is with the assumption that the Mutual fund will grow by 20%. What if it falls by 20%??? All the calculations will reverse. Your loan liability will not come down, it will stay as it is, but your returns will not come at all – because you will not be willing to sell your mutual fund invested units for a loss – will you??

And the longer you’ll have to wait for your mutual fund to show profit, the bigger will be the interest that you will have to repay. Hence, the entire risk is bourne by you – the investor and the loan taker.

Why is the bank allowing investors to take this leveraged risk??

Banks are not fools that will simple throw away money to anyone. They come with an offer only if they find it meaningful and profitable. When you take a loan it is your responsibility to repay it. So irrespective of how your mutual fund performs, you will have the liability to repay your loan back.

Now look at some numbers. Banks also act as distribution agents for mutual funds. So when you take a loan for mutual fund investment or NFO loan, the bank will get its distribution charges from the fund house – which can be as little as 4% or as high as 8%.
Even if it is just 4%, then for a 1 million or 10 lakh investment, the bank will pocket 40,000. Also, it will earn interest on the loan amount of 800,000 at 12%. Hence, its effective net return will be 4% from distribution charges + 12% from loan interest amounting to a whooping 16% return (minimum). And most interestingly, the banks returns of minimum 16% are guaranteed. However, the investors returns are “Subject to market risk”.

So think before you leap. Nothing wrong in trading or investing using other people money or a loan amount, but be ready to face the fallouts, which may cause you a major setback. Loan Offers from the banks can be still given a consideration, and so are the mutual funds and the NFO that are expected. All the best! Table of Contents

Forex currency trading and Hedging strategies-1

Hedging is a common buzz word in the financial world. Not only on the investment front, but also for the businesses that have any kind of dependency will have to look for hedging against fluctuations in forex prices, either by currency trading or forex hedging.

But what exactly is hedging? How does hedging work? What all financial instruments are required in hedging? In this article, let me give you an example of hedging and the answers to some such similar questions.

In simple words – hedging means eliminating the risk. Also, some financial experts and professors say that risk can never be eliminated, so for them, hedging means eliminating the effects of risk.

Starting the hedging example at the root level:

Let’s say there is a farmer who has harvested his field and is expecting to produce 1 quintal (100 Kgs.) of wheat grain after 3 months. Now, he is planting today for expecting future returns – a typical case of investments. Instead, this is observed in everyday’s life. You work for a month, and then get the salary. A shopkeeper buys products today and sells it later for profit.

However, from the point of view of farmer, there is a big risk. The risk is that if the weather is good then there may be big supply of wheat as most of the farmers will have good crop – so since the supply will be high, the demand will fall and so will the prices fall. Therefore he is at a risk of getting lower prices.

Also, if the weather is bad, then he may not have a good crop. So though there will be big demand due to shortage of supply and hence higher prices, but he will not have sufficient amount of crop to sell.

Ultimately, he is at a risk. So what should he do?

Before going into the solution, let’s take the case of a baker who needs wheat for preparing bread and earn his living by selling the bread he prepares in his bakery.

The baker is running a risk of high price of the wheat, which may be due to bad weather.
So he is at risk.

Both in case of farmer and baker, the risk comes in from the future price fluctuations and uncertainty. For the farmer, it is the low price that he may get for selling his crop, and for the baker, he may have to pay a high price for the wheat which is used as an ingredient to his business.

So, what both of them can do is get into an agreement for the future. The agreement can be something like this:

Let’s say the current price of wheat is $1 PER Kg. The farmer is worried that he will be at a loss if after 3 months when his crop is ready for sale, the price may come down to say, just $0.75 per Kg.
On the other side, the baker is worried that the price of wheat may rise in 3 months time and it may reach higher, say $1.25 per Kg.

Hence, they both meet up and decide to get into an agreement with a certain FUTURE price of wheat, say $1.05. As per the agreement, the farmer will deliver 1 quintal of wheat (100 Kgs.) after 3 months time and the baker will pay to the farmer $105, (100 Kgs. * $ 1.05) the same rate they agreed upon.

So what has happened here? Since the farmer and the baker were worried about the future price movements of the product, they got into an agreement TODAY, so that their FUTURE RISK is covered. Three months down the line, let whatever be the price of wheat, the contract will be honoured by both the farmer and the baker.

Case 1 - Say if after 3 months, the wheat price reaches $2 per Kg, then the baker will be in profit - Because he got into a FUTURE contract with the farmer to buy wheat at $1.05 per Kg. It will be the farmer who will loose on his prospective earnings. However, the farmer will still receive his expected rate of $1.05.

Case 2 - On the other hand, if the wheat price drops to $0.50, then the farmer will be winning – because of his future agreement. The baker will have to buy the wheat from him at $1.05 per Kg rate, though the baker can purchase it for cheap in the open market. Hence, the baker will loose on the current market prices.

But the most important part of such a future contract is that both the parties have to agree to a future price and obviously they will do it only if they are satisfied with it. Hence, in case -1, even if the farmer appears to be on the loosing side with respect to the current market price, he has actually achieved the purpose of eliminating the risk of price fluctuation – He has got the SELL PRICE that he wanted. In case 2, even though the baker appears to be loosing because of paying a higher price than the existing market price, he has achieved the objective of eliminating the risk in buy price – he has got the BUY PRICE that he wanted. This is a typical and most fundamental example of hedging or risk management.

Not only with farmers and bakers, risk management and hedging is something that is practiced all throughout the globe. Intelligent CFO’s and organizations that have businesses split across various countries and revenues in different currencies do go for hedging and risk elimination.

Continue to Part 2: What to look for hedging while buying stocks?

Forex trading and Hedging strategies - 2

This is part 2 of the article: Forex trading and Hedging strategies - 1. Please read the first part before continuing with this one.

The same goes for investments as well. If I buy a stock today, then I might be worried about fall in prices 3 months down the line. Hence, I might like to get into an FUTURE agreement with some other party, at a pre-specified and agreed FUTURE price, for some such quantity of stocks. So I will enter into a future contract with another party, and the price at which the agreement is made is called the FUTURE price. At the expiry of the contract, I will deliver the shares to the other party, and the other party will deliver me that much future price for each of my share.

This is typically what you observe when you see the so called “F&O” section or the “Futures and Options” section of the stock market. The future business relates to these future contracts that traders make with each other, obviously via the exchange.

Let’s take an example. Say it is January 1st, and I bought 100 Microsoft shares today at $30. I have an investment horizon for 3 months i.e. till March end and I am worried that the price may fall. So what I do is that I place a SELL order for a future contract for my desired future price that contract will last till March. Say I expect a 10% return on Microsoft stock, i.e. the stock to reach $33 in 3 months time. Therefore, I will place the FUTURE SELL order for selling 100 Microsoft shares in future (3 months) at the expected future price of $33. Since I am willing to sell the Microsoft shares in the month of March, it is called March Future.

The order will be placed through my broker and will remain open at the exchange, unless someone is willing to BUY that future order. Hence, there has to be a buyer who is willing to buy my sell future order at my desired price, otherwise my order will expire. So let’s say I place my sell order at 10 am and at 2:30 pm, someone agreed to buy my future contract of Microsoft. A deal is done and we are locked into an agreement via the exchange.

Interestingly, nothing is exchanged at present – it’s only a contract that we’ve agreed on.
Exchange happens only on the expiry date, i.e. after 3 months, I will deliver 100 shares to the stock exchanges and I will receive $3300 in my bank account (less the brokerage). The other party, whom I may not even know because of the stock exchange in between, will receive 100 shares from the exchange and will have to deliver $3300 to the stock exchange.

Practically, the shares are not exchanged. It all is settled in cash. Hence, If say the price of Microsoft goes to $35, then I will still have to pay $2 * 100 shares = $200 to the other party via the exchange. I will make up for my $200 loss by selling my shares in the open market at the price of $35. Hence, I will get $5 as profit from selling my share, and $2 as a loss due to futures contract. The net return for me would be $3, which is what I wanted to achieve (10% return on $30 buy price).

Say if the price falls down to $25, then I will receive 33- 25 = $8 from my future contract counterparty, and I will sell my shares at a loss of $5 each. Again, I will get $3 as my profit.

So, either way the stock price moves, just because I have secured a future contract, I was able to achieve my desired profit level of 10%. However, nothing in this world comes for free. If I had not entered into the future agreement, I would have made (35 -30 = $5) per share profit instead of $3. So while going for hedging, I am loosing future potential of profit. Anyways, hedging is done to achieve a certain level of risk management. Therefore, one must then not worry about his hypothetical losses in case there is a significant bull run in the market or the stock.

Continue to Part 3: How to know if company I’ve invested in is hedging?

Forex trading and Hedging strategies - 3

This is part 3 of the article: Forex trading and Hedging strategies - 1. Please read the first part before continuing with this one.

To understand the market terminology, the Future contract that I will get into will be called a Microsoft March Future (similarly we can have different futures like Reliance March Future, Wipro February futures, etc). The March future will have a future price, which in this case is $33 for Microsoft March Future. Same way you will have Wipro February future price that may be 515, and so on. So what you might see on the business news channel everyday, where they say that “Reliance January Future is trading at 2800 as against the spot price of 2750” – it means that the future contract of Reliance stock expiring in January has been agreed for trading at 2800. The spot price is the today’s market price of reliance. In this case, since the future price is higher that the spot price, it is said that the future is trading at a PREMIUM of 50 (2800-2750) or for Microsoft, it will be $3 ($33 - $30). Sometimes, when we have the future price below the spot price, it is said to be trading at a DISCOUNT.

Now, let’s take some more examples from the investment companies or forex currency risk. Let’s say Infosys (Infy) knows that it is going to receive $ 1billion in 3 months time, because it will deliver a software product to a US based client. Since Infy is based in India, it will need to convert that money in Indian Rupees. Hence, if the USD-Rupee forex currency rate decreases, then Infy will receive less rupees for the $ 1 billion – there is a RISK. Hence, what it does is that it gets into a future contract with another party, let’s say a bank trading in forex currency, and fix a FUTURE exchange rate. Suppose the current exchange rate is Rs. 40 per dollar, and the agreed future price is Rs. 40.5 per dollar between Infy and the bank, then on the expiry date 3 months down the line, Infy will give 1 billion dollars to the forex trading bank, and bank will give 1 billion * 40.5 Rs to Infy, irrespective of the then existing market rate.

Hence, by using this kind of future contracts, the companies try to hedge their cash flows and income. What is more important here is the security that one gets, the certainty that one wishes, that he will definitely receive this much amount of money irrespective of which way the prices go. This is the whole heart and soul of hedging – avoid uncertainty and fix the prices right now!

When you are looking at a company which has significant cash flows from foreign presence, do try to find out whether it is using hedging or not. Usually it is clearly indicated in the annual report. Even if it is not mentioned in the annual report, then you should look at the past declared results of the company. If they have used hedging or forex currency trading contracts in the past, then it will be mentioned in the past reports in terms of future price contracts, etc. And hence, there is a high chance that the the company will continue to use hedging against forex price fluctuations in the future as well. For e.g., companies like TCS managed to show good profit last quarter because they were already using hedging strategies for forex reserves.

Where does the disappointment come in?
The problem is with the expectations. For e.g., If the dollar again becomes stronger to the rupee, then the profits of Indian companies will increase. But since they may be using future contracts to hedge their forex price fluctuations, they may appear to be loosing as compared to the existing market price. Therefore, when the street or investors are expecting some fabulous results from a company, the company may not be able to deliver the expected results if it is hedged using some such future contracts. So ultimately, it may fall either way. It all works RANDOMLY.

A typical case is the Airline industry. Historically, it has been observed that most of the airline companies run in losses. That includes state run airlines as well as private airline players. Even if the handfuls of airlines are in profit, their returns on investment is not as good as other sector companies. The reason is simple. An airline like Lufthansa having presence in more than 40 countries, how long can it hedge? And against how many different currencies by trading in forex currency?

One investor may feel proud that his investment is a company like Infosys is set to grow because infosys is having presence in more than 30 countries (just an example). The fact is that more dependency you have, the more problems a finance officer faces in hedging. It all depends upon luck and randomness. Trade in forex, get into currency trading, hedge your position and future cashflows, ultimately, you will fall victim to efficient markets – the markets that work randomly.
However, it is always good to keep an eye on what the company management is doing in terms of hedging –especially the forex trading. It’s better to take pennies as profit by getting into a future contract, instead of sitting with unexpected huge dollar loss exposures! Table of Contents

Insurance Agents, insurance Policies and Commisions

Here is some more good news for people seeking insurance. IRDA is having plans to make insurance agents more accountable for the insurance policies and other investment products they are going to sell to the customers. However, it’s just a news item, and I wish that it should not remain just a news item citing a proposal. Something concrete should be expected and implemented. In the recent past, there have been many proposals, like waiving off the entry load for mutual funds, taking off insurance policies with complex commission structures, and so on. However, nothing concrete has been done till now. One can only wish things are implemented.

However, the following news item reveals some of the bare truths of the world of insurance agents and their commissions.

As per the news items:

Commission structure for insurance agents is set for a major overhaul. In a move that is likely to have far reaching consequences, Insurance and Regulatory Development Authority, IRDA wants to make agents more accountable by linking their commissions to the services offered by them reports CNBC-TV18’s Priyal Guliani.

An insurance advisor earns (on an average) as much as 30% commission in the very first year of selling an insurance policy and subsequent drop in the commission structure to about 7.5% in second and third year, does not attract him enough to continue offering correct services. As a result, more often than not, services of an advisor fail to meet investor’s expectations after the first year. Now the insurance regulator plans to phase out payment of commissions over a longer time frame. It intends to remove the yearly cap set up under the insurance act 1938 and keep the structure flexible based on the service provided by the agent.

This is also to ensure that the discontinuation of insurance policies, which is as high as 60% in the first year and 15% on an average, comes down.

Insurance industry growth rate is riding high on the sale of unit linked insurance products, which attracts as much as 30% commission in the first year itself. Most often, this product rather than being sold as an insurance policy is shown as an investment tool and compared to mutual funds, resulting in its mis-selling and that is the biggest concern of the insurance regulator.

A 10 member committee set up by IRDA in September 2007 to study commission structures is expected to present its report on the last day of this year.

News item Ends:

Now look at that mess – Commission as 60% is offered to Insurance agents in the very first year.

There has to be a reason and some justification for such stupid offers. The reason is that such huge amount of commission is offered to insurance agents to get the investor into buying an insurance policy which locks him for a long term commitment as long as 25-30 years. Moreover, such policies also have hidden clauses and conditions that if the investor discontinues the policy, he will have to suffer a major loss. The end result is that the insurance agents sell to the ignorant customers such policies that do not fit into the customers requirements at all. The only thing that the agents are concerned is to earn the high level of commissions – as high as 60%. The investor is then left with “Hidden conditions” and “his investments are subject to Market Risks”.

Read through the comments left by so many readers about the big amount of premium they are paying towards their insurance policies. So many questions have been posted asking me when is the right time to exit this policy, what is the loss that I will have to bear if I exit this insurance policy now and so on. Even after buying such policies, the investor is no longer aware of the policy details. Yet, we are all there to jump in, on the advice of the “highly educated” and trustworthy agents or in the name of tax-savings. All we end up doing is making a mess of our money in the commissions and end up getting into long term commitment of paying of insurance premiums.

Let me repeat once again - Buy insurance products for Insurance purpose, buy investment products for investments purpose, buy tax-saving products for tax-saving purpose. Do not mix them all.! Table of Contents

Forex trading risk: effect of forex on stock prices

In this article, I will cover the topics like
• how forex rates affect the business of a company
• how force rates effect the economy of a country
• how much risk is there in a business involving forex transactions,
• the risks in forex trading, and in general,
• What an investor should look for while investing in companies having significant dependency on forex

All of us know that it is impossible for any bluechip, mid cap and sometimes even a small cap company to remain shielded from a forex rate change. Not only the IT companies biggies like Infosys, TCS, etc. have significant dependency on forex rates, mid and small level companies also depend on it significantly, though indirectly. For example, a small penny stock like Pentasoft Technologies may be getting contracts from biggies like TCS. So if the work of TCS is affected due to forex rate changes, the billing amount will change and so will the income and earnings of Pentasoft Technologies will be affected. Not only in IT, any export driven industry like textile, leather, etc. will also have significant dependency on forex rates. Also, companies that do not necessarily export, but have significant presence in foreign countries may also be affected. For example, reliance may have refineries in Sudan, Tata Steel after buying Corus is now having major stake on Euro and so on. Ultimately, directly or indirectly, the entire economy is dependent on forex rates.

It’s always better to take an example, which automatically answers many questions. I’m sure many of you might have heard of Freddie Laker. Freddie Laker was the pioneer in coming up with the concept of “No-frill” Airlines, or cheap airline travel without many facilities. If today you can see many no-frill airlines like EasyJet, Ryan Air, Deccan Airlines, etc., which made the air travel accessible to common man, it was Freddie Laker who first came up with this concept, that too between long distance countries UK and the US.

Laker started SkyTrain, a no frill airline that was supposed to fly between the 2 big cities, London in UK and New York in the USA. It was the very first and innovative transatlantic venture, which was supposed to revolutionize the airline industry with the concept of no frill cheap air-tickets, making it affordable to the common man.

So it all began with a big hype. It took years for Laker to get government approval and finally he started off with his first flight in 1977. The way it was supposed to work was as follows:

In the 1970’s the Great British Pound (GBP) to US Dollars (USD) forex rate was low. That meant high value of GBP to that of USD, so for UK tourists planning to visit US, it was cheaper. Hence, there were many tourists from UK who would visit US and SkyTrain targeted these tourists. Moreover, Laker started with 1 aircraft and looking at the great response he got from the tourists, he later purchased 5 more airplanes to expand his business.

The only problem was that these airplanes were purchased on lease and were financed in US dollars.

Everything was going quite well for few years. Somehow, in 1982 –within less than 5 years, the Skytrain Company got bankrupt. Why?

The reason was faulty and costly assumptions that were made.

The business had major dependency on forex rate GBP-USD. It was assumed to remain low or go down further. Instead, contrary to the assumption, it increased. Once the GBP-USD forex rate increased, there were fewer tourists to USA - Simply because it was becoming unaffordable for UK people to pay for high expenses in US. Hence, the no. of tourists travelling from UK to US reduced significantly and the earnings of Skytrain was hit significantly.

But it was not all. It was double-trouble. On the liability side, the Skytrain Company had a major setback. Since the aircrafts used by the airline were taken on lease, and that too in USD loan, it became costly to repay the same amount of money because of the GBP-USD forex rate change.

Hence, the trouble compounded. Less Income in GBP, more repayments in USD. Finally the airline collapsed and declared bankruptcy in 1982 – just within 5 years of operations.

And let’s not forget, that Freddie Laker was considered a business tycoon, a stalwart and was regarded as one of Margaret Thatcher's "golden boys" of industry. Following the successful launch of "Skytrain" in 1977, he was given the honour of “knight” the following year in recognition of his services to the airline industry.

This is what typically happens with such vague and costly assumptions – even big business minds may fail. It took only a year for Dollar to become weaker by 12% as compared to Rupee. The result – 20 lakh people in different export industry sector lost their jobs (official figure). Estimated figure is around 50 lakhs. And when someone in the labour group looses his job, an entire family dependent on him looses the livelihood. We take pride in India Booming and economy surging ahead leaps and bounds – who cares as long as I am getting my MNC salary.

Today, the travel agencies are offering good packages in Rupees for US travel, just because the dollar is cheaper. Just one year back, it was unaffordable for many people and there were no such offers. It all works in market terms. And the sense of market cannot be judged by anyone, as I’ve explained in my previous article on forex trading and how forex rates move.
So the next time you decide to buy shares of a company, just try to get into the fine details of how much forex dependency the company is having. Can it really keep up with the fluctuations in forex rates? Is it using hedging strategies to cover the losses that may occur due to forex risk?
In the next article, I’ll cover the process of hedging and how one can benefit from it. Table of Contents

Weekend Effect on Stock Prices - 2

Continuing further from the first part of this article on Weekend Effect on Stock Prices, here is the second part:

However, the weekend effect has been prominent only in the US & UK stock market along with Japan, while it is completely absent in the other stock markets like Singapore, Malaysia and Philippines.

The case of Japan is an interesting one, because Japan allows Saturday trading during the period of observation of this stock market data. The presence of a strong weekend effect in Japan, which allowed Saturday trading for a portion of the period studies here indicates that there might be a more direct reason for negative returns on Mondays than bad information over the weekend.

Here is something more interesting:
The negative returns on Mondays cannot be justified for a reason of the absence of trading over the weekend. The returns on days following trading holidays, in general, are characterized by positive, not negative, returns – which is completely contradictory to what we observe in case of Monday effect.

Here is a graph showing the returns following the holidays in US – where the weekend effect has been most prominent:

As we can observe from the graph above, the holiday effect has been prominent for positive returns in case of most of the US holidays – except for American Independence day (4th July). The return on 5th July is negative, but still very low compared to the positives that we observe on other days following holidays.

So what can be concluded from these findings and observations?
I really don’t know. The data that is used in the above studies dates back to 1927.
What has happened in the past may not repeat in future. What has happened in USA may not happen in other countries of the world.

Give it a shot – offcourse with your luck. And hope to be lucky! :- )
Table of Contents

Weekend Effect on Stock Prices

-- Along with the January effect on the stock prices, there is another effect that has persisted over long periods and over a number of international markets – called the weekend effect.
It attributes to the differences in returns between Mondays and other days of the week.

-- Over the years of observation of stock market data, returns on Mondays have been consistently lower than returns on other days of the week.

This is also termed as the “Monday effect on stock prices”

Reasons for The Weekend Effect:

􀁑 The Monday effect is really called a weekend effect since the bulk of the negative returns is compensated in the Friday close to Monday open returns. The returns from intraday returns on Monday are not the actual reasons in giving away the negative returns.

􀁑 The Monday effect is far more prominent small stocks than for larger stocks.

􀁑 The Monday effect is eqully worse following three-day weekends than two-day weekends.

􀁑 There are some other reasoning like arguments that the weekend effect is the result of bad news being revealed after the close of trading on Friday and during the weekend. Even if this were a commonly observed case, the return behavior would be inconsistent with a rational market,
since rational investors would build in the expectation of the bad news over the weekend into the price before the weekend, leading to an elimination of the weekend effect. However, this effect can still be observed.

In the next article, let us discuss about the weekend effect in international markets
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Stock Prices: January Effect on Stock Prices

Continuing further from the first part of this article on January Effect on Stock Prices, here is the second part:

A number of detailed explanations have been suggested for the observed January effect,
but few only the following give a reasonable justification:

• Tax loss selling by investors

Taxes are the biggest concern for traders and investors across the world.
In the US, December is end of tax-year. Hence, at the end of the tax-year, there is wide spread selling of the stocks which have 'lost money' to capture the capital gain, driving down the prices, presumably below true value, in December, and a buying back of the same stocks in January, resulting in the high returns.

Then, there is also a “wash sales rules” which prevents an investor from selling and buying back the same stock within 45 days, and there has to be some substitution among the stocks.
Thus investor X sells stock A and investor Y sells stock B, but when it comes time to buy back the stock, investor X buys stock B and investor Y buys stock A.

It will be interesting to note the same effect happening in the month of March to April for countries like India, where the financial year ends in the month of March. Moreover, there is no such rule like “Wash Sales Rule” in India, so traders can keep on betting on the same stocks again and again.

• A second reasoning is that the January effect is related to institutional trading behavior around the turn of the years. It has been noted, for example, that ratio of buys to sells for institutions drops significantly below average in the days before the turn of the year and picks to above average in the months that follow. However, once again to repeat, it has only been observed historically. There is no guarantee that the same will continue further.

• A third and very important Behavioural Aspect that has been observed is due to Christmas and Holiday Season. Since it is festival and holiday time in the US (and other western countries), people need money for spending – either for buying gifts for their loved ones, making new purchases for self and family, or for going on enjoying the holidays. All this results in huge spending and the investors usually try to take the money out of their investments. Hence there is wide spread selling. This again causes stock prices to tumble just before festive season, i.e. early and mid-December. The same investors will again come back in January for putting in fresh money and starting again, hence the January effect predominates.

Not only for USA, the January effect is prominent for other countries as well. Here is the graph showing the historical returns in the month of January as compared to other months for different countries across the globe.

However, all the observation and data dates back to 1927 and is primarily concerned with USA stock markets. It forms an interesting case for other countries like India because firstly, the Indian financial year is different from the US financial year and secondly, the festive season is in October-November (Diwali/Dusshera). So things may be different for stock markets like India.
However, the Indian stock markets are still dominated by FII and other foreign investments, so this effect can be seen in India too.
We are about to enter January, so one may try his luck if he or she wishes - off course at his own risk ! :-)
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Index Fund and ETF Performance

Nickp2 has sent me this data table for the performance of Index Funds.

As clearly visible in the table above, almost all the Index Funds are returning well below their benchmark indices (as low as 5%). This is the risk and problem with Index Funds as compared to ETF.

Andy had also left a similar question about his Index Fund investment, saying that his index fund returns are below the nifty index that his index fund is tracking.

Seems to me that there is a lot of confusion between Index Funds (IF) and Exchange Traded Funds (ETF).
Both are assumed to be the same, however, they are quite different in the way they are created and the way they work.

Ultimately, their performance is also different.

While introduing ETF's and IF's, I have already published an article to differentiate between the Index Funds and Exchange traded funds.
Here is the link to the previous article, comparing index funds and ETFs and the difference between the two, please read it for gettting a clear picture about how index funds are created and how exchange traded fund units are created. Ultimately, their perfomance is different and so are the charges that you pay for them.
The article also gives a table at the end, displaying the amount of money going into various investments. ETF's are growing really faster than Index Funds.

Therefore, go for ETF's as compared to Index Funds. The profit in index funds is eaten up by the fund management charges. Also the time difference in rebalancing the portfolio of Index Fund also makes is a laggard as compared to ETF's.

Hope this article clears all the doubts.

Thanks Nickp2 for the data! Table of Contents

Seasonal Effects on Stock Prices:January Effect

Here is something that might be of great interest to the traders and market-makers who trade on intra-day or weekly basis:

Empirical studies suggest that a variety of seasonal and temporary effects can be observed in the behaviour and movement of stock prices. Among them, the primary ones are:

• The January Effect: Stocks, on average, tend to do much better in January than in any other month of the year.

• The Weekend Effect: Stocks, on average, seem to do much worse on Mondays than on any other day of the week.

• The Mid-day Swoon: Stocks, on average, tend to do much worse in the middle of the trading day than at the beginning and end of the day.

One thing should be noted very well that while these empirical effects are only historical, they atleast provide some basis for traders, However, it is not at all certain whether any of them can be used with 100% accuracy to generate excess profit from stock trading.

In this article, I’ll concentrate only on the January effect and in the later articles, I’ll cover the remaining.

The January Effect in Stock Prices

• Studies of returns in the United States and other major financial stock markets have revealed strong signals in return behavior during different months of the year.
• As observed, Returns in January are significantly higher than returns in any other month of the year. This phenomenon is called the year-end or January effect and it can be traced to the first two weeks in January.

Another interesting observation is that the January effect is found to be much more prominent for small cap stocks or small firms than for larger firms.

As can be observed from the graph of the figure above, the monthly returns in the month of January have been significantly higher. However, the data used dates back to 1927 and hence conclusion can be drawn from the above chart for trading only based upon your risk taking responsibility.

In the next article, let's discuss about the explanations, reasoning and whether and how to benefit from such an effect.
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Trading Strategies (Short Term): Filter Rule

In this article, I will explain one of the trading strategies that is attempted by traders to benefit from the price movements of the stocks.

This trading strategy is called the “Filter Rule” and falls under the so-called serial correlation strategy.

In a filter rule, an investor gets into a buying position i.e. buys a stock if the price rises X% from a previous low of the stock and then holds the stock until the stock price reaches to below X% from a previous high. The magnitude of the change (X%) that triggers the trades varies from filter to filter depending upon the value of X selected by the trader. However, smaller changes result in more transactions per period and higher transactions costs.

The simple assumptions that are followed in this trading strategy are:
Price changes are serially correlated and that emerges from price momentum theory, i.e., stocks which have gone up strongly in the past are more likely to keep going up than go down.

The following table summarizes results from a study on returns, before and after transactions costs, on a trading strategy based upon filter rules ranging from 0.5% to 20%. ( A 1% rule implies that a stock is bought when it rises 1% from a previous low and sold when it falls 1% from a prior high.)
(Table based upon empirical results available in various books and internet)

Results and interpretations of Table above:

􀁑 The one and only filter value that beats the returns from the buy and hold
strategy is the 0.5% value, but it does so before transactions costs.
This strategy creates 12,514 trades during the period which generate
enough transactions costs to wipe out the principal invested by the
􀁑 While this test is dated, it also illustrates a basic problem with
strategies that require frequent short term trading. Even though
these strategies may earn excess returns prior to transactions costs,
adjusting for these costs can nullify the returns completely.

So in conclusion, this strategy may work provided each time your bets are good. However, a good and justified way of making money from this strategy is through efficient money management. Try and attempt to double and triple your bets if the previous one goes wrong, and look for opportunities. Then and only then this strategy may give some fruitful results. Remember, be ready to get wiped off completely, and be prepared with big money if following this strategy.

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Forex Currency Trading: How forex rates are determined?–1

Since last one year, the dollar is consistently weakening, not only against the rupee but also with the other currencies in the world. Hence, the rupee is getting stronger. Ultimately, you get fewer rupees for every dollar as compared to what you use to get 1 year before. Just one year back, every dollar use to give 45 Rs. Today, every dollar is only worth 39 Rs. What changes the forex rates and how the forex rates are determined?

In this article, I will try to answer some such questions.

Though there are various theories that explain about how foreign exchange rates are determined, the simplest approach at the root level is the “Purchasing Power Parity”.

Suppose that a basic ingredient of food, like a Potato, may cost 20 Rs. for a kilo in India. And, the same 1 kg potato may cost half a dollar in USA. Hence, for the same quantity of a commodity of purchase, the values in 2 different currencies should have equal purchasing power.
Therefore, by simple mathematics,
20 Rs = ½ dollars
=> 1 dollar = 40 Rs.

The above is the root cause explanation of the movement of forex rates. It again relates to the efficient market hypothesis. If say, that potatoes are available for only Rs. 10 a kilo in India, while in US, they are available for 1 dollar a kilo. Hence, people will start buying cheaper potatoes from India instead from US. Ultimately, a time will come when the Indian Rupee valued potatoes will rise in price, so that they are at a justified level with respect to the dollar. Then equilibrium will be reached.

However, though the above example looks simple to understand, but the forex market does not work that simply (like with potatoes). Along with potatoes, there are hundreds or thousands of several other commodities that determine the trade between 2 countries. Secondly, one commodity may be a necessity in one country, while useless in other. For example, an air cooler is required in hot weather of Rajasthan, but not in New York. The world looks at Vietnam for pepper production, at Australia and South Africa for Gold, at Middle East and Nigeria for Oil. Hence, it all depends upon the trading activities and the price of forex money keeps moving so that the trade deficit is compensated for.
Thirdly, the world is an open market – not just between 2 countries. Coffee is a major produce of Brazil, China as well as India. However, coffee is required all over the world. Hence, the market rates of coffee are determined in open markets where major countries compete, which again ultimately depends upon the forex rates. It’s a recursive process - The rates of commodities forces the forex prices, and the forex rates move the commodity prices, and the cycle continues but not necessarily in that order. It depends upon the demand and supply curve of all the commodities, currencies and how the economy is performing. Ultimately, RANDOMNESS RULES.

More reasons for Forex prices to move: Continue to Part II

Forex Currency Trading: How forex rates are determined?–2

This is part II of the article Forex Currency Trading: How forex rates are determined?– I. Please read the first part before proceeding with this one

Another reason for forex rates to move is due to interest rates. Suppose that in Europe, the interest rates are at 4% per annum, while in India, the interest rates are 10%. What will happen on the investments front?

People from Europe (including fund managers, FII, investors) will rush to India and start investing in Indian fixed income products like Bonds, etc. (provided they are convinced about the stability of the country and good returns). This will create a big demand for Indian Rupee, because Indian investments can be made in rupees only. Hence, the forex rates will start changing, so as to accommodate for this demand and supply. The Indian rupee will start becoming stronger as compared to European euro, and the process will continue.

The government of India, the RBI is struggling with this problem at present. The rates in US are at record low – another cut of atleast 25 basis point is expected by today evening. But the interest rates in India are high. So there is a big inflow of dollar in India, which is creating a big demand for Indian rupee and hence the rupee is getting stronger.
The government can as well cut the interest rates, but that will affect lots of economic factors and prices of other basic commodities and primarily, the inflation. Hence, the equilibrium is established automatically by the market factors, the demand and supply of commodities, the interest rates, the inflation and other market forces.

Can anyone predict anything about the future? Atleast I would not claim anything. Right from the prices of commodities, the production of commodities which ultimately depends upon the weather conditions, the government stability and its rise and fall, the interest rates, the entire market and the investors confidence and behaviour. Hundreds of thousands of factors play a role in forex price determination. No body can be certain about anything.

Forex market is said to be the most active market across the globe. It is the only market in the world that runs 24 hours non-stop. Share markets have their timings, bond markets have their timings, but forex markets never sleep. I was in Mumbai last year with a friend of mine who trades in Australian dollars and US dollars for a big investment bank. At 2:30 at night, he got a call from US counterpart, about a possible political issue in Australia. Immediately, he rushed to his office to check his holdings in Australian dollars. Later, the news appeared to be rumour and he returned at 5:30 am, just to return back to the office at 8:30 am. This is what is called the real dynamic market!

All one can do is make a short term prediction for movement of forex rates. It is very easy for me to say “Dollar Rupee will remain in the 39-41 range during this month.” Making long term predictions is difficult.

India has already lost 20 lakh jobs in the different export sectors due to dollar rising – this is the official figure. The unofficial figure can be as high as 50 lakhs. And an export worker loosing the job means a low income family being deprived of its livelihood.

Till last year, IT companies use to make the index like Sensex run. This year, they have pulled it down significantly. Infy trading at 2100 levels touched lows of 1550 – a clear loss of 25%. All courtesy of the Dollar rupee exchange rate. No one can predict the rates and its impact in the long run. All one can do is keep making bets with one’s assumptions and speculations. If you ask me where is the dollar rupee rate headed, my answer would be “I don’t know”. If you want to listen what will make you feel happy, then there are thousands of “investment advisors” and “business experts” waiting to serve you.
Here is an example of how forex rate change collapsed a company, which was run by a noted business tycoon! Table of Contents

Job Fair in China

Some images from a JOB FAIR in CHINA.
We feel proud to be the Outsourcing Hub of the world! The Dragon is waiting!

Employee stock options plan (ESOP): Should you opt?– 1

Now-a-days, offering Employee stock options plan (ESOP) is a common way for companies to try and make lucrative offers to hire and retain employees. The simple reasoning that is given behind offering ESOP is that “You perform better, so the company does well, hence you get better salary and the return on stock options is also improved. Hence, Employees drive their own productivity and take their own share from it .” All sounds well and good, but are ESOP really worth buying?

Now, I’m not going to get into the controversial issues on calculation of taxes like Fringe benefit tax and other stuff. Let us look at ESOP from an investment perspective. I will attempt to answer the questions like:

How employee stock option plan works?
Should I invest in employee stock option plan?
What are the risks in employee stock option plan?

So you work for a reputed company listed on the world renowned stock exchange like NASDAQ or NYSE. As a part of your job offer, you are given the option to buy “Employee stock option” at a specified price and the option maturity can be anything from 1 year to 5 year – meaning that it will take that much time before you could reap the benefits of your employee stock option plan.

Let’s say that on certain parameters like salary and designation, you are offered an option to buy 100 shares of your organization, 2 years down the line, at a price of $ 24 each.

You look at the offer, and you decide to opt for it. What happens next?

For next 2 years, each month some portion of your money will be deducted from your salary in the name of “purchase of stock options”. In the above example, you decide to buy 100 shares at price of $24 each, so the total cost will be $2400. So, over the next 2 years, or 24 months, an amount of $100 will be deducted from your salary and be credited towards your “Employee stock option plan”. This process will go on for 2 years or 24 months, making it a total of 24 months * $ 100 = $2400. In case your company is listed in USA and you are working in India, and equivalent of $100 will be deducted based upon the $-Re forex conversion.

So what happens after the maturity duration of 24 months?

At the end of maturity, the market price is looked at.

If the market price of your company stock is equal to or less than $ 24 (your offer price of employee stock option plan), then nothing happens in terms of returns. You get back your $2400 without any returns on it.

If the market price of your company stock is more than $ 24 (your offer price of employee stock option plan), then you get the returns. Suppose the stock price has reached $30, so you get back your $2400 plus ($30-$24 = $6) per share as profit, totaling to $600 as net profit in this two years time.

Hence, overall, you don’t loose anything. It’s either you get back your principle amount back without any returns OR you get back your principle as well as returns – based upon what is the market price of stock at the end of maturity with respect to the offer price of the stock option.

The working of “Employee stock option” can be displayed in the following graph (RED line):

If the market price of stock goes above the offer price of $24, you make a positive profit – which grows linearly as the stock price moves ahead (the slanted red line above $24).
If it remains below $24, you make ZERO profit, i.e. you don’t loose anything (the flat Red line below $24)

Hence, it is a safe bet. If the price is higher than offer price, you get the profit as the difference between the current market price and your offer price. Otherwise, you get your money back.

But is it so really safe to buy Employee stock option?
Continue to Part II

Employee stock options plan (ESOP): Should you opt?– 2

This is part II of the article Employee stock options plan (ESOP): Should you opt?– I. Please read the first part before proceeding with this one

But is it so really safe to buy Employee stock option?

First thing: What appears to be ZERO loss or NO loss situation, in case the stock price remains below $24, is not necessarily a ZERO loss. Remember, when you are buying a stock option, then you are giving a 2 year long commitment to the organization to deduct the salary and keep it with the organization. What if you decide to switch the job after 1 year? There will be complex terms and conditions mentioned for this case.

Secondly, It comes as a cost. If you invest this money elsewhere, you may make better returns or save tax if you invest in tax saving instruments. Maybe your organization offers to keep your money in recurring deposit accounts, but there can be better return offering instruments. Hence there is an opportunity cost of capital with ESOP investments.

Thirdly, your take home salary will come down.

Fourth (and the most important one), you are at a real big risk by putting all the eggs in one basket. The risk of perfect correlation!
You work for a company. You get your salary from it. As long as the company does well, you will keep on getting good pay. At the same time, the stock price will also either remain stable or grow. You will GAIN on both fronts.
However, if things start to go bad, then everything will start going down simultaneously. Your salary will not rise or might even go down. The stock prices will also start tumbling down. You will LOOSE on both fronts.

While signing up for ESOPs, employees usually look only at the goody-goody picture. The management also tells them all great phrases – “As an ESOP holder, you will be a partner in company”, “Your rewards will be linked to your performance”, “You are an excellent performer, and hence your performance will enhance company’s results and productivity, driving the stock prices. You will benefit from it by holding ESOP”.
However, what we tend to ignore is the risk part.

Take the example of US based automobile companies. Employees of companies like GM were fired from jobs mercilessly. The same employees were also holding stock options of their employer companies. Due to job cuts, markets took it as a negative signal and the stock prices went down significantly. The employees first faced with salary cuts, later not only lost their jobs but also lost on their ESOPs. Though it is claimed that the money in ESOP is safe, it comes at a cost. Investing in ESOP means cutting your present take home salary for PROBABLE future gains – which may or may not come.

Take the case of Indian IT companies. Companies like Infosys initially trading at 2100+ range are now down to 1550 – a clear case of 25% reduction in stock price. Employees are now being hit hard with the appreciating Rupee Dollar forex rate. They are now expected to work for more hours, cannot expect any major hike in salary and at the same time their stock options may now be worthless.

Usually I don’t give a clear cut verdict on any investment instrument. But for ESOP, my verdict is a CLEAR NO. Never opt for ESOPs. Instead, invest in other sector instruments which are different from your field of job. If working for automobile, invest in IT or Utilities, if working for IT, invest in automobile, Utilities or other sectors.

ESOP is usually long dated investment requiring commitment. One may also think of going for tax-saving instruments or ETF or Index funds in the long run. But ESOP – a clear NO NO.
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Islamic Mutual Funds: Sharia Mutual Funds

Recently, there has been a big hike in Islamic banking and Islamic investment instruments and financial products.
Along with US, UK, Middle East and Europe, India too is expected to catch up soon with financial products that comply with Islamic principles of money management and investments.

In this article, I will try to cover the basic principles behind the Islamic financial instruments and their working. A good example of "How Islamic Mortgage Work?" is available here (Opens in a new window)

As per the Islamic laws, charging interest on any transaction is illegal This forms the basis of Islamic investments and mortgages. Hence, it becomes difficult for Muslims to take up loans like home loan, mortgage or any other financial transactions, if they have to strictly comply with their religious faith and Shariyat laws.

Sharia scholars on the council prohibit investments in businesses that charge interest or have a debt ratio greater than a third of their assets. Industrial companies that have financing units, such as Ford Motor Co. and General Electric Co., are among those failing the test. Hence, no investments can be made in these companies. Banking is not the sector for Islamic investments, unless it is an Islamic bank working on Islamic principles.

The Islamic mutual funds also can't invest in companies that generate operating income from un-Islamic activities, including pork processing, tobacco, liquor, pornography and gambling operations. That takes away big companies like Benson and Hedges, Liquor companies, lot of online website companies, etc.

Typically, they end up investing in Energy stocks, like Exxon Mobil and BP, Utilities companies such as FPL Group Inc., textile stocks, etc.

Luckily for moneyed Muslims, there are a number of Islamic Financial Institutions (IFFs) out there catering to the needs of the devout. Over 250 of them to be exact managing funds totalling more than $300 billion (as per data for 2006). And with more and more Muslims interested in pious repositories for their assets, even financial institutions in the West are getting into the act.

According to the Koran, trade is allowed but not interest. Thus Muslims are forbidden from paying or earning interest on their investments and Islamic banks cannot lend their money in the form of credit. Furthermore Muslims cannot invest in companies counter to their religious beliefs, such as those involved in alcohol or gambling, pork products, pornography, or armaments.

The world market is fast growing in for the Islamic Mutual funds and investments. Middle-east has been the front runner in the race to launch the Islamic investment products and funds, but US and Europe did not take much time to identify the opportunity and join the race. The world is already full of financial products and investment instruments that fulfill the Islamic laws of investment.

Not only across the globe, Indian markets are also fast developing such funds. Recent hype in Indian financial industry has led the mutual fund management companies to look into the money management industry complying with Islamic principles, because they know very well that India houses the second largest muslim population in the world (just after Indonesia). Millions of Muslims are still not betting their money in financial instruments just because their working does not comply with their religious faith.

Coming to the returns from such funds, the same concept applies here. Since these kind of funds are restricted to a set of industry sectors, their performance depends upon how the sectors and their stocks have performed. There is no guarantee of anything.
Be prepared to see loads of funds coming in the market very soon.

Arbitrage Trading: Example, Introduction, Overview-1

In this article, I will attempt to introduce the concept of “Arbitrage Trading”

What is Arbitrage Trading? How does arbitrage trading works? How to make profit from Arbitrage Trading? What are the risks with Arbitrage Trading?

Arbitrage trading literally means “Risk Free Profit” . A similar concept can be extended as “Free Lunch” or “Free Money Making Machine”.
Across the globe, traders and market makers attempt to get this risk free profit while attempting to do arbitrage trading.

Let’s take an example:
Let’s say a stock XYZ is listed on 2 stock exchanges: NASDAQ as well as NYSE (Same like Reliance is listed both on NSE and BSE).

So as an arbitrage trader, I attempt to benefit from the stock price difference between the two stock exchanges for the same XYZ stock. Let’s say the XYZ stock is trading at $20 on NASDAQ, and at the same moment, the price at NYSE for XYZ is $20.50. Hence, I spot this price difference, and buy XYZ stock on the exchange where it is available for cheap, and immediately sell it at the exchange where it is costlier.

In the above example, I’ll buy 100 shares of XYZ on NASDAQ with a BUY price of $20 and immediately sell 100 shares at NYSE for $20.5. Hence, in the process (if everything goes well), I make $0.5 per share, or 100 shares * $0.5 = $50 on the trade, within less than a minute.

So, at the end of this exercise, I will have ZERO position in XYZ stocks, i.e. RISK FREE (as I’m not holding anything), and still I make a profit – that’s why RISK FREE PROFIT or ARBITRAGE TRADING.

One of the major reasons for stock prices to move with every single tick of time is because of arbitrage trading. Traders and market makers across the globe keep on continuously buying and selling stocks on one or two exchanges, attempting to get the benefit of price difference. This leads to price change and very high level of volatility in prices of stocks that are traded heavily.

So at the end of the day, if you see a volume of 10 million shares of Reliance stock being traded, then it is possible that a single trader may have bought 1 million shares on NSE and immediately sold them on BSE for a better price – causing a total of 2 million shares to be traded. However, he is having ZERO position at the end.

Interestingly, though traders and market makers across the globe keep on attempting to go for arbitrage trading, they sometimes fail miserably.

The risks involved in Arbitrage trading is no less. One has to simultaneously BUY and SELL.
What if your BUY order gets executed, and your SELL order does not? You end up sitting on a very big number of shares.
Then, what if your SELL order gets executed, but the BUY order does not? At the end of the day, you will be forced to close your position by buying at a higher price – which will result in a big loss.
What if your BUY order for 100 shares was executed, but the SELL order was executed only for 50 shares?

Continue to Part II: How to beat risk in Arbitrage Trading?

Arbitrage Trading: Example, Introduction, Overview-2

This is part II of the article: Arbitrage Trading: Example, Introduction, Overview-I. Please start with this first part before continuing with this one.

A simple way to beat the failure in arbitrage trading is to go for effective capital management and keep on doubling your bets if your buy decision goes wrong. However, there has been no sure shot model through which risk-free profit can be made. Ultimately, Arbitrage Trading is nothing but BETTING.

Computers have been used to directly trade using algorithms, using capital management concepts - yet till date - all these algorithms have resulted in big failures.

Take this case; Royal Dutch SHELL (a Holland based Oil company) is listed on both London stock exchange and Amsterdam stock exchange. As a part of my job, I was attempting to test if arbitrage opportunities exist between LSE and AEX.

There were some problems identified firsthand:
• London is one hour behind Amsterdam, so time difference factor had to be considered for pre market, post market and overlapping market timings.
• LSE trades in Pounds, while AEX trades in Euros, hence tick by tick data for forex should also be taken into consideration

Ultimately, after a long running effort, the algorithm was designed, tested and the back-testing showed that it is resulting in very very profitable results.
All set to go, the model was installed with live data feed and we were hoping that the computer will make billions for us, but within 3 hours it wiped off all our capital. Another few weeks we continued modifying the algorithm and testing with live feed from stock markets – it was profitable sometimes; and equally bad, it was in loss same no. of times.
What was hurting the model was the transaction costs. Unfortunately, we could not generate any realizable profitable gains – contrary to the success on historical data, the model was just not able to understand the market scenario. We kept on testing it over a long period of time, ultimately, it was sent to the “Recycle Bin”.

There has been no model in the history of stock markets which has managed to give a consistent and good Risk free return. That was the reason I’d questioned the Quant based “Lotus India Agile Fund” in my review.

The case of ETF is an interesting one. One of the readers had asked “If ETFs are the best bet in the market, why should anyone sell it?”. The reason is “Arbitrage Trading”.

The organizations which issue ETF’s buy the underlying stocks listed in the indices – that too in big number. Hence, they have a net positive position in terms of stocks. To offload that, they issue (or sell) ETF units, at a slightly higher price. Hence, their position is secure, because they do not have any net position, and yet they make decent profits. Ultimately, they have to keep an eye on Index changes, and consolidate their positions accordingly.

Can we individuals benefit from arbitrage trading?
YES – if you take up a fulltime traders job, and keep a constant eye on every single price change in the market hours. At the same time, you should also have big amount of money to play around with and ability to get wiped off completely. And yes, the LUCK factor – because MARKETS ARE EFFICIENT and RANDOMNESS RULES.

One may try his luck if he wishes

Strategies of Financial investment experts

This is an email forward I received. Don’t mean any offence to anyone but I just enjoyed it – Hope you all will do it too :- ))

A young and pretty lady posted this on a online popular forum:

Title: What should I do to marry a rich guy?

I'm going to be honest of what I'm going to say here. I'm 25 this year.
I'm very pretty, have style and good taste. I wish to marry a guy with $500k annual salary or above. You might say that I'm greedy, but an annual salary of $1M is considered only as middle class in New York. My requirement is not high. Is there anyone in this forum who has an income of $500k annual salary? Are you all married? I wanted to ask: what should I do to marry rich persons like you? Among those I've dated, the richest is $250k annual income, and it seems that this is my upper limit. If someone is going to move into high cost residential area on
the west of New York City Garden (?), $250k annual income is not enough.

I'm here humbly to ask a few questions:
1) Where do most rich bachelors hang out? (Please list down the names and addresses of bars, restaurant, gym)
2) Which age group should I target?
3) Why most wives of the riches is only average-looking? I've met a few girls who doesn't have looks and are not interesting, but they are able to marry rich guys
4) How do you decide who can be your wife, and who can only be
your girlfriend? (my target now is to get married)

Ms. Pretty

Here's a reply from a Wall Street Financial trader:

Dear Ms. Pretty,

I have read your post with great interest. Guess there are lots of girls
out there who have similar questions like yours. Please allow me to
analyze your situation as a professional investor.
My annual income is more than $500k, which meets your requirement, so I hope everyone believes that I’m not wasting time here. From the standpoint of a business person, it is a bad decision to marry you. The answer is very
simple, so let me explain. Put the details aside, what you're trying to
do is an exchange of "beauty" and "money": Person A provides beauty, and
Person B pays for it, fair and square. However, there’s a deadly
problem here, your beauty will fade, but my money will not be gone
without any good reason. The fact is, my income might increase from
year to year, but you can't be prettier year after year. Hence from the
viewpoint of financial strategies, I am an appreciation asset, and you are a
depreciation asset. It's not just normal depreciation, but exponential
depreciation. If that is your only asset, your value will be much
worried 10 years later.

By the terms we use in Wall Street, every trading has a position, dating
with you is also a "trading position". If the trade value dropped we
will sell it and it is not a good idea to keep it for long term - same
goes with the marriage that you wanted. It might be cruel to say this,
but in order to make a wiser decision any assets with great depreciation
value will be sold or "leased". Anyone with over $500k annual income
is not a fool; we would only date you, but will not marry you. I would
advice that you forget looking for any clues to marry a rich guy. And by
the way, you could make yourself to become a rich person with $500k
annual income. This has better chance than finding a rich fool.

Hope this reply helps. If you are interested in "leasing" services, do
contact me…
A Wall Street Big Firm Trader

Trading and Investment for beginners

Recently saw the movie “Om Shanti Om”. Not sure how many of you liked it, but to me it was a clear cut example of “How to make a complete mess of a classic movie called Karz”.

Interestingly, every single item of it was copied ditto from the Rishi Kapoor starrer KARZ. Yet, the producer of Karz, Subhash Ghai, appeared in this copied version. Right from Cricket Matches to TV Reality shows, the actor, actress, producer, director, everyone whole heartedly attempted to promote the movie at every stage.

Despite being a ditto copied version, the movie managed to reap profits. Even people like me who are critics and hate such copied attempts, watched the movies in costly multiplexes, spent a big amount of money on tickets, another big amount on costly pop-corns and parking fee at multiplexes, just to discover that the movie is too hopeless.

Even the ever repeated dialogue was copied from the famous book “The Alchemist” – “If you dream of something, the entire universe conspires to attempt to make it meet with you”

Now the producer, director, actor and all knew that the movie is copied – maybe they had the idea of improving the old classic. But the fact is that it was targeted towards the younger generation of audience, who may have not seen the original. People who have seen the original movie would know that the latest one would no where stand in front of the old classic.

The same thing goes on in the financial world. Every month, a new set of young guns start earning. After some time, when they get sufficient money and savings, they start pondering about what to do with it? Shop, Eat, Celebrate? The question finally leads them to the stock market. Everyone believes that they are there to make money, and it is only the risk taking ability that brave hearts like them need to develop, so that their profits keep on increasing.

The agents, like the film promoters, are there to (mis)guide them. They can open demat accounts for them, assist them with their valuable investment advice and keep collecting their brokerage.

If the person is lucky, he makes profit. It usually takes him a long time to discover what is good and if he is in real profit or not. By the time he discovers it, the broker has collected a big amount of profit from him. It is only then this person realizes that the best ways to invest in into index fund or Exchange Traded funds (ETFs), or an alternative is to be LUCKY with you stock picking skills.

Someone asked me in my previous post that if Index funds are the most efficient alternatives, then why is everyone not investing only in Index funds? To understand this, one should understand how the ETF’s and Index funds are brought into the market. Some details are covered in these articles: ETF and this article

The people who are issuing (selling) ETF shares are the ones who are actually buying the shares of the constituent companies. They do it in large numbers, so they get the shares for cheap. They then create the ETF or Index fund units and sell it in the open market for a bit higher price. Since they trade in huge volumes, they make decent profits.

Unfortunately, as long as the newcomers will keep entering the stock markets with their novice level of knowledge, they will continue to be living under the false impression of stock picking skills and money making strategies. In the long run, one can only be lucky or he will later discover that what he has been doing was not worth as compared to the indices.

Be it a movie, or a cricket match or a casino or even betting on horses and dogs (in western countries), the world is full of examples where newcomers join the stream with a hope to make money – but all meet the same fate in the long run. The sooner we realize our luck and limitations, the better!

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