Have you ever felt that a stock was intrinsically over-valued? That the profits and the quality of the company made it worth a lot less as compared to what the market thinks?
Have you ever been a “stockpicker” and carefully sold a stock based on a sense that it was worth less than the market price?
A person who feels like this takes a short position on the cash market. While doing this, he faces two kinds of risks:
1. His understanding can be wrong, and the company is really worth more than the market price; or,
2. The entire market moves against him and generates losses even though the underlying idea was correct.
The second outcome happens all the time. A person may sell Reliance at Rs.190 thinking that Reliance would announce poor results and the stock price would fall.
A few days later, Nifty rises, so he makes losses, even if his intrinsic understanding of Reliance was correct.
There is a peculiar problem here. Every sell position on a stock is simultaneously a sell position on Nifty.
This is because a SHORT RELIANCE position generally gains if Nifty falls and generally loses if Nifty rises. In this sense, a SHORT RELIANCE position is not a focused play on the valuation of Reliance. It carries a SHORT NIFTY position along with it, as incidental baggage.
The stockpicker may be thinking he wants to be SHORT RELIANCE, but a short position on Reliance on the market effectively forces him to be SHORT RELIANCE + SHORT NIFTY.
• Those who are bearish about the index should just sell nifty futures; they need not trade individual stocks.
• Those who are bearish about RELIANCE do wrong by carrying along a short position on Nifty as well.
There is a simple way out. Every time you adopt a short position on a stock, you should buy some amount of Nifty futures. This offsets the hidden Nifty exposure that is inside every short–stock position. Once this is done, you will have a position which is purely about the performance of the stock. The position SHORT RELIANCE + LONG NIFTY is a pure play on the value of RELIANCE, without any extra risk from fluctuations of the market index.
How do we actually do this?
1. We need to know the “beta” of the stock, i.e. the average impact of a 1% move in Nifty upon the stock. If betas are not known, it is generally safe to assume the beta is 1. Suppose we take WIPRO, where the beta is 1.2, and suppose we have a SHORT WIPRO position of Rs.200,000.
2. The size of the position that we need on the index futures market, to completely remove the hidden Nifty exposure, is 1.2 *¨ 200,000, i.e. Rs.240,000.
3. Suppose Nifty is at 1200, and the market lot on the futures market is 200. Hence each market lot of Nifty is Rs.240,000. To long Rs.240,000 of Nifty we need to buy one market lot.
4. We buy one market lot of Nifty (200 nifties) to get the position:
SHORT WIPRO Rs.200, 000, LONG NIFTY Rs.240,000
This position will be essentially immune to fluctuations of Nifty. The profits/losses position will fully reflect price changes intrinsic to WIPRO, hence only successful forecasts about WIPRO will benefit from this position. Returns on the position will be roughly neutral to movements of Nifty.
Have you ever been a “stockpicker” and carefully sold a stock based on a sense that it was worth less than the market price?
A person who feels like this takes a short position on the cash market. While doing this, he faces two kinds of risks:
1. His understanding can be wrong, and the company is really worth more than the market price; or,
2. The entire market moves against him and generates losses even though the underlying idea was correct.
The second outcome happens all the time. A person may sell Reliance at Rs.190 thinking that Reliance would announce poor results and the stock price would fall.
A few days later, Nifty rises, so he makes losses, even if his intrinsic understanding of Reliance was correct.
There is a peculiar problem here. Every sell position on a stock is simultaneously a sell position on Nifty.
This is because a SHORT RELIANCE position generally gains if Nifty falls and generally loses if Nifty rises. In this sense, a SHORT RELIANCE position is not a focused play on the valuation of Reliance. It carries a SHORT NIFTY position along with it, as incidental baggage.
The stockpicker may be thinking he wants to be SHORT RELIANCE, but a short position on Reliance on the market effectively forces him to be SHORT RELIANCE + SHORT NIFTY.
• Those who are bearish about the index should just sell nifty futures; they need not trade individual stocks.
• Those who are bearish about RELIANCE do wrong by carrying along a short position on Nifty as well.
There is a simple way out. Every time you adopt a short position on a stock, you should buy some amount of Nifty futures. This offsets the hidden Nifty exposure that is inside every short–stock position. Once this is done, you will have a position which is purely about the performance of the stock. The position SHORT RELIANCE + LONG NIFTY is a pure play on the value of RELIANCE, without any extra risk from fluctuations of the market index.
How do we actually do this?
1. We need to know the “beta” of the stock, i.e. the average impact of a 1% move in Nifty upon the stock. If betas are not known, it is generally safe to assume the beta is 1. Suppose we take WIPRO, where the beta is 1.2, and suppose we have a SHORT WIPRO position of Rs.200,000.
2. The size of the position that we need on the index futures market, to completely remove the hidden Nifty exposure, is 1.2 *¨ 200,000, i.e. Rs.240,000.
3. Suppose Nifty is at 1200, and the market lot on the futures market is 200. Hence each market lot of Nifty is Rs.240,000. To long Rs.240,000 of Nifty we need to buy one market lot.
4. We buy one market lot of Nifty (200 nifties) to get the position:
SHORT WIPRO Rs.200, 000, LONG NIFTY Rs.240,000
This position will be essentially immune to fluctuations of Nifty. The profits/losses position will fully reflect price changes intrinsic to WIPRO, hence only successful forecasts about WIPRO will benefit from this position. Returns on the position will be roughly neutral to movements of Nifty.