Learnings from the stock market

With the introduction of index options, the derivatives market is all set to shift to a multi-product environment from a single-product market. Options like futures are leveraged products used by participants to manage the risk in the underlying market. Many people perceive options to be very risky. Debacles like the Barings episode are responsible for this misconception.

At this juncture, when options are being introduced in the Indian capital market, it would be prudent to understand what happened in the Barings case to prevent similar incidents from occurring here.
The episode
The man behind the widely-reported debacle, Nicholas Leeson, had an established track record of being a savvy operator in the derivatives market and was the darling of the top management at the Barings headquarters in London.
As head of derivatives trading, Leeson was responsible for both the trading and clearing functions of Barings Futures Singapore (BFS), a subsidiary of London-based Barings Plc.
Leeson engaged himself in proprietary trading on the Japanese stock exchange index Nikkei 225. He operated simultaneously on the Singapore Exchange – Derivatives Trading Ltd., (SGX – DT) (erstwhile Singapore International Monetary Exchange, SIMEX), Singapore and Osaka Securities Exchange (OSE), Japan in Nikkei 225 futures and options.
A major part of Leeson's trading strategy involved the sale of options on the Nikkei 225 index futures contracts. He sold a large number of option straddles (a strategy that involves simultaneous sale of both call and put options) on Nikkei 225 index futures.
Without going into the intricacies, it may be understood that straddle results in a loss, if the market moves in either direction (up or down) drastically. His strategy amounted to a bet that the Japanese stock market would neither fall nor rise substantially.
But events took an unexpected and dramatic turn. The news of a killer earthquake in Kobe sent the Japanese stock markets tumbling. The futures on the Nikkei 225 started declining and Leeson's straddle position started incurring losses.
Desperate to make some profit from his straddles, he started supporting the index by building up extraordinarily huge long positions in Nikkei 225 futures on both exchanges - SGX – DT and OSE.
However, the Barings management was made to understand that Leeson was trying to arbitrage between the SGX-DT and OSE with the Nikkei 225 index futures.
When OSE authorities warned Leeson about his huge long positions on the exchange in Nikkei 225 futures, the trader claimed that he had built up exactly the opposite positions in the Nikkei 225 on SGX - DT. He wanted to suggest that if his positions in the Nikkei 225 at the OSE suffered losses, they would be made up by the profits by his position in the SGX - DT.
A similar impression was given to SGX - DT authorities, when they inquired about Leeson's positions. While Leeson misled both exchanges with wrong information, neither exchanges bothered to cross-check the trader's positions on the other exchanges because they were competing for the same business.
Both exchanges were more concerned about protecting their financial integrity and in doing so, allowed the continuation of the exceptionally-large positions of Leeson after securing adequate margins.
We all know the consequences. A single operator couldn't take the market in the desired direction and the market crashed drastically.
Consequently, Barings registered losses on Leeson's futures and straddle positions. But, we must note that the flames of the Leeson disaster did not singe the financial integrity of either market. This was because the markets were protected with proper margins.
The lessons
A single operator can't move the market: Leeson was trying to drive up prices by buying index futures on the Nikkei 225 but could not succeed as the market was gripped by pessimism emanating from the devastating Kobe earthquake.
The point is that, a single operator cannot change the direction of the market and it is always prudent to live with the market movement strategically. In this instance, a better strategy for Leeson would have been the dynamic management of his portfolio.
For example, with the falling value of the index, his put leg of the straddle started incurring losses (call was to expire worthless), and he had the choice to square his put options off at the pre-determined level (cut-off loss strategy).
But Leeson, instead of squaring off his short put option position, chose to support the index price by buying futures on the Nikkei 225 and failed.
Traders should have clearly defined and well-communicated position limits: Position limits mean the limits set by top management for each trader in the trading organisation. These limits are defined in various forms with regard to product, market or trader's total market exposure etc.
Any laxity on this front may result in unbearable consequences to the trading organisation. These limits should be clearly defined and well communicated to all traders in the organisation.
Meticulous monitoring of position limits is a must: We may note that Leeson, too, had position limits set by top management, but, he exceeded all of them.
This attempt at crossing limits did not come to the notice of the top brass at Barings as Leeson himself was in charge of supervising back office operations at BFS.
It is understood that he had sent fictitious reports about his trading activities to the Barings' headquarters in London. Had the top management been aware of the real situation, the disaster could probably have been avoided.
Therefore, scrupulous monitoring of the position limits is as important as setting them. The top management's job of monitoring the positions of each dealer in the dealing room may be facilitated by bifurcating the front and back office operations.
Different people should be in charge of front and back-office operations so that any exposure by dealers, over and above the limits set, can be detected immediately. It means having proper checks and balances at various levels to ensure that everyone in the organisation has the disciplinary approach and works within set limits.
In fact, trading systems should be capable enough to automatically disallow traders any increase in exposures as soon as they touch pre-determined limits.
Exchanges should compete professionally: Both the competing exchanges, SGX – DT and OSE, were unconcerned about checking Barings' position at the other exchange.
While both the exchanges were safeguarded through margins, people must appreciate the fact that the effect of a big failure like Barings goes much beyond the financial integrity of a system.
The point to be noted is that exchanges can compete, but at the same time, must co-operate and share information. It could also help in deterring efforts at price manipulation.
Big institutions are as prone to risk as individuals: One broad issue from an overall market perspective is that big institutions are as prone to incurring losses in the derivatives market as is any other individual.
Therefore, irrespective of the entity, margins should be collected by the clearing corporation/ house and/ or exchange on time. Only timely collection of margins can protect the financial integrity of the market as we have seen in the Barings case.
The above-mentioned points are relevant to trading organisations in derivatives market. They have to intelligently work in-house to avoid any mishaps like the Barings episode at any point in time.
SEBI has done a good job in the Indian derivatives market by making margins universally applicable to all categories of participants including institutions. This provision will go a long way in creating a financially-safe derivatives market in India.
Conclusion
Clearly, the failure of Barings was not a 'derivatives' failure' but a failure of management. After the investigations were through in the Barings case, the Board of Banking Supervision's report also placed responsibility on poor operational controls at Barings rather than the use of derivatives.
An important lesson from the entire episode is that we all need a disciplinary and self-regulatory approach. The moment we go against this fundamental rule, this leveraged market is capable of threatening our very existence

Source: Bombay Stock Exchange.

Growth of Mutual Funds

The Indian Mutual fund industry has passed through three phases.The first phase was between 1964 and 1987 when Unit Trust of India was the only player.By the end of 1988,UTI had total asset of Rs 6,700 crores. The second phase was between 1987 and 1993 during which period 8 funds were established (6 by banks and one each by LIC and GIC).This resulted in the total assets under management to grow to Rs 61,028 crores at the end of 1994 and the number of schemes were 167.
The third phase began with the entry of private and foreign sectors in the Mutual fund industry in 1993. Several private sectors Mutual Funds were launched in 1993 and 1994. The share of the private players has risen rapidly since then. Currently there are 34 Mutual Fund organisations in India. Kothari Pioneer Mutual fund was the first fund to be established by the private sector in association with a foreign fund.
This signaled a growth phase in the industry and at the end of financial year 2000, 32 funds were functioning with Rs. 1,13,005 crores as total assets under management. As on August end 2000, there were 33 funds with 391 schemes and assets under management with Rs. 1,02,849 crores. The Securities and Exchange Board of India (SEBI) came out with comprehensive regulation in 1993 which defined the structure of Mutual Fund and Asset Management Companies for the first time.

INDIAN RUPEE

Introduction

Rupee is the name given to the official currency that is used in several countries including India, Bhutan, Pakistan, Sri Lanka, Nepal, Mauritius, Maldives and Indonesia. The name rupee comes from the Sanskrit language word ‘rupyakam’ meaning silver coin. Rupee in different regions is denoted with different symbols most commonly Rs, ₨ and Rp. One unit of the currency is equivalent to one hundred equal paise.

Among all the countries mentioned above that have rupee as their national currency; the Indian rupee is the most important with respect to value, preference and popularity. India stands among those countries that discovered the need for a currency and the first rupee coins were issued as early as in the 16th century. The currency code and numeric code for Indian rupee according to the ISO 4217 standard are INR and 356 respectively. The currency in India is denoted with the sign Rs.

Overview

India retains the reputation of issuing the some of the earliest coins in the history of mankind. The currency of India i.e. the Indian rupee is also one of the well-established currencies in the world. The importance of the Indian rupee in the world market is characterized by the fact that Bhutan and Nepal peg their currencies to the Indian rupee. Moreover, the Indian rupee is considered a legal tender in Bhutan that has dollorized the currency. Indian rupee does not use the western number system and has a number system of its own. As in the western number system, the large values of money are counted in terms of hundred, thousand, million and billion respectively, in the Indian number system the large values are counted as hundred, thousand, lakh and crore. The Indian number system is also popular among the countries like Pakistan, Nepal, Myanmar, Bhutan and Bangladesh.

Earlier the rupee coins were made up of silver and that is where this name ‘rupee’ is derived from as the word ‘rupyakam’ means silver coin in the Sanskrit language. But when the large silver mines were discovered in the United States of America and parts of European continent, the value of silver declined drastically as compared to gold on which all the other strong economies were based. As a result, the value of Indian rupee also declined as compared to other currencies in the world and this incident is called the ‘fall of rupee’.

 Structure

 Indian rupee did not use the decimal system and rather was subdivided into 16 annas till 1957. In 1957, the decimal monetary system was adopted and one unit of rupee was restructured equivalent to 100 equal paise. The currency in the country is issued in the form of banknotes and coinage, the Reserve Bank of India and the Government of India possessing the issuing authority for banknotes and coins respectively. The central bank i.e. the reserve bank of India is entitled to change the banknote series and the Mahatma Gandhi series, which is in circulation currently, was launched in 1996. The notes are issued in 7 denominations i.e. Rs 5, Rs 10, Rs 20, Rs 50, Rs 100, Rs 500, Rs 1000. Two more denominations for banknotes i.e. Rs 1 and Rs 2 are still in circulation but no new notes are being printed as coins for both these denominations are being minted now. Each note depicts the face value of the note in 17 languages. The notes also have some unique features quite often called the security features that help in avoiding the duplicity and illegal circulation of the notes. These features include 

• Mahatma Gandhi watermark


• Silver security


• Latent image


• Micro-lettering


• Fluorescence


• Optically variable ink


• Back to back registration

Coins for the Indian currency are minted in 7 denominations namely 10 paisa, 20 paisa, 25 paisa, 50 paisa, Rs 1, Rs 2 and Rs 5 under the Coinage act 1906. The country has four coin mints one each at Mumbai (Maharashtra), Hyderabad (Andhra Pradesh), Kolkata (West Bengal), Noida (Uttar Pradesh). Like in the case of banknotes, the management of circulation of coins is in the hands of the Reserve Bank of India.

 History

India is the place where the concept of coinage developed at its earliest in around 6th century BC which later on built the base for other currencies of the world. according to the historians, the Indian currency i.e. rupee was brought into existence by Sher Shah Suri in the 16th century and it was evaluated as equal to 40 copper coins per rupee. The dominance of Mughals over India started diminishing when the British arrived in the country. The paper money was introduced under their reign in the latter part of the 18th century. Bank of Hindostan made the earliest rupee notes issues in the year 1770.

It was followed  by some more issues of the currency notes by private and presidency banks. For 100 odd years, the issue of bank notes by the private and presidency banks continued but with the formation of The Paper Currency Act  in 1861, the issue of notes was monopolized by the Government of India. The government of India (British India) initially appointed the presidency banks as their agents to help it with the circulation of bank notes as it was a tough job to promote the use of common note over a wide stretch of area. The notes had to be made a legal tender due to the problem arising from the redemption of these notes.

In 1867, the presidency banks were dismantled from the positions as the  agents to the Government of India and the responsibility of the management of the currency was given to the mint masters, account generals and the controller of the currency. The first series of notes that was issued by the government of India was the Victoria portrait series. The notes in the series were uni-faced and were issued in 5 denominations. This series was replaced by the underprint series of notes in 1867 which was kept in use for than 50 years. This long duration of time observed many positive changes in the bank note quality and introduction of a few security features as well. The need to issue small denominations note arose with the beginning of the world war I and Rs 1 note was issued for the first time.

In 1923, the underprint series was replaced by the king’s portrait series and they were continued to be used till 1935. The reserve bank of India took over the authority to print and circulate banknotes from the government of India. The notes bearing the portrait of George V was replaced by the notes bearing the portrait of George VI in 1938. In 1940, the one rupee note was re-launched due to the emergence of second world war. The notes with the portrait of George VI were in circulation till 1947 and were taken off the money market with the independence of India. The Indian rupee was adopted as a sole currency of the country and the use of all other domestic coinage was put to an end. The country adopted the decimalization standards in the year 1957. The current Mahatma Gandhi's portrait series was introduced in the year 1996.

 Factors affecting the exchange rates between two countries

The volatility in the foreign exchange rates depends upon a numerous macro economic factors that have different degrees of importance to different economies of the world. Some special and exceptional factors affecting the rates may also exist in the case of different countries. Following are shown the common factors on which the foreign exchange rate depends

• Flow of imports and exports between the countries


• Flow of capital between the countries


• Relative inflation rates


• Fluctuation limits on exchange rate imposed by the governments of the countries


• Merchandise trade balance


• Rate of inflation in the country


• Flow of funds between the countries for the payment of stock and bond purchases


• Relative growth


• Short term and long term interest rate differentials


• Cost of borrowings

Position Sizing Strategy

Now that the market is in a short term downtrend and stock tip threads have mostly disappeared I think it is a good time to discuss what is really important in trading - Position Sizing / Money Management Strategies. I Would like to hear/discuss the different sorts of position sizing strategies experienced traders here use for stock trading.

For new traders:

"Position Sizing" is the way you determine the number of shares of a stock you would buy when you decide to initiate a trade (and also how many shares you would continue to hold throughout the duration of the trade). It also decides how much equity will be allocated to a single position. Position Sizing is used by everyone even though they might not think about it (usually traders just buy 100 or 50 shares or any number that they are comfortable with or can afford). But good position sizing is what makes or breaks a trader, it is the strategy that keeps a trader in the business longer. It turns a mediocre trading system into an excellent one (but won't help a losing system).

The most popular/recommended position sizing strategy is to risk not more than 2% on any single position.

New traders - make sure you go thru' previous threads in "Risk & Money Management" section of this forum, there are good posts on risk & money mgmt by Traderji & CreditViolet.

Books on position sizing:

Trade Your Way To Financial Freedom by Dr. Van Tharp
Portfolio Management Formulas by Ralph Vince
The Mathematics of Money Management by Ralph Vince
The Trading Game by Ryan Jones

My Strategy:

I use a combination of percent risk & percent volatility strategy. Here are the rules I use:

- My main aim is to ensure that I stay in the business longer so my trading system gets a fair chance to realise its potential.
- No position should be greater than 10% of my total trading equity
- I don't risk more than 1% of my total trading equity on any single position
- I make sure my positions are "volatility balanced". In other words I make sure that all my positions fluctuate approximately the same each day in the market. I do this using Average True Range of the stock.

Example:

Say I am planning to buy HINDLEVER, here is what I would do to determine the number of shares I would buy:

Total Equity : 100,000.00
Max Equity for each trade : 10,000.00 (10% of total equity)
Risk Amount : 1,000.00 (1% of total equity)
Volatility Amount : 500.00 (0.5% of total equity. This is the fluctuation level per day per position)

Average True Range (10 Day Avg) : 5.63
Last Market Closing Price : 173.20 (For simplicity assume this is the entry price)
Stop Loss at : 163.40 (Will get out just below previous reaction low)

Number of shares to buy (percent risk model) = Risk Amount / (Entry Price - Stop Loss Price)
Number of shares to buy (percent risk model) = 1000 / (173.20 - 163.40)
Number of shares to buy (percent risk model) = 102 Shares

Number of shares to buy (percent volatility model) = Volatility Amount / Average True Range (10 Day)
Number of shares to buy (percent volatility model) = 500 / 5.63
Number of shares to buy (percent volatility model) = 88 shares

Number of shares to buy (based on Max Equity for each trade) = Max Equity for each trade / Last Market Closing Price
Number of shares to buy (based on Max Equity for each trade) = 10000 / 173.20
Number of shares to buy (based on Max Equity for each trade) = 57 shares

I will buy minimum number of shares determined from the above three models. So in the above case I would buy 57 shares.

So here is what I basically do. I am still trying to fine tune these things. The above parameters used are what I am currently using but I am in the process of doing trial & error to come up with parameters that fit me well. I would now like to hear what the experienced traders here do.

What is money management?

Money management is the process of analyzing trades for risk and potential profits, determining how much risk, if any, is acceptable and managing a trade position (if taken) to control risk and maximize profitability.
Many traders pay lip service to money management while spending the bulk of their time and energy trying to find the perfect (read: imaginary) trading system or entry method. But traders ignore money management at their own peril.

The importance of money management can best be shown through drawdown analysis.
Drawdown
Drawdown is simply the amount of money you lose trading, expressed as a percentage of your total trading equity. If all your trades were profitable, you would never experience a drawdown. Drawdown does not measure overall performance, only the money lost while achieving that performance. Its calculation begins only with a losing trade and continues as long as the account hits new equity lows.


Suppose you begin with an account of 10,000 and lose 2,000. Your drawdown would be 20%. On the 8,000 that remains, if you subsequently make 1,000, then lose 2,000, you now have a drawdown of 30% (8,000 + 1,000 - 2,000 =7,000, a 30% loss on the original equity stake of 10,000). But, if you made 4,000 after the initial 2,000 loss (increasing your account equity to 12,000), then lost another 3,000, your drawdown would be 25% (12,000 - 3,000 = 9,000, a 25% drop from the new equity high of 12,000).

Maximum drawdown is the largest percentage drop in your account between equity peaks. In other words, it's how much money you lose until you get back to breakeven. If you began with 10,000 and lost 4,000 before getting back to breakeven, your maximum drawdown would be 40%. Keep in mind that no matter how much you are up in your account at any given time--100%, 200%, 300%--a 100% drawdown will wipe out your trading account. This leads us to our next topic: the difficulty of recovering from drawdowns.

Even worse is that as the drawdowns deepen, the recovery percentage begins to grow geometrically. For example, a 50% loss requires a 100% return just to get back to break even (see Table 1 and Figure 1 for details).

Professional traders and money mangers are well aware of how difficult it is to recover from drawdowns. Those who succeed long term have the utmost respect for risk. They get on top and stay on top, not by being gunslingers and taking huge risks, but by controlling risk through proper money management. Sure, we all like to read about famous traders who parlay small sums into fortunes, but what these stories fail to mention is that many such traders, through lack of respect for risk, are eventually wiped out.


Guidelines that should help your long-term trading success.
1. Risk only a small percentage of total equity on each trade, preferably no more than 2% of your portfolio value. I know of two traders who have been actively trading for over 15 years, both of whom have amassed small fortunes during this time. In fact, both have paid for their dream homes with cash out of their trading accounts. I was amazed to find out that one rarely trades over 1,000 shares of stock and the other rarely trades more than two or three futures contracts at a time. Both use extremely tight stops and risk less than 1% per trade.

2. Limit your total portfolio risk to 20%. In other words, if you were stopped out on every open position in your account at the same time, you would still retain 80% of your original trading capital.

3. Keep your reward-to-risk ratio at a minimum of 2:1, and preferably 3:1 or higher. In other words, if you are risking 1 point on each trade, you should be making, on average, at least 2 points. An S&P futures system I recently saw did just the opposite: It risked 3 points to make only 1. That is, for every losing trade, it took 3 winners make up for it. The first drawdown (string of losses) would wipe out all of the trader's money.

4. Be realistic about the amount of risk required to properly trade a given market. For instance, don't kid yourself by thinking you are only risking a small amount if you are position trading (holding overnight) in a high-flying technology stock or a highly leveraged and volatile market like the S&P futures.

5. Understand the volatility of the market you are trading and adjust position size accordingly. That is, take smaller positions in more volatile stocks and futures. Also, be aware that volatility is constantly changing as markets heat up and cool off.

6. Understand position correlation. If you are long heating oil, crude oil and unleaded gas, in reality you do not have three positions. Because these markets are so highly correlated (meaning their price moves are very similar), you really have one position in energy with three times the risk of a single position. It would essentially be the same as trading three crude, three heating oil, or three unleaded gas contracts.

7. Lock in at least a portion of windfall profits. If you are fortunate enough to catch a substantial move in a short amount of time, liquidate at least part of your position. This is especially true for short-term trading, for which large gains are few and far between.

8. The more active a trader you are, the less you should risk per trade. Obviously, if you are making dozens of trades a day you can't afford to risk even 2% per trade--one really bad day could virtually wipe you out. Longer-term traders who may make three to four trades per year could risk more, say 3-5% per trade. Regardless of how active you are, just limit total portfolio risk to 20% (rule #2).

9. Make sure you are adequately capitalized. There is no "Holy Grail" in trading. However, if there was one, I think it would be having enough money to trade and taking small risks. These principles help you survive long enough to prosper. I know of many successful traders who wiped out small accounts early in their careers. It was only until they became adequately capitalized and took reasonable risks that they survived as long term traders.

10. Never add to or "average down" a losing position. If you are wrong, admit it and get out. Two wrongs do not make a right.

11. Avoid pyramiding altogether or only pyramid properly. By "properly," I mean only adding to profitable positions and establishing the largest position first. In other words the position should look like an actual pyramid. For example, if your typical total position size in a stock is 1000 shares then you might initially buy 600 shares, add 300 (if the initial position is profitable), then 100 more as the position moves in your direction. In addition, if you do pyramid, make sure the total position risk is within the guidelines outlined earlier (i.e., 2% on the entire position, total portfolio risk no more that 20%, etc.).

12. Always have an actual stop in the market. "Mental stops" do not work.

13. Be willing to take money off the table as a position moves in your favor; "2-for-1 money management1" is a good start. Essentially, once your profits exceed your initial risk, exit half of your position and move your stop to breakeven on the remainder of your position. This way, barring overnight gaps, you are ensured, at worst, a breakeven trade, and you still have the potential for gains on the remainder of the position.

14. Understand the market you are trading. This is especially true in derivative trading (i.e. options, futures).

15. Strive to keep maximum drawdowns between 20 and 25%. Once drawdowns exceed this amount it becomes increasingly difficult, if not impossible, to completely recover. The importance of keeping drawdowns within reason was illustrated in the first installment of this series.

16. Be willing to stop trading and re-evaluate the markets and your methodology when you encounter a string of losses. The markets will always be there. Gann said it best in his book, How to Make Profits in Commodities, published over 50 years ago: "When you make one to three trades that show losses, whether they be large or small, something is wrong with you and not the market. Your trend may have changed. My rule is to get out and wait. Study the reason for your losses. Remember, you will never lose any money by being out of the market."

17. Consider the psychological impact of losing money. Unlike most of the other techniques discussed here, this one can't be quantified. Obviously, no one likes to lose money. However, each individual reacts differently. You must honestly ask yourself, What would happen if I lose X%? Would it have a material effect on my lifestyle, my family or my mental well being? You should be willing to accept the consequences of being stopped out on any or all of your trades. Emotionally, you should be completely comfortable with the risks you are taking.

The main point is that money management doesn't have to be rocket science. It all boils down to understanding the risk of the investment, risking only a small percentage on any one trade (or trading approach) and keeping total exposure within reason. While the list above is not exhaustive, I believe it will help keep you out of the majority of trouble spots. Those who survive to become successful traders not only study methodologies for trading, but they also study the risks associated with them. I strongly urge you to do the same.