You dont know what you dont know

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Let me start with example. There is a internet message board called reddit. Communities on it are call subreddits. Among thousands of communities on gaming, cooking, landscaping and other activities, there is one for traders. And I use that word very loosely here. It is called WallStreetBets. Started as a genuine community for traders to share their research, it slowly evolved into a degenerate cacophony of gamblers trying to use derivatives market in america to place all-or-nothing type of bets. One such user was called 1r0nyman. He did some research and found out that there is an options strategy called Box Spread.

Here’s how a box spread works. You enter a bull call spread and enter a bear put spread in such a way that the bought call and sold put are of the same strike price and the bought put and the sold call are at the same strike price. In short, you enter into a long synthetic future at one strike price and enter into a short synthetic future into another. Here’s an example:

You can see in the payoff diagram that no matter where the Nifty moves the profit will be 203. Such strategies are called arbitrage strategies where traders try take advantage of market inefficiencies. But for retail traders the profit is not even enough to cover the cost of the trade. If you trade with a discount broker like Zerodha, you are charged 20 rs per order. Then it could only be economical if you could enter into at least 10 such spreads at a time so make something post charges. Also for 10 spreads you will need about 4 lac of margin. That makes roughly 2000 rs return a half a percent return for the trouble. There are some other problems as well. If you do not enter at the exact prices the arbitrage will not exist. Nifty lot size is 75, which means if you miss entries by as little 2.6 rs there wont be any arbitrage. Only large institutions and HFTs do this since this strategy is only efficient when done with automated systems.

Our trader buddy 1r0nyman had only seen the payoff diagrams. He figured that options on the SPY ETF which is comparable to our NIFTYBEES would work for this trade. He did the calculations and proclaimed that this trade literally can’t go t*ts up because money at risk is zero. Now here’s the catch. In India we trade in European style of options. That’s what the E in CE and PE stands for. European style of options can not be exercised before expiry. There is another flavor of options though called American options. These options can be exercised any time the buyer of options feels like. Now since we are short two options, one call and one put, one of them will always be in the money. Meaning there will always be the risk of one of those two options being exercised and us being forced to either give delivery of or take delivery of the underlying. Box spread is only profitable if held till expiry. But as soon as 1r0nyman entered into his trade, which was several times his account, people started exercising the options. He lost about $60,000 on an account of just $5,000. His broker realized what had happened and immediately closed 1r0nyman’s account. But sometime between getting into the trade and broker force closing the account, 1r0nyman had taken $12,000 worth of profit out from trading account into his bank account. So though his account showed a loss of $60,000, 1r0nyman made over 100% profit before closure. The loss was borne by his broker since 1r0nyman wasn’t supposed to be able to take that much leverage in the first place. Since then that broker has banned box spreads from their platform.

So what’s the lesson here? 1r0nyman didn’t know how bad his trade can go. But what is worse is his broker didn’t know about such catastrophic strategies. That is why it is important to remember that you will not know what you don’t know until the time something like this happens.

In India MCX didn’t know what happens when price of Crude is forced below zero in the international market. On MCX all futures contracts are physically settled. So if you hold a long contract of futures of Crude, you will have to take delivery of 100 barrels of oil. If you hold a long contract of Gold you will have to take delivery of 1 Kg of gold. Yes you read the units right.

Futures contracts on NSE are cash settled on a day to day basis. If you had 10L margin but zero cash in your account, you could enter into a future long in Nifty. About 1.3L of margin will be blocked. Let’s say unfortunately Nifty closes 100 points down and your account shows an MTM loss of 7500 rupees. At the end of the day exchange expects you to pay that 7500 loss in cash. Margin will not work there. So despite having over 8L of margin in your account your broker will raise a margin call against your account. You didn’t know that you don’t know about cash settlement. But you will have to come up with that money somehow.

‘I didn’t know’ excuse doesn’t work in stock market. As a market participant you are expected to do your own due diligence.

So be aware, be prepared, and happy trading.

The perspective

Every time a stock hits its lifetime high, the social media starts buzzing with lines such as ‘Just 3 Lac invested in XYZ-MULTIBAGGER company in the year LISTEDDATE would have been equal to YOUCOULDHAVEBEENRICHB*TCH today!’.

When I was a newbie in the markets and came across such tweets, I felt my parents (and by extension me) missed their opportunity of being filthy rich. But once I became a little used to the stocks and their erratic behavior, I realized how smart, albeit unknowingly, my parents were. Let us talk about one of the poster children of such multibagger returns; MRF. Since its listing in the year 1999, it has increased by approximately 4500%. I will throw one line as well. Just one lac invested in this stock back then would have been 45 lac today. But here’s the detail I missed. back then access to markets was not as straight forward as it is today. The maze of brokers, sub brokers and market operators would have been very difficult to navigate for someone like my parents. Not being savvy about financial world, they would have relied on the recommendations of their broker. And we all know how shady that business was for small investors back then.

And looking at MRF today and talking about how great that investment would have been is the epitome of hindsight bias. What if you had invested the same one lac in reliance power? It would have been equal to one thousand. Yes that’s right. 99% of your capital would have been lost in ether. There are countless other stocks which were trading at 1600 once and now quote at 1.6 rs. Many have completely vanished altogether.

There were some logistical issues as well. Shares were issued in physical format, the settlement period was long, minimum margin requirement with the broker was high, etc.

Many can’t afford MRF today. At the CMP of almost 64000 rs, it remains the most expensive stock listed in the Indian markets. When it was listed, it traded at around 2000 rs. But remember in the year ’99, 2000 rs was more than what many people earned in a month.

We all revere Warren Buffet as one of the greatest investors of all time. One of his commandment clearly states that you should only invest within your circle of competence. Tech companies were out of his. Stock market was out of my parents’ and of many contemporary of theirs. So they did what they understood; LIC, PPF, real estate and gold. Is it the optimum portfolio allocation by modern portfolio constructions standards? Not by a mile. But at least they didn’t lose their sleep over what market did…

Disclaimer – The names of the companies are for illustration purposes only.