Badla/Hedging through futures
Question: In the last Article, you explained how vyaj badla can be done using Stock Futures. What other badla can be done?
Answer: Share badla can also be done using Stock Futures. This includes undha badla possibilities also.
Question: Please tell me about Share badla. Who can get into Share badla?
Answer: Typically, the Share badla participant owns shares and is in need of funds for a short period of time.
Question: Why can’t I sell the shares if I need cash?
Answer: Yes you definitely can, but you will lose the profit from upside if the share price were to move up.
Question: You mean, I can protect the upside and still get cash for my shares?
Answer: Yes – that is exactly what I mean.
Answer: Suppose you have 1,200 shares of Satyam which is currently quoting at Rs 220 per share – a total value of Rs 2.64 lakhs. You need cash, but protect the upside profits.
All you need to do is – one – sell your shares in the cash market and get paid the Rs 2.64 lakhs and – two – buy Satyam (one month) futures in the derivatives market (say at Rs 221 per share).
The futures position will keep your profits intact, if the share price moves up.
Question: How do I get my shares back and when?
Answer: The futures will expire on the last Thursday of the month. On the last Thursday (or before that at any convenient time), you should reverse the transaction i.e. you will sell your Satyam futures and buy back Satyam shares.
Question: Will I not carry a price risk – price of Satyam shares may move up or down in the interim period.
Answer: No, your position will be a covered position – any market movements will not affect you at all. Suppose Satyam moves up to Rs 250 at the month end, you will find that you have made a loss of Rs 1 per share (Rs 30 loss on the cash market shares and Rs 29 profit on Satyam futures).
On the other hand, if Satyam moves down to Rs 200 per share you will still have made a loss of Re 1 per share (Rs 20 profit on the cash market shares and Rs 21 profit on Satyam futures).
Question: Why do I make this loss?
Answer: The loss of Re 1 per share is your interest cost. You have enjoyed Rs 2.64 lakhs for a period of (let us say) one month. The interest cost for this borrowing is only Rs 1,200 (Re 1 per share on 1,200 shares). This works out to an interest cost of less than half per cent per month (very attractive borrowing rate).
Question: How do I know when this type of share badla is attractive?
Answer: You should watch the cash market and futures market prices closely and look for opportunities when the futures market price is not too high. For example in the above case, the futures prices were only Re 1 higher than the cash market prices. You should then convert this Re 1 cost into an annualized interest cost. For example (1/220 = 0.45%).
If only 10 days are left for expiry, this would translate to a higher rate of 1.35% per month (0.45 * 30/10).
Question: What is undha badla and how can this be affected in the futures market?
Answer: Undha badla in the olden days was a situation which could sometimes emerge due to a bear trap. If some bears have short sold shares and are unable to deliver them, bulls could trap them. Bears would then negotiate for delivery and bulls would let them have delivery, but at a price. Thus, the bulls would enjoy the best of both worlds – viz – funds and liquidity (on sale through delivery basis) and also badla long position (advantage of profiting on price rises).
Question: How does this happen in the futures market now?
Answer: In the futures market, undha badla is much simpler. Whenever futures are quoted at a price lower than the cash market price, the situation is undha. For example, if Satyam shares are quoting in the cash market at Rs 220 and Satyam (one month) Futures are quoting at Rs 218, you have a classic undha situation going.
Question: What should I do?
Answer: You sell Satyam shares in the cash market (you should have Satyam with you like in the share badla example above) at Rs 220 and at the same time buy Satyam Futures are Rs 218 in the derivatives market. On expiry (or before that whenever you find prices converge), you should liquidate both positions. That is, you should buy back Satyam cash shares and sell Satyam Futures. It does not matter whether Satyam has moved up or down in the meantime, as your position is completely hedged.
Question: What is the benefit to me?
Answer: You have enjoyed liquidity for one month (say Rs 2.64 lakhs in the above example) and you have also enjoyed a profit of Rs 2 per share (or Rs 2,400 on 1,200 Satyam shares). This profit is similar to interest earned by the undha badla player.
Question: I have heard that hedging is possible using Futures. What does this mean?
Answer: Hedging is certainly possible using Futures. Suppose you hold Infosys Shares and are nervous about the share in the short run. You can consider Hedging.
Question: If I am nervous, would I not sell Infosys straight away?
Answer: Yes, you will if you believe that Infosys is moving down in the long run. But if your nervousness is temporary, then selling Infosys might be a bad solution. In the first place, after you sell, Infosys might move up. In most cases, investors find it difficult to buy the same share at a higher price. Practical evidence suggests that most investors are unable to acquire good shares once having sold them. The second common problem is that of capital gains. If your cost is much lower than today’s price, you might have to pay capital gains taxes on sale of your shares.
Question: What is the alternative?
Answers: Hold on to your Infosys shares and sell Infosys futures instead. As a result, you will have a covered position (no profit no loss) for the period of time covered by futures. For example, if you sell one month Futures, you are covered for one month. If Infosys is quoting at Rs 4,000 and you sold Infosys (one month) Futures for Rs 4,060, you have – one – hedged your position for one month – and – two – made a profit of Rs 60. It does not matter whether Infosys moves up or down.
Question: If it moves up, I would have made a profit?
Answer: Yes, had you not hedged your position, you would have made a profit. However, you have lost that profit now. Remember, a hedge is not a device to maximize profits. It is a device to minimize losses. As they say, a hedge does not result in a better outcome, it results in a more predictable outcome.