How much trading capital does one need?

Trading Capital

How much trading capital does one need?

 

When one invests in stocks in the cash market (i.e., when taking delivery of the stocks, and holding them for a long time), the notion of how much capital is involved is straightforward. The total amount invested at any point is your capital, and returns must be calculated accordingly.

Trading Capital

When it comes to trading, this is not so clear. This is because of:

  1. Trading involves leverage. Typically, the amount of leverage available is anywhere from 5X to 10X. So, if the money invested for margin is Rs. 1 Crore, the positions created will be anywhere from Rs. 5 Crore to Rs. 10 Crore.
  2. Because of the leverage involved, the amount of drawdown is also magnified. And unlike in investing, the drawdowns (in other words, the mark to market losses) must be made up in cash daily. So, in addition to the margin in a) above, another sum must be kept aside for drawdowns.

 

 

How much money should be kept aside for drawdowns?

 

The answer is not so clear. In practice, I follow the following calculation:

 

  1. For each strategy I use(Note: I am a purely system trader, I do not use discretion to time my trades, so I can use backtest results. Discretionary traders will not find this post useful), I note the maximum exposure of the strategy (in terms of margin) in the last 10 years. I also note the maximum drawdown on the strategy in the last 10 years. So, if a long mean reversion strategy involves 40 open positions (at a time of a massive fall in the market), and each position involves Rs. 1 lakh as margin, then Rs. 40 lakhs is needed as margin. In addition, if the maximum drawdown in the last 10 years is Rs 40 lakhs, then the total capital to be kept aside is Rs. 80 lakhs. This way I would be able to fund my account in the face of any market condition.
  2. I repeat the above calculation for every strategy I use, and then I total all the strategies up to arrive at the figure of the total capital to be kept aside. So for instance, I would trade two strategies like the one mentioned above, I would have to keep aside 1.6 crores.

 

This is a somewhat conservative way to go about it. In practice, I would rarely require as much capital, because long and short strategies are rarely likely to both experience a combined drawdown. Also, as long mean reversion strategies kick in, long trend following strategies start getting wound up. So, in real life, I am unlikely to need as much capital. However, it is better to be safe than sorry. I like to have a margin of safety. I therefore keep aside the capital based on the above calculation.

Notice that I am using the phrase “keep aside the capital”, rather than use “invest the capital”. That is because capital can be generated for trading in many ways.

How can trading capital be generated?

  1. Cash  in the form of liquid ETFs (i.e., liquid bees) and broker float. One third of the capital required to be kept aside is invested in this manner. Brokers will give 90% margin against liquid bees. Around 80% of the amount is in liquid bees, and the balance in my broking account. (keeping 100% in liquid instruments would involve transaction fees which may exceed any return expected). This cash of course represents investment in the trading business.
  2. Shares as margin. Typically, brokers will give margin between 60% to 80% on widely traded stocks. Again, I keep one third of the capital required to be kept aside in the form of stocks in my demat account.
  3. The last third is probably likely to be used extremely rarely, in the face of a massive market meltdown. I keep this in the form of overdraft accounts against securities (where all I pay is the annual renewal fees) or in the form of inter corporate deposits (ICD’s which I can call at short notice) and in government securities which can be instantly liquidated.

Why this 1/3:1/3:1/3 pattern? In a way, it is completely empirical.

However,  in a general sense, the margin against stocks represents the “core” margin required on  a daily basis. For instance, if the normal maximum position size is Rs. 10 crores, I require Rs. 2 crore as “core” margin. This can be provided cost-free by taking margin against stocks.

The balance in the brokerage account is usually around 25% of the total cash, and represents normal mark-to market losses for a couple of days. So, if the position size is Rs. 10 Crores, then it is reasonable to assume that two back to back falls of 2% are possible. So to keep Rs. 40 lakhs in the brokerage account is reasonable. The balance in the liquid ETFs is to accomodate large drawdowns, or the occassional spike in position size (I use long mean reversion strategies and long trend following strategies, so in the case of a sharp market downturn, I suffer a sharp drawdown on the trend following strategies, and a sharp increase in the position size of the mean reversion strategies simultaneously).

The balance 1/3 in OD’s, ICD’s and Short term gilts is essentially just margin of safety, in the case of a black swan event, or in the case of a 2008 like market meltdown.

Given the pattern above, how do you calculate the amount of capital invested in trading activity, so as to calculate the return on capital employed?

Calculating the return on trading capital

  1. The cash invested is clearly part of the capital. Liquid ETFs (currently) yield around 6% (pre-tax). Float in a brokerage account does not earn you anything. Hence, the dividend amount received on ETFs should be added to the total trading profit or loss.
  2. When shares are kept aside as margin, then it is not so clear that we should use them as part of the capital involved in trading. The stocks earn capital gains and they also earn dividends. And it is not as if I bought the stocks to invest as margin. I bought the stocks because they are good stocks to invest in. This is just an added utility.
  3. Similarly, when an overdraft account is created using securities as collateral, those securities should not be viewed as capital invested in the trading business. Similarly, ICD’s earn between 11 and 13%, and I might have invested in the ICDs anyway. So, I don’t think those should also be treated as trading capital. However, Government Securities (which earn around 6-7%) should be calculated as part of the capital invested, and the dividends or capitals gains thereon should be added to the total trading profit or loss.

Thus, when you see return on trading capital figures elsewhere in this blog, you should interpret the trading capital in the above manner.

Monthly Updates on Portfolio Performance

In an earlier post, I had mentioned several reasons why I would not publish monthly updates on portfolio performance anymore.

However, it is now time to revisit those reasons. The first reason I gave was a practical one. I was spending too much time on monitoring day to day performace, and that was taking a toll on me. Well, I have now used Access and VBA to create a database infrastructure, and so the difficulty in monitoring has been minimized greatly. I still have to spend half an hour or so everyday to enter everything, but I need it do monitor my trading activities anyway.

The second reason I gave was that I was spending too much time on minute by minute monitoring of my stock portfolio, leading to increased trading activity. Well, over time, I have acquired the discipline required not to obsess over minute by minute changes, even if I do monitor them. So I am less worried about it than earlier.

The third reason I gave was that as a long term investor, I did not see the need to compare myself with benchmarks on a monthly basis. I still believe this to be true. But I am now also a trader, and in trading, I am trying to trade for income. So that certainly involves monitoring myself in the long term and short term against benchmarks. Also, I realize that as an investor or as a trader, I do need to have “Alpha”, an outperformance against benchmarks.

Conclusion

Because my thinking has evolved, or because my situation has changed, I am now resuming the posting of monthly updates on performance.

2 Month Investment and Trading Returns (As on Feb 08, 2017)



 

Here is a comparision of my last 2 month performace of both Trading and Investing, relative to various indices and mutual fund performance.

Investing performance is slightly understated, since it does not include dividends. In the next installment, I shall take care of this.

I have explained the methodology involved in creation of these performance curves elsewhere.

I don’t want to comment on this performance too much, since it is only a 2 month performance, during which the market yo-yoed like crazy. But still, it is interesting to note that my investing performance was better than my trading performance.

Investment Performance October 2014



The last 2 months were not happy, from a relative performance point of view. The reasons for this are not difficult to see. I went on purchasing IDFC, Oberoi Realty and IL&FS Investment Managers, despite poor market performance. This general underperformance of some of my largest holdings was a prime reason for the underperformance. Other stocks which significantly underperformed also included Selan Exploration and Sesa Sterlite, partly driven by the Oil price fall. NMDC was another underperforming, based on low global iron ore prices, though NMDC’s own financial performance should continue to be robust.

Here is my graph of relative performance:

Here is a table of rolling returns:

Column1 Nifty Midcap Nifty SBI Midcap Fund Kotak Classic Fund My Porfolio
Last Month 3.3 4.3 3.6 4.4 3.8
Last 3 Months 5.6 7.6 13.0 7.5 8.3
Last 6 Months 22.0 32.7 41.0 24.0 47.3
Last Year 32.3 53.4 76.1 38.5 89.4
Since Inception 32.3 53.4 76.1 38.5 89.4

Portfolio Composition and changes in August 2014



Here is the list of stocks which constitute 1% or more of my portfolio:

Stock Latest Price Inv. Price Overall Gain % % of Portfolio
Oberoi Realty (52) 255.15 239.2 6.68 9.59%
IDFC (77) 142.35 130.0 9.52 8.14%
eClerx Services (17) 1,345.00 1026.5 31.02 3.23%
ILandFS (31) 20.35 15.0 35.95 2.65%
Selan Explore (28) 562 317.7 76.88 2.45%
Cummins (4) 699.3 411.2 70.05 2.39%
IRB Infra (15) 257.3 81.3 216.29 2.09%
Larsen (16) 1,581.85 1024.8 54.36 2.04%
NMDC (27) 177.85 133.0 33.75 1.99%
Bharat Forge (9) 856.75 272.3 214.69 1.97%
Mayur Uniquoter (11) 434.25 111.0 291.1 1.95%
Kaveri Seed (13) 930 296.6 213.51 1.89%
MPS (14) 545.1 128.7 323.66 1.88%
Balkrishna Ind (11) 752.6 232.3 223.92 1.86%
Shilpa (11) 517 375.1 37.84 1.74%
Sesa Sterlite (3) 279 151.0 84.78 1.67%
RS Software (14) 539.6 206.5 161.29 1.56%
EID Parry (13) 220.6 141.5 55.93 1.52%
Sun Pharma Adv (18) 197.85 121.9 62.27 1.48%
PTC India Fin (6) 44.15 15.0 194.98 1.41%
Hind Zinc (18) 165.1 122.0 35.34 1.36%
Indian Hotels (13) 96.55 59.9 61.06 1.35%
PI Industries (10) 437.6 159.0 175.23 1.35%
Ajanta Pharma (14) 1,604.10 1007.7 59.18 1.30%
Grindwell Norto (7) 490 256.5 91.02 1.25%
Munjal Auto Ind (11) 84.7 34.0 149.17 1.20%
Tata Inv Corp (13) 561.45 405.0 38.63 1.19%
Oriental Carbon (9) 290 113.2 156.17 1.17%
ITC (21) 349.95 307.0 13.99 1.11%
NTPC (6) 141.3 130.2 8.51 1.07%
ICICI Bank (9) 1,548.75 933.8 65.85 1.05%
Sobha Developer (12) 465.5 288.6 61.28 1.03%
Banco Products (2) 142.1 56.2 153.02 1.00%

The stocks representing more than 1% of my portfolio now constitute 68% of my portfolio, and the number of stocks are 33. 32% of the portfolio is represented by the top 8 stocks. I fully intend to concentrate further, so that the top 8 stocks represent 50% of the portfolio.

However, the concentration of scripts has hurt me, since my top stocks, Oberoi Realty, IDFC, Selan Exploration, and IL&FS Investment Managers have significantly underperformed the market in the last couple of months. The only one amongst the top 5 which saw outperformance was eClerx Services. Other top stocks which underperformed included Mayur Uniquoter, IRB Infra, BKT and Sterlite and Shilpa.

The three stocks which saw major outperformance was my old favorite MPS Ltd., and Kaveri Seeds. NMDC and Larsen, while not majorly outperforming in the month, gave me the benefit of buying these stocks on dips in July.Old favorite Cummins continued to do well. Another stock that did well in August was SPARC. PTC India Financial Services and RS Software did remarkably well in August.

What new stocks did I buy? I bought some Exide and some Amara Raja, since both constitute a nice duopoly, I bought HPCL, because there is tremendous value embedded in the company, with or without GOI policy issues, I bought Kitex Garments on a ValuePickr recommendation, Mazda Ltd and Linc Pens on my own reading of the balance sheets and potential. I added to Indian Hotels on a dip after the result. I bought HIL on an India Nivesh Recommendation. Finally, I continued to buy IDFC on dips.

Performance Tracker for August 2014

Here is a graph of my investment performance in August 2014:

 

While I continued by relative performance over the other benchmarks, I am still quite disappointed with my performance in August 2014.

Why is this? Well look at the table of rolling returns below:

Returns My Portfolio Kotak Classic SBI Midcap Nifty
Last Month 6% 5% 7% 3%
Last 3 Months 18% 9% 18% 9%
Last 6 Months 64% 31% 41% 30%
Since Nov,8, 2013 85% 36% 67% 32%

So, while my portfolio still outperformed the large caps, the one month and 3 month performance over the SBI Midcap fund is disappointing.

Why was this so? Partly, I think because IDFC and Oberoi Realty have now a nearly 20% share of my portfolio. And these shares are hardly moving. As a result, the overall portfolio performance is getting muted. While this is disappointing, I still believe strongly in both stocks. And I am using the relative underperformance of these two stocks to buy more.

On a more positive note, the total assets being managed by me have grown to nearly 3 times what it was in November 2013. Part of it is a nearly 80% jump in the NAV. Partly, it is more investment.

Given that I believe we will have a secular bull run for some years if the Modi government performs, I intend to deploy more funds in the market. However, now each stock I intend to purchase is going to have some thing going for it, which is aside from government regulations, and which is unlikely to perform very poorly, if the promised economic agenda does not materialize.

 

 

Portfolio Composition and Changes in July, 2014

Portfolio Composition, July 2014

 

Here is the list of stocks which comprise more than 1% of my portfolio at the end of July 2014.

Stock Latest Price Overall Gain % Percentage of Portfolio
Oberoi Realty (49) 251.9 5.34 10.23%
IDFC (71) 149 15.87 8.57%
eClerx Services (17) 1,284.95 25.17 3.40%
ILandFS (25) 24.85 75.91 3.16%
Selan Explore (28) 585 84.12 2.80%
IRB Infra (15) 249.1 206.21 2.23%
Mayur Uniquoter (11) 430 287.27 2.13%
Balkrishna Ind (11) 769.9 231.37 2.10%
NMDC (26) 169.8 28.28 2.06%
Larsen (14) 1,469.15 45.25 2.03%
Cummins (4) 606.9 49.22 1.93%
Shilpa (11) 514 37.04 1.91%
Sesa Sterlite (3) 282.5 87.09 1.86%
Bharat Forge (9) 722.25 165.29 1.83%
Kaveri Seed (13) 700.15 136.03 1.57%
Ajanta Pharma (14) 1,664.60 65.18 1.49%
EID Parry (13) 190.65 34.76 1.45%
Hind Zinc (17) 162 33.88 1.43%
Sun Pharma Adv (18) 168.2 37.95 1.39%
MPS (14) 348.05 170.51 1.32%
PI Industries (10) 383 140.88 1.30%
RS Software (14) 407 97.08 1.30%
Tata Inv Corp (13) 539.4 33.19 1.26%
Grindwell Norto (7) 420 63.73 1.18%
Indian Hotels (8) 94 75.65 1.18%
Munjal Auto Ind (11) 75.75 122.84 1.18%
NTPC (6) 140.45 7.86 1.17%
Oriental Carbon (9) 264 133.2 1.17%
PTC India Fin (6) 33.15 121.49 1.17%
ILandFS Trans (15) 228.7 70.18 1.17%
ITC (20) 349.6 14.84 1.16%
ICICI Bank (9) 1,474.00 57.85 1.10%
Muthoot Cap (10) 170 80.81 1.07%
Tata Steel (4) 549.9 100.66 1.07%
Sobha Developer (12) 438.8 52.03 1.07%
TCS (7) 2,515.10 42 1.03%
Banco Products (2) 129.5 130.58 1.01%
Reliance (6) 975.4 29 1.01%

What has changed? For one, I have spent all of July 2014, increasing my stake in Oberoi Realty and IDFC. This was as per my earlier stated intention. Now, both stocks comprise around 10% of my portfolio. This is essentially in keeping with my objective to concentrate my portfolio. Sometime this month, I will write about my investment rationale for both stocks.

I sold all of my Clariant Chemicals, simply because it had risen out of sync with possible valuations, and invested the proceeds in eClerx services. Increasing my exposure to eClerx was also my stated intention in earlier posts.

I also increased my exposure to NMDC and Tata Global Beverages, on a dip in prices of both. I increased my holding in Shilpa Medicare and PI Industries (PI following nice results). Finally, poor Larsen and Toubro results for the quarter resulted in sharp dip in prices, which I bought into.

I sold out of Morganite Crucible, more for the sake of not investing in stories without any technological or brand edge. Instead, I dipped my toes into Bayer CropScience, and on the MNC theme, increased my exposure to Grindwell Norton. Finally, there was some buying of PTC Indian Financial Services and IL&FS Investment Managers, both on a relative dip in market prices.

Concentration continues apace. The stocks which comprise at least 1% of my portfolio are now down to 38, and the total percentage of these in my portfolio is now more than 75%.

My eventual aim is to increase the concentration even further, with 25 scrips comprising around 90% of my portfolio.

What stocks gave the best performance in July, 2014 within my portfolio?

IDFC for sure, following the RBI announcement on CRR and SLR requirements on infrastructure loans. IRB Infra, following a decent result, and positive government announcements for the roads sector. IL&FS investment managers, despite becoming ex-dividend.

From the ValuePickr basket, Ajanta, PI, Mayur and Shilpa, all gave great returns in July.

Another great stock last month was Bharat Forge.

Investment Performance in July 2014

After a relatively muted performance in June, July was again more of the same. Part of this was the overall relative poor performance of the markets. As far as my portfolio was concerned, there was outperformance vis a vis the Nifty, and I finally managed to outperform the small cap index too, but compared the SBI Magnum Midcap fund, the performance was not better.

Nevertheless, there was reason enough for satisfaction. My performance might have been even better, had I not lost some money in speculation based short term trading. I am still not able to do this well, and maybe I should just stop doing it. That, or I need to control my psychology better.

Here is the familiar graph of overall fund performance. As you can see, the total assets undermanagement are increasing very rapidly. This is because I am deploying fresh cash, and also because the portfolio is doing well.

 

I have tried to improve upon the graph a bit. I hope this is more intelligible than the earlier version.

Also, as always, a table of rolling returns:

Returns My Portfolio Kotak Classic SBI Midcap Nifty
Last Month 5% 1% 5% 2%
Last 3 Months 42% 14% 24% 15%
Since Nov, 2013 75% 28% 56% 26%

As you can see, since Nov 2013, my portfolio, in terms of the NAV, has increased by 75%. The Nifty, meantime, has increased only by 26%, and the SBI Magnum Midcap fund, by 56%. In a blended sense, between the Kotak Classic Fund and the SBI Midcap Fund (Blended in a ratio of 1:2. similar to the ratio of large caps to small caps in my portfolio), the outperformance in 3 quarters is around 30%.

As always, to understand how the NAV for my portfolio has been arrived at, I would refer you to the following post: Understanding the NAV Calculation

Investment Performance in June 2014

After the blowout outperformance in May 2014, my portfolio performance in June 2014 was somewhat muted, relatively speaking.

Here is a graph of my portfolio performance:

 

Here is a table of returns:

Returns My Portfolio Kotak Classic SBI Midcap Nifty
Last Month 7% 5% 7% 3%
Last 3 Months 35% 17% 20% 18%
Since Nov, 2013 66% 27% 48% 23%

As you can see in the table above, my portfolio outperformed the Nifty by 4% last month. Over the last 8 months, this outperformance has been a whopping 43%. However, it has been the time for Small Caps and Midcaps. And my porfolio consists largely of such small caps and midcaps. Compared to the SBI Midcap Fund, my porfolio performance is not as phenomenal. In the last month, the performance has been in line.  And the BSE Small Cap Index has actually eclipsed my portfolio, though not by more than 0.5% over 8 months.

What went up? Ajanta Pharma and R.S. Software, both stocks accumulated in the last 3 months. Clariant, another favorite of mine. Muthoot Capital Services, Balkrishna Tyres, Bharat Forge, IRB Infra and Mayur Uniquoters. In short, a bunch of Midcap and Small Cap stocks.

Investment Performance in May 2014

Here is a graph showing my investment performance in May 2014. This investment performance should be seen in the context of the hedging that I had carried out, to protect myself on the downside in the case that the election results would be unfavourable to the markets. This is despite my being reasonably certain of the results. However, sometimes one believes what one wants to believe, and I think it was prudent to, when faced with an event that could cause a catastrophe in the markets, protect one self on the downside. What I did is that I purchased Mayend out of the money put options, with strike prices 5% to 10% lower than the Nifty and the Bank Nifty on the date of purchase. Why the Bank Nifty? Well, I have mostly small and midcaps in my portfolio, and in the case of an unfavourable result, the likelihood that my stocks would perform worse than the Nifty was a given. On the other hand, the Bank Nifty moves more closely to my portfolio, so I preferred to hedge with the Bank Nifty. I wish it was possible to trade in Midcap Nifty options, but those options are not enabled.

The portfolio performance below includes the cost of the options, which of course, given the sharp market upmove, expired without any value.

Portfolio performance cannot be assessed without understanding the risk the portfolio carries. This was one key takeaway for me from the book by Howard Marks, The Most Important Thing. In this case, the risk that I carried on May 16, 2014 (Election Results Day) was much lower than most other investors, who were not similarly hedged. Hence, if I had a lower performance than my benchmarks, I would not (or should not) have been unhappy.

With the caveat above, I present the graph below with my performance for the month.

As you can see, I had a blowout month. I far outperformed the Nifty, and the Kotak Classic Fund. I did much better than the SBI Magnum Midcap Fund.

This is also understood in the table below:

Returns My Portfolio Kotak Classic SBI Midcap Nifty
Last Month 21% 9% 11% 10%
Last 3 Months 38% 17% 17% 18%
Since Nov, 2013 55% 21% 39% 20%

Since November 2013, I have returned 55% on my portfolio. The SBI Midcap Fund returned 39%, while the Nifty returned 20%. In May alone, I outperformed all 3 of my benchmarks by at least 10%, inspite of my portfolio being hedged.

Reasons to be proud. Whether this result is due to luck in the timing or particular choice of stocks, or some small ability, we will see in the long run.