Anatomy of a Losing Trade

Today, I lost approximately Rs.4000 in a Sun Pharma Options Trade. It is worth examining the trade, because I think it gives valuable trading lessons.

On the face of it, why am I even talking about this trade? It is only one among the hundreds that I do every month. The amount involved is trivial. Losses are the part of life of any trader. So why worry about it? Forget it, and move on, just like a bunch of other losing trades.

I think, however, that this particular trade contains valuable lessons on what not to do while trading. And therefore merits a deeper examination.

I consider myself an experienced and sucessful trader. One who has a track record of success, who is diversified across instruments, and someone with (at my risk levels) who has access to unlimited capital, and a proven capacity to bear tremendous losses. Why did I get this trade wrong?

First, the logic of the trade and the trade itself.

At a time (10 a.m on 22 Feb 2018, expiry day) when Sun Pharma was trading at 528-529 (up nearly 0.75% on a weak market day), I entered into a 530CE/540CE ratio trade in the ratio 1:3.

I got the idea for such trades from Jeff Augen’s excellent book on trading options at expiration. In this book, Augen talks about two peculiar behaviors in options on expiration day. The first is the propensity for stocks to exhibit pinning behavior (getting pinned to a strike price, and jumping discretely from one strike price to another), and the other is the dramatic collapse of IV (or a dramatic time value decay, in an Indian context, because we have no after market). Augen suggests therefore that it makes sense to enter into call ratio trades in heavily traded stocks. What he suggests is that one chooses the long strike of the call ratio where the underlying is just out of the money or just in the money. And then he suggest selling a ratio at the next higher strike, which just allows for a small net debit or credit (and which usually results also in the trade being roughly delta neutral to begin with). If the underlying falls, the both sides of the ratio expire worthless, and all you lose or gain is the small debit/credit one started with. If the underlying rises, but not too much, the long side of the ratio will expire in the money, and the short side will expire worthless, resulting in a nice gain. And if the underlying does get pinned to the higher strike, then the profits will be tremendous. Breakeven is when the underlying rises by [Strike Price Spread + Strike Price Spread/ratio], which is usually a 3.5% or so move, which is unlikely in most stocks.  So the risk:reward characteristics of the trade are excellent.

Unfortunately, I have still not been able to build conviction that stocks in India also exhibit pinning behavior. Unfortunately, I still don”t have a database of minute prices in stocks, and so I haven’t been able to backtest this (am in the process of correcting this)

In this particular Sun Pharma Trade, I purchased one Feb 530CE at 5.2 Rs, and sold 3  Feb 540 CE at 1.9 Rs. This resulted in an initial credit of Rs. 0.5 or on the lot, a credit of Rs. 550. Nice. I was a happy camper.

There was a lingering fear at the back of my mind. Sun Pharma was due for some news flow (the FDA inspection of one its plants was ongoing). The risk was positive news flow which would result in a sharp price increase.

The second problem, as I see it, was that while I entered into several similar trades on other stocks around the same time, I was entering into call ratio spreads on expiry for the first time. And I was quite personally excited to see this work.

The third issue I think was that I had a successful run at options trading for the first time in the Feb expiry, with practically no losing trades. So I was actually quite eager to retain my profits (though my options profits/losses are a  much smaller component of my overall trading position, and these losses/profits are not material).

 

 

Trading Performance November 2017

Trading Performance November 2017

Trading Performance in November 2017 was on the muted side. The last three months have not been great for my trading performance, which has actually been negative, and substantially so, even though markets have been positive. Over the year, returns are a fabulous 150% on my invested capital. These large fluctuations in trading returns are a function of the trading systems I use. In fact, in November, trading the stock markets has not been that bad, but commodities have given horrendous returns, which has led to a low performance overall.

I am now trying to introduce options into the mix, and in November, I had a profitable month trading options. I have still not deployed substantial capital for options trading, but I will over a period of time.

Here is a table of my trading performance(as well as investment performance) for the month of Nov 2017, and for longer periods:

Trading Performance
Table showing my trading performance(as well as investment performance) compared to different benchmarks

Investment Performance Nov 2017

Investment Performance Nov 2017

November was not a great month for markets. The Nifty actually declined slightly, while the broader indices were in the green, but just so. Portfolio investment  performance was similarly muted, with the portfolio having returned just 2.77%. It has been more than a year since I started keeping track, and the overall returns for the year till Nov 2017 have been 37.66%. It seems optically great till one considers that Nov 2016 had the demonetization even and subsequent sharp fall. So comparisions are bound to be favorable. Also, one has to consider that the SBI Small and Midcap Fund returned 61.12% during the same period. So good portfolio performance, but not great.

One swallow does not make a summer, and so also 1 year does not represent a lifetime of investment returns. It gives only a snapshot of lifetime performance, and it does not say anything about the risks taken to derive the investment returns. Nor does it say anything about the future course of returns. However, as we keep up this exercise of tabulating returns, month after month, for several years, hopefully, we will be able to derive some conclusions.

In the meantime, I am sticking to my general investment style. Low churn, buy low valuations, catch falling knives when the company’s survival is not at risk. Keep a trend towards concentration.

What can say about a year’s returns? My portfolio outperformed all the indices I track, as well as the HDFC Top 200 Fund. My portfolio also outperformed the two PMS schemes by a considerable margin. And the portfolio grossly underperformed the SBI Small and Midcap Fund. It has been a great run for small and midcap stocks. However, we will see how these perform as time passes.

Here is a graph of the returns:
Investment Returns
Investment performance of my portfolio, as well as those of several benchmarks

A table representing the same data is part of the next post, which will talk about trading returns.

 

Trading Performance-October 2017

Trading Performance-October 2017

October 2017 was not good for my trading activity. The market kept whipsawing between rises and falls, and though the Bank Nifty on which I primarily trade went up 4 % in the month, I suffered a considerable drawdown.

Here is a table showing my trading performance relative to other benchmarks.

TradingReturns
Table showing my Trading performance in relation to other benchmarks

As you can see, my trading performance has resulted in a nearly 25% fall in the overall return in the last 3 months, of which 14% was in October alone. I do hope the tide changes soon.

Overall though, I am still ahead of all other benchmarks for the year. This is the nature of the trend following trading game. Huge outperformance for brief periods, and then steady attrition in returns for long periods. Hopefully, it means that you come out ahead of the investment pack in the long run.

However this large volatality in trading returns makes me more and more inclined to include options strategies as part of the trading mix. i am currently engaged in developing the technical expertise to analyse and develop Options Trading Strategies. It will take a long time, perhaps as long as a year or two. But I convinced that that is the way to go.

Investment Performance-October 2016

Investment Performance-October 2017

Here I am with another edition of my investment performance. This was a month in which the market, especially, Small and Midcap Stocks went up considerably, after a relatively muted August and September.

While the markets were strong, my own stocks did only ok. IDFC and IDFC Bank continued to do poorly, while certain other stocks, like CanFin Homes, EClerx and Ajanta also did poorly. On the other hand, Oberoi Realty, which is by far my biggest holding, did fine, and so did Bajaj Finserve/ A whole host of smaller holdings, like DCM Shriram, BKT, Indiabulls Housing Finance also did well.

Overall, of all the benchmarks, my porfolio did marginally worse than the Midcap Index, and considerably worse than the SBI Small and Midcap Fund, which had a blowout performance. Otherwise, on both a monthly and yearly basis, my investment performance was marginally better than the performance of the HDFC Top 200 fund,  and was considerably better than the indices as well as both the PMS schemes I own, the MOSL “Value Strategy” fund, as well as the Centrum Deep Value Fund. One must wonder why anyone should invest in these PMS’s and give managers a fee, when one can have a reasonable portfolio and do considerably better.

Investment Returns
Graph showing my investment performance in relationship to other benchmarks

 

I have also tabulated the results:

Investment Returns
Table showing my investment performance in relation to other benchmarks

Trading Performance-September 2017

Trading Performance-September 2017

The Yo-Yo of markets during the month was not at all good for performance of my trading activity in September. I use mostly trend following strategies, across different time frames, and sideways markets did not do much for the returns from trading activities, and in fact, there was capital loss.

I am still up for the financial year, and quite well. But the whole situation is testing my patience now. These are the periods when stoicism is valuable as a philosophy, and I am as stoic as they come. So we will continue the same, no matter what the state of my patience.

Here is a tabular representation:

Investment and Trading Performance
Comparison of investment and trading performance of my portfolio and trading activity relative to various benchmarks

Investment Performance August 2017

The market turned distinctly weak in August 2018. All the major indices fell, with the Bank Nifty falling by more than 3%. Continued FPI selling, tepid results, GST related disruptions and continued geopolitical tension was somehow contributory to the relatively tepid movement.

Investment Returns
Investment Performance August 2018

Except for the SBI Small and Midcap Fund, all the other benchmarks, as well as my own investment performance had a negative performance for the month.

While my investment performance continues to trail the SBI Small and Midcap Fund (this stands to reason: Small and Midcap Stocks have outperformed the Large Caps, and while portfolio is geared towards Small and Midcap Stocks, I have several large caps, like Reliance, ITC, L&T, ICICI Bank in my porfolio. Naturally, my portfolio performance is a cross between the Small Cap Performance and Large Cap Performance), it does outperform all other benchmarks.

The performance of the PMS schemes is particularly distressful. I would imagine that PMS managers should outperform my own investment performance, or those of MF managers (who charge much less). But in fact, PMS schemes have clearly underperfomed this year. Now, it may be that some manager did outperform, it does not appear so for the average of all managers. And those who do outperform, don’t seem to do it consistently over a long period.

My portfolio continues to underperform a bit because of the drag from IDFC, IDFC Bank and EClerx, which are in my top five holdings. On the other hand, outperformance by Bajaj Finserv, HPCL, amongst other stocks, allows be to clock in respectable performance.

 

 

 

 

Trading Returns and Performance-July 2017

Trading Returns and Performance

July 2017 was a great month for my trading performance. Here is a table which shows the trading returns over the last nine months.

Portfolio Returns
Table of Returns for different time periods

As can be seen, my trading activity gave a return of 59% in July 2016 alone. This was in conjunction with a rise in the bank nifty of 8.15%. However, as I kept withdrawing capital from trading and deploying it in debt, I am not clear as to what the trading capital showed be considered. In any case, trading activity for me is a business which created income, not a wealth generating activity. Hopefully, wealth will get generated through my debt, equity and real estate portfolio. So I am far more interested in the absolute returns from my trading activity.

This month, I also started trading commodities in earnest. The total capital set aside for commodities is still a fraction of the total for the Bank Nifty. Hopefully, over a period of time, this shall rise.

Currently, I am trading Crude/Natural Gas, Gold/Silver, Zinc/Copper. I feel that trading a basket of instruments shall improve the stability of my trading performance. However, I am still not confident of increasing the position size of the commodity basket.  Over a period of time, I shall slowly increase this.

Below is my trading equity curve till July 2017.

Trading Performance
Trading Equity Line for the last nine months (Normalized to an arbitrary base)

What about drawdown? Well, in July 2016, there were several days where the trading equity was at the maximum, and there was no drawdown at all.

Here is the drawdown:

Drawdown
Trading Drawdown Curve (Normalized to an arbitrary figure)

All in all, a very satisfying performance in trading activity in July 2017.

Trading and Investment Performance-May 2017

Trading Performance May 2017
Investment Performance May 2017

 

Again, after a haitus, I present my trading perfonmance and investment performance.

Here is a graph of my performance, both for trading and investment, in comparison with various benchmarks. The benchmarks I have included are the performance of the HDFC Top 200 and SBI Small and Midcap Funds, and two PMS’s I have invested in, the MOSL Value Strategy, and the Centrum Deep Value Strategy, in addition with 3 indexes.

Performance of trading systems and investment gains
Trading Returns and Investment Returns

As can be seen, the trading has had a great last few months. However, there is a caveat here. In my base calculation for capital employed (i.e., the 1000 figure in November), for trading, I have only included the actual capital employed in my brokerage accounts, and not the shares pledged as margin, or the reserve cash I hold. Still, all in all, a creditable performance.

My investment performance in the last seven months is also not bad, second only to the HDFC Top 200 Fund. I otherwise beat both the PMS’s and the indexes handily.

What risk did I take to get these stellar trading returns? Quite a bit. Please see below:

Trading Equity Line
Absolute trading equity line.

As can be seen, there is a deep drawdown in the months of October and November 2016. This corresponded to three external events, Brexit, Trump Election and Demonetization. Such deep drawdowns are what keeps one afraid of trading in futures. I have since changed strategies (more in another post), and hopefully, I can avoid such sharp drawdowns in the future.

Trading Equity Drawdown
Drawdown of Equity from Maximum Equity

Portfolio Composition at the end of June, 2014

I am trying to maintain the discipline of disclosing my portfolio over the weekend after expiry in every month.

Notable purchases during the month include a significant increase in my holdings in IDFC and Oberoi Realty, and an increase in my holdings in Idea Cellular and an initial position in Tata Global Beverages. I also bought a reasonable amount of Sabero Organics as a special situations play. Amongst small caps, I created small positions in Morganite Crucible and Mazda Engineering. I trimmed my holdings in JP Infra and in Alkyl Amines.

I have too diversified a portfolio. Over a period, it will only became like the Nifty Junior. I am therefore trying to increase the concentration in my portfolio, and for the moment, two stocks, IDFC and Oberoi Realty are in my focus. I intend to increase my holdings further. I will give an investment thesis on both next week.

I am also increasing my exposure to Idea Cellular, though at a slower clip than the above two. The reason is simple, telecom stocks have got back pricing power, and the eminent entry of Reliance Jio, to my mind, is an overblown fear. Reliance has not demonstrated that when it comes to engaging the consumer that it is better than competitors. This is true for its previous telecom foray, as it is true for its retail foray. I have little doubt that they will be a serious player in the telecom space, but existing telecom players are not going to roll over and die. Idea’s balance sheet is the best amongst Bharti, RCom and Idea, and it is executing its plan well. This can be a FCF business of high proportions.

Sabero Organics was bought mainly from the point of view of merger with Coromandel International. The merger should not happen within a month or so, and buying Sabero today means buying Coromandel at a 7% or so discount.

Stock Latest Price Inv. Price Overall Gain % % of Portfolio
IDFC 128.35 112.35 14.24 4.05%
ILandFS 23.4 13.81 69.46 3.50%
Selan Explore 594.5 317.72 87.11 3.46%
Oberoi Realty 259.1 204.00 27.01 3.36%
Larsen 1667.3 949.93 75.52 2.48%
Cummins 639.3 406.70 57.19 2.47%
IRB Infra 224.6 81.35 176.09 2.44%
Balkrishna Ind 735.9 232.34 216.74 2.43%
Sesa Sterlite 289.35 150.99 91.63 2.32%
Mayur Uniquoter 374.5 111.03 237.29 2.25%
Clariant 861.05 617.20 39.51 2.12%
NMDC 178.95 121.65 47.1 1.96%
Kaveri Seed 721.2 296.64 143.12 1.96%
EID Parry 209.4 141.47 48.02 1.93%
Bharat Forge 608.25 272.25 123.42 1.87%
Hind Zinc 163.9 121.00 35.45 1.76%
Ajanta Pharma 1522.6 1007.73 51.09 1.65%
Sun Pharma Adv 160.25 121.93 31.43 1.61%
MPS 345.45 128.66 168.49 1.59%
eClerx Services 1159.8 866.27 33.88 1.56%
Indian Hotels 102.3 53.51 91.16 1.56%
Tata Inv Corp 547.15 404.99 35.1 1.55%
NTPC 152.25 130.22 16.92 1.55%
Sobha Developer 511.55 288.64 77.23 1.51%
Munjal Auto Ind 78.5 33.99 130.93 1.48%
Oriental Carbon 269.9 113.21 138.42 1.46%
Syndicate Bank 157.85 69.59 126.83 1.29%
ITC 319.75 304.43 5.03 1.28%
PI Industries 329 144.63 127.48 1.28%
ILandFS Trans 206.8 134.39 53.88 1.28%
Reliance 1012.1 756.12 33.85 1.27%
PTC India Fin 31.55 13.93 126.5 1.27%
ICICI Bank 1384.65 933.81 48.28 1.26%
Tata Steel 518.9 274.05 89.35 1.23%
Grindwell Norto 408.25 231.16 76.61 1.20%
Muthoot Cap 156.75 94.02 66.72 1.20%
Bajaj Electric 336.5 209.83 60.37 1.19%
TCS 2399.55 1771.20 35.48 1.19%
VST Tillers 1766.55 421.86 318.76 1.17%
Banco Products 115.4 56.16 105.48 1.09%
Poly Medicure 503.35 278.36 80.83 1.08%
RS Software 276.4 206.52 33.84 1.07%
Sasken Comm 220.45 180.30 22.27 1.07%

This constitutes 79% of my total portfolio. I am disclosing those stocks which constitute more than 1% of my portfolio. IDFC has gone up from 3.4% to 4.05%, even without any price increase. Oberoi Realty has gone up from 2.4% to 3.4%. I fully intend to have both of these at 10% within the next 2 months.