What is the similarity among solar power, wind power and lighting a bulb by pedalling a bicycle? All of them harness the energy that would have been otherwise wasted.
What if we tell you that you can employ the same concept in stock trading?
Arun Nair, a Thiruvananthapuram-based software developer cum stock trader, is using a peculiar hedging strategy that has limited downside, if any, and generates 5-6 percent profit each month.
The strategy, which involves two legs – buying Bank Bees as a property and trading Bank Nifty options as an insurance on that property – is “a painfully slow strategy but gives wonderful returns without drawdown”, according to Nair. This strategy tries to juice the market movement in Bank Bees to create an additional source of income for a trader.
Trial and error
Nair, a 42-year-old, started his journey into the stock market by investing into initial public offers (IPOs) in 2005-06. “I used to invest in almost all IPOs. I made money in names like DLF and Idea,” he said.
Subsequent years were littered with buying and selling individual stocks. He got serious about trading only in 2018-19. Even then, he would take directional trades, but they did not work out that well for him as he made money in some but lost in others. Neutral strategies like Straddle also did not work for him.
“You make money in Straddle if the market is range bound.If market moves in a direction, you end up fire fighting, your margin requirement goes up, and more often than not, you end up losing money,” he said.
The inspiration to create this hedging strategy – instead of naked trading earlier – based on Bank Nifty came as he started developing algo trading strategies for other traders, which he continues to do so.
Trade setup
The capital requirement for setting up Nair’s strategy is Rs 3 lakh (it could be Rs 3.5 lakh depending on some brokers’ requirement). The set up is as follows:
Step 1: Use Rs 2 lakh to buy Bank Bees, which is one of the oldest exchange traded funds (ETF) based on Nifty Bank index. By buying this, you will be exposed to some of the top banking names of the country.
Step 2: Pledge Bank Bees units to get extra margin on your trading account. We will now use Rs 1 lakh left from initial capital and pledge margin to create a hedge.
Step 3: For the sake of understanding, let us assume that Nifty Bank is at 41,600. We will create a Butterfly – which is a trading strategy – to insure our portfolio against drawdown in the market.
Step 4: At the start of any monthly expiry, buy put for the strike just below at the money strike, that is, 41,500 in our example, followed by selling another put 1,000 point below (at 40,500). To create a Butterfly, sell another put at 39,500, followed by buying a put at 38,500.
Step 5: You don’t need to square off the trade, no matter how the market moves. At the expiry, your trades will be cash settled. As the new series starts, create another Butterfly using the similar steps.
Risk management
The risk in this strategy is limited, as the whole strategy is based on premise of managing risks.
No matter where the market moves, you will make money in one of the legs. For instance, if the market moves higher, your Bank Bees will make money but you will lose money in trading. But if the market falls, your Butterfly will make money even as Bank Bees loses money.
Though, there are certain scenarios when you will lose money. For instance, if Bank Nifty falls, say, more than 15 percent in a month, which is rare, but can happen. In such a case, both Bank Bees and Butterfly will lose money.
The risk reward ratio in this strategy is usually 1:3 or 1:4, says Nair.
Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
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