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Benefiting from leveraging in stock market

Many times, I face a problem of not having enough capital to make big gains in the equity market. I always used to think of capital constraints and how can I overcome it for “Quantum Leap” and as they said, “necessity is the mother of invention” (May be people are using this strategy but for me it’s outcome of 14 years of part time experience in the Equity market). I want to put my views in 5 minute reads and therefore will start with point of how to benefit from leveraging by reducing the risk.

We all, at-least people acquainted with stock market know that futures and option contracts are a few of the more common methods investors use to add leverage to their portfolios. In futures we can take a buy or sell position on pre-defined contracts (fix number of shares) and don’t have to pay full amount. Only with initial margin we can start trading. (We should also have additional funds apart from initial margin to settle daily profit or loss calculated based on daily variation in prices).

E.g. If I have to buy 9000 shares of Tata Power in delivery, Assuming current prices of 77 Rupees per share, I should have 9000 * 77 = ~7,00,000 rupees = ~10191 $ (1$ = 68 Rupees) to buy it.

(I consider 9000 shares because, as per Indian stock exchanges 1 future contract of Tata Power is of 9000 shares).

But in Futures, I need 15% initial margin of contract size (7,00,000 rupees) that is 1,05,000 rupees (~1550 $) + additional amount to pay in case if it goes 8-10% below this price that comes around 70,000 rupees (~1000 $).

  • Hence, in 1,75,000 rupees (~2500 $) one is ready to take position of 7,00,000 rupees (~10191 $) for one contract.

Let’s, extrapolate it for 10 contracts (Depending on your risk appetite)

  • In 17,50,000 rupees (25,000 $) one can take position of 70,00,000 (~100,000 $). 
  • If stock goes up by 20% then we make profit of 14,00,000 rupees (20,000 $) with invested or kept aside money of 17,50,000 (25000 $).

On negative side, I am considering one is buying the stock with maximum 10% of downside and in case of any geopolitical issues or negative news on company, one should be able to sell it at 5-8% losses. Hence, one should be ready to have losses up to 3, 50,000 to 6, 00,000 rupees.  (~ 5000 to 9000 $).

What should be the strategy to make high probability of trade ending on positive side?

If this is so easy, anyone with very basic understanding of Futures can start trading but now comes the stock selection; can we do this with any stocks available in futures trading? – Because if one selects wrong stock then it’s leveraging to lose moneyJ. (Losing pants in stock market)

Here one’s study & analysis of stocks and business is useful, because equipped with this information we are reducing our risk. We are trading with leverage, NOT blindly but with analysis.

My check list for selecting stocks & reducing risk

  1. “A” group stock: Selected stock should be “A” group to avoid big movement, in one day and in turn avoid margin calls and squaring of the positions at unfavourable rate.
  2. Out of favour stock: Stocks should have been languishing for quite some time, e.g. fundamentally good but out of favour. So we know, if our call is wrong we can limit our losses to 5-10% on downside.
  3. Fundamentally strong business: fundamentally stock should be good and one should be convince that if trading calls go wrong, then we should be able to hold for the 10-12% downside. This gives courage to hold positions.
  4. Hedging the position (only if required): Buying Put option. This makes the trading little complex & adds additional cost, but reduces the risk to great extent.
  5. Trade only for 10-20% upside: Once it goes up by 10%-20 then “down side limited” benefit is not available with this stock.

Hence strategy is identify the correct stock, buy in huge quantity at appropriate time & exit at 10-20% return.

Now let’s come to the business,

Can we identify appropriate stock in today’s condition for this kind of leveraging, try it with Tata Power? (Integrated power producer).

Few Market rationales for current low price (In my view),

  1. Leveraged balance sheet.
  2. Utility is a regulated market. General assumption is limited upside.
  3. In Indian context, “Power Distribution Companies” are under debt & don’t have money to buy from power producers and also these distributors are from different state governments not run by central Govt.

My rational for buying,

  1. Down side is limited around 10-12%, I have been watching this stock from last 2 years seems to be stable, unless anything fundamentally changes.
  2. High debt but not because of completely wrong business model, in my view, it was 70% due to wrong govt. policy and 30% due to Management.
  3. Almost all Government policy related challenges are addressed by new government or in final stages of resolution.
  4. Most important Valuation: Current Market Cap is of 21000 Cr. Rupees (~3088 Million $) + Total Debt is around ~42000 Cr. Rupees (6176 Million $). It’s power producing capacity is ~100200 Mega Watt.
  5. If someone wants to put this size of power plant it takes 5-7 Cr. / Megawatt (~1 million $) means for 10,000 MW, cost should be 60,000 – 70,000 Cr. Or in dollar terms around (10,300 million $) and time to set up is 2-3 years, but this company is ready with it now. Hence valuations are not stretched.

Open Risk

  1. Any geopolitical event around the world or particularly related to India which are not in our control.
  2. Any wrong news of the target company, though we have “A” group company, so keep the eyes and ear open.
  3. Insufficient God’s grace 🙂

Addition to all these analysis following two statements of Warren Buffet will also give you required courage to execute it,

  1. “Risk comes from not knowing what you are doing”
  2. ”Opportunities come infrequently.When it rains gold, put out the bucket, not the thimble”.

I am convinced and making a choice? Are you?

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The Blockchain Ecosystem – Short FAQ

In last few days, I was reading many news articles about banks & financial companies joining hands for digitising of processes in different areas like vendor financing, International payments etc. using “blockchain technology” (underlying technology to Bitcoin) & its potential to disrupt traditional processes particularly in financial service industry. I decided to delve deeper into it particularly after reading news that Goldman SachsJP Morgan & few other leading financial institutions filing patents for different solutions with underlying Blockchain technology.

Post my study on this topic, I found that it’s very important to understand “Blockchain & its Ecosystem” rather than focusing on its technical working or Industry specific use cases. Once Ecosystem is understood it’s very easy to correlate the developments in this area. For initial understanding, we can consider technical details, like which Algorithms are used, execution of blockchain transaction, how they solve typical ‘double spending problem’ as “BlackBox” & try to understand the basics of ecosystem. As a business consultant, taking pride in simplifying the complex concept and presenting it to business stakeholders, I decided to connect all these dots & present it in frequently asked question format (FAQ) with my own explanation. It would take 7-9 minute of your reading time, I tried to keep it for 5 minute reading, but looking at topic, I hope additional few minutes would be worth spending.

Q1. What is Blockchain Technology?

A Blockchain—the technology underlying bitcoin and other crypto currencies—is a shared digital ledger, or a continually updated list of all transactions. This decentralised ledger keeps a record of each transaction that occurs across a fully distributed or peer-to-peer network, either public or private.

  • Using Blockchain technology, any party in the network can initiate a transaction (e.g. fund transfer, or any other digitised asset) and updates the copy of “distributed ledger” maintained by all stakeholders in this transaction.
  • Once updated, this transaction is verified by other nodes (called Miners in Bitcoin context) on the network & based on different “consensus mechanism” (running sophisticated algorithms) these nodes confirms only genuine update.
  • Post verification by all required nodes, it’s stored as block. Each time a block gets completed, new block is generated and these blocks are linked to each other (like a chain) in proper linear, chronological order and it’s available for all nodes to check and validate for next processing, providing total transparency.

Note: People who don’t understand ledger can consider it as a “File” where different entries are made regarding transactions.

Q2. Who are these “Parties” in the above transaction?

  • Transacting “party” is nothing but one of the different stakeholder representing nodes of the blockchain network e.g. Bank initiating fund transfer or person initiating any asset transfer request.
  • If we consider “Bitcoin” as reference then any person with computer or mobile can buy and exchange bitcoins or pay for the goods and services.

In terms of two financial entities, it’s like two banks in different countries doing fund transfer transaction. But so far it’s only on “Private Blockchain Network” (please check explanation of it in due course).

Currently, most of the large financial institutions are working on different applications in their labs or technology centre. Few have started on experimental basis. E.g. Goldman Sachs wants to put foreign exchange trade on block chain, New York stock exchange (NYSE) & few other exchanges wants to explore block chain technology etc.

Q3. Can any Party or Entity take part in the transaction?

Again in “Bitcoin” context yes, and technically based on a blockchain technology also it’s possible. But to answer in detail, it’s also important to understand the concept of

  • “Public Blockchain Network”
  • “Private Blockchain Network”

Public Blockchain Network:

  • No one owns the technology in public Blockchain network, like technology behind Internet or email. E.g. Bitcoin is an example of “Public Blockchain Network” It’s controlled by Bitcoin users and developers around the world on consensus.
  • Once any transaction is verified and updated, it’s almost not possible to revert it in Public Blockchain Network, any changes in it can create security risk.
  • It also offers potential to reduce transaction fee.

Private Blockchain Network:

  • This blockchain network is set up & maintained by private entity. Security protocol control & limit access to authorised parties only. E.g. one of the large private bank in India ICICI Bank executed money remittance from Dubai with their Private Blockchain Network.
  • Nodes in this network are part of one organisation or consortium which decides their participants & aim of using this technology in advance. E.g. R3 which is distributed database technology company and it leads a consortium of more than 50 of world’s biggest financial institutions.
  • Private blockchains can authenticate transactions more quickly and there is possibility to revert any transactions as all nodes are of pre-selected parties or of one organisation as compare to public network.

Q4. Who is doing verification of this transaction on “Distributed Ledger” by running sophisticated algorithms & What are their incentive?

  • Processing & validating these transactions needs computer power and in turn investment in specialised hardware and software. In “Bitcoin” context many Fintec companies or startups are investing in it and they are rewarded for this mining work with “Bitcoin”.
  • These companies are “nodes” in this Public Blockchain Network. These participants are very important, because in distributed ledger” system we need more number of nodes to reduce cost, increase speed and possibility of frauds.
  • In “Private Blockchain Network” these nodes could be simply computing terminals maintained by owner of that network or consortium members with technical capabilities to perform validation of transaction.

Q5. Is Blockchain technology really going to remove the third party intermediaries?

  • In “Public Blockchain Network” yes, we can see it from the “Bitcoin Network” but bitcoin is not any sovereign backed currency. When we talk about large scale authorised financial transactions of sovereign currency, we have yet to see any commercial use of “Public Blockchain Network”.
  • In case of “Private Blockchain Network”, Private entities or Consortium’s have own protocols & authorisation rules etc. then that particular entity itself is equivalent of third party intermediary e.g. if R3 consortium today comes up with “Private Blockchain Network” for “International Payment” then indirectly it becomes intermediary (trusted entity), even though technically this transaction is with “distributed ledger” technology.

Q6. Any company, who wants to take benefits of “Blockchain Technology”; do they have to invest in technical infrastructure (hardware, computing machines executing smart contracts, consensus algorithms etc.)?

  • Not necessarily, It’s normal strategic decision making for any organisation to go for cloud solutions (pay-as-you-use models) or invest in own infrastructure. In my view, big multinationals or financial institution may set up own private block chain network depending on applicable regulations & cost benefit analysis.
  • Consortium’s can also set up their own Private Blockchain Network or may use “Blockchain-as-Service” model offered by many leading technology companies.
  • Blockchain service suits and platform providersThese are also very important stakeholder in this ecosystem; these companies are offering Blockchain Technology as service. Hence many corporations who don’t want to develop their own network or invest in technology can use these solutions. Few leading providers are,
    • Hyperledger Project: IBM leading role in the Linux-led Hyperledger Project.
    • Ethereum: It is an open source, public blockchain-based distributed computing platform, featuring smart contract.
    • Microsoft Azure: Block chain as service (BaaS) from Azure.

There is no doubt that blockchain will usher huge benefits to banks and financial institution, but below two points are important and needs to be considered about this technology.

  • It’s not “one-size-fits-all” solution. Based on requirements, appropriate solution should be designed.
  • Apart from technological requirements, certain legal points are still not clear for commercially role out of financial use cases. E.g. Lack of Legal framework for the insolvency of the block chain participants, liability for enforcing anti-money laundering (AML) standards & managing overlapping jurisdictions. I hope benefits of this technology will force governments and legal bodies to work on it or priority.

I believe this technology is going to be disruptive & in today’s challenging business scenario Corporations need to come up with strategy to implement it sooner than expected.

Acknowledgement & Note: I have tried to use links in the post, but this analysis is outcome of secondary research on Internet. Views shared are my own and I welcome your views, suggestions through comments!!

The Blockchain Ecosystem – Detail

I was reading a lot about the blockchain technology and revolution (now days “disruption” is the right word to use it) it may bring in different domains particularly in Banking & Finance. I had idea about Bitcoin (Crypto Currency) but never paid attention to it, since it is without any regulatory framework or without any sovereign support. But in last few days, I have come across few news articles that Goldman SachsJP Morgan & few other leading financial institutions filing patents for different solutions with underlying blockchain technology (underlying technology to Bitcoin) and then, I decided to go deeper into it.

I found many articles explaining the blockchain technology or its theoretical use cases in the different areas. Hence, few articles related to working of blockchain technology were too much technical and other were too shallow (Only use cases). As a business consultant taking pride in simplifying the complex concept & presenting it to non-technical business stakeholders, I decided to connect all these dots & present it to reader in such a way that post reading, one should be able to understand the blockchain technology and its ecosystem in holistic manner.

Blockchain in simple terms: It is an emerging way for businesses, industries, and public organisations to almost instantaneously make and verify peer to peer transactions. It’s transparent, secure & fast because from start of the transaction to end of it, all involved authorised parties are verifying all earlier transactions (through complex algorithms) before saving it on their version of file. (It’s called “Distributed Ledger, more explanation is provided in due course). All these recorded transactions are open to public scrutiny, hence few possibilities of manipulation.

Imagine a scenario, where person buying a land or house doesn’t need to register it with “Government land record office”, when particular house is bought or sold, this digital transaction itself is the proof that can be archived in the database – “Distributed Ledger” of concern Government departments, mortgage banks etc. at same time. All these stakeholders will have single source of truth, updated with latest changes in the underlying Asset.

Little difficult – ok, let’s look at a current real life scenario of a fund transfer between two companies located in different countries. We will see changes in this typical “International Payment” process with the introduction of “Blockchain” technology. When we are going through the “Blockchain” based process, I hope many questions will start popping up to reader and I will try to address it in that context itself so that reader can really co-relate it.

Company “A” in USA wants to transfer funds to Company “B” in India. Normal process has two or three scenarios based on different permutation and combination. But to keep it simple, we will consider following one.

If concern banks of company “A” in USA and Company “B” in India who wanted to do transaction is NOT part of same “clearing house”

e.g. in USA its Clearing House Inter-bank Payments System (CHIPS). If “bank AA” and “Bank BB” of “Company A” and “Company B” respectively are not part of CHIPS then process of fund transfer is as follows,

  1. “Company A” in USA initiate fund transfer request with its “bank AA”.
  2. “Bank AA” looks for the correspondent “Bank AAA” which is member of clearing house, and then transfers funds through SWIFT to “Bank AAA”.
  3. Correspondent “Bank AA” will send fund transfer command to clearing house for transferring it to “bank BBB” in Japan which is correspondent bank of “bank BB”. (Of company B).
  4. Clearing house will make the necessary credit (in BBB record) and debit (in AAA’s record) as both are its member.
  5. Post receipt, “bank BBB” will transfer funds through SWIFT to “bank BB” and then “bank BB” will deposit it in company B’s account.

Every layer or party in this transaction adds time & commission, and ultimately customer pays for it.

Fig 1: Typical Fund Transfer Process with Clearing House (Intermediary)

Fig 1: Typical Fund Transfer Process with Clearing House (Intermediary)

New process with Block chain technology should be with following steps

  1. “Company A” in USA initiate fund transfer request with its “bank AA”.
  2. “Bank AA” directly executes fund transfer request to “bank BB” in Japan via the “Blockchain network” (We will be discussing this point in detail but actually this activity takes place automatically with some agreed protocols, algorithm between all participating institutions).
  3. “Bank BB” in Japan receives the fund and deposits it in the account of “Company B”
Fig 2: Fund Transfer with Blockchain Technology

Fig 2: Fund Transfer with Blockchain Technology

Process is simple, but above step-2 throws up many questions,

  • How this block chain network works? Where is the centralised ledger managed by clearing house? (Note: People who don’t understand the ledger can consider it as “File” where different entries are made regarding transactions.)
  • How “bank AA” can trust “bank BB” without any intermediary (Trusted third party – clearing house)? What are these nodes in the network?
  • “Blockchain Network”, Is it Private network or Public network like Internet and who owns it?

Let’s take one by one and connect these dots to understand the complete Ecosystem of Blockchain.

Working of blockchain network:

If we see the normal process which is in practice today (Please check the fig: 1) with intermediary, primary function of intermediary (Clearing House) is bringing trust in the transaction. Centralised ledger lies with clearing house, it has both banks in its network and it’s responsible for settlement.

In case of block chain technology, its “distributed ledger” (Please check fig: 2) maintained by all stakeholders in the transaction. Every authorised party (Node in network) read and writes in their copy of ledger which is validated using some algorithm with other ledgers in the network following same protocol. Only validated transactions are stored in the ledger.In summary, a shared ledger contains the single record of all network transactions, and is replicated across all network members. Hence everyone involved have single source of truth in the form of distributed ledger which is updated with each transaction in the network.

Trust between two banks in absence of trusted third party – clearing house & Nodes in the network:

If we see the process in above Fig: 2, it seems to be very simple but to understand it in detail blockchain network should be explored in context of its different stakeholders.

  1. Nodes in the network & it’s functionality
    • These nodes are responsible for the maintenance of the ledger and verification of transaction.
    • Every node in the block chain network is maintaining its own copy of distributed ledger where entries are made for the credit and debit. Entries are maintained with correct order by following few algorithms which decides on the consensus mechanism & few other things.(These are technical details, but it’s necessary for security and validation of “Distributed Ledger”. It’s to avoid scenario where people are misusing the network by double spending. e.g. Mr. A has only 1 million Euro to spend but he is creating two transactions at fast pace and transferring more money to multiple parties than his actual account balance).
  2. Network participants representing the “Nodes in Network”
    • These nodes can be different stakeholders in transactions e.g. participating banks, Government Agencies, manufacturing firms, securities firms etc.
    • If the blockchain network is private then company who owns or defines this network can decide which parties can become these nodes. Based on the requirement of the underlying asset e.g. Money, Shares or Piece of Land, involved parties can agree on the smart contracts and responsibilities of different nodes. Also all stakeholder companies can decide about the remuneration of nodes. If blockchain network is part of big organisation & developed for its internal transactions then these nodes are more doing the role of maintaining the distributed ledger.
    • If the blockchain network is public  like underlying network of “Bitcoin” then technically any computer (owned by anyone) can be connected with required hardware & software to perform above mentioned duties of node. Generally these are called bitcoin miners in that ecosystem. (Bitcoin startups). In public blockchain network these nodes will be paid for their contribution and this is equivalent of processing fee in any transaction.
  3. Blockchain service suits and platform providers: These are also emerging as very important stakeholder in blockchain technology and these companies are offering Blockchain technology as service. Hence many corporations who don’t want to develop their own network or invest in technology can use these suits. Few leading providers are,
    • Hyperledger Project:IBM leading role in the Linux-led Hyperledger Project.
    • Ethereum:It is an open source, public blockchain-based distributed computing platform, featuring smart contract.
    • Microsoft Azure:Block chain as service (BaaS) from Azure.

The important point which I would like to make about “Distributed Ledger and Blockchain” is they are NOT “one-size-fits-all” solution. Based on the requirements, approach should be decided regarding type of blockchain network, different stakeholders & their role, protocol to be followed etc.

Summary:

It all started with “Bitcoin”(crypto currency – no physical existence but piece of data in block chain), but it’s underlying technology – “Blockchain” found applications in multiple domain and now large financials companies wants to cash on it. Blockchain is going to reduce the cost and complexity of cross-enterprise business processes. Its distributed ledger makes it easier to create cost-efficient business networks, where virtually anything of value (any Asset like Currency, Document & Financial securities etc.) can be tracked and traded, without a centralised point of control. Blockchain is already showing great promise across a broad range of business applications. E.g.

  • International Payment: It can help in addressing current problem of the correspondent banking system by allowing peer to peer transactions.
  • International Trade Finance: In areas of “Asset Tracking”, “Smart Contracts” etc. where the challenges are manifold particularly trust factor and solvency of the trading partner.
  • Over the Counter (OTC) market infrastructure: OTC trading is major business area of investment banking departments and involves the trade of all kind of financial products. E.g. Blockchain networks allow securities trades to be settled in minutes, rather than days.

There is no doubt that blockchain will usher in huge benefits to banks and financial institution, but apart from technological requirements there are certain points which are still to be resolved for commercially rolling out these use cases. Like, Lack of Legal framework for the insolvency of the block chain participants, liability for enforcing anti-money laundering (AML) standards & managing overlapping jurisdictions.

No doubt we are on cusp of disruption in banking & finance processes but we still have some time to catch up before ship leaves the shore.

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