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?