Given the run of losses as well as extended period of consolidation in May, when further losses looked inevitable, every investor would have looked hard at the portfolio, and wondered if there was any way to make it bullet proof and brooded on their previous choice of stocks and decisions. Decision making is almost always about confronting risk, which in turn is about heading into the unknown. And unknowns are weighed by pitting the prospects of permanent capital loss against that of opportunity loss.
If, as per accounting terminology, businesses can be considered as going concerns, that plan to be in business in the foreseeable future, markets, being representative of such businesses, always tend to price future gains. In other words, more often than not, the risk of opportunity loss gets greater attention, at the time of stock selection or portfolio construction. But given a choice between that, especially in the last few weeks, and a continuously bleeding position, certainly, a market-neutral position is a happy one to be in. So, if you set out to have that as the worst-case scenario, then, the best bet is to give your stock or portfolio sufficient time to perform, so that even a sharp erosion from the top does not worry one. One approach towards this is to be an aggressive buyer in a low-interest rate regime or when inflation is on the lower side. This is a conventional approach that has stood the test of time, but the trick here is to have enough capital ready at the start of the cycle. Another catch here is that we think in terms of events, and makes us take our eyes off the turn of cycles, and instead respond to the fear caused by the events.
Building a market-neutral strategy for a long-term portfolio is dominated by capital allocation and diversification, while short or medium portfolio requires a more dynamic approach, one that requires continuous repair and rectification.
An approach using index derivatives is to sell Nifty straddles in a relatively low volatility environment. This helps give a steady, though low income, when stocks begin to lose their directionality, or when it is difficult to squeeze gains out of stocks. The income from this strategy is derived out of the time value, or excess premium that option buyers are prepared to give, in anticipation of big moves. Thus, this strategy hinges on the investor’s ability to read the volatility conditions of the market.
Another approach, this time using stock derivatives instead of index, uses a combination of OTM puts (or OTM calls) and take delivery (or give delivery). This is different from conventional option buying in terms of investment required. This has the advantage of making use of premium gains if things go your way and taking the route of the physical delivery if it doesn’t. This is a bit tedious than conventional approaches but gives flexibility in volatile and uncertain market situations.
While the mix and approach differ for long-term and short-term market neutral strategies, what is common is the need to construct a portfolio with anticipating oscillations on downsides. While this comes at the expense of a bit of gain, it is certainly better than facing sharp draw downs.
