Hope you are safe and in good health.
Let say, for example, we have 15 Lakhs which we want to invest in Nifty Exchange Traded Fund (ETF).
We can buy Nifty from the futures market at 18- 20% margin. Nifty closed on 10th July, 2020 at 10768, multiplying by lot size 75, we get approx Rs 8 lakhs per lot. After keeping 3 lakhs margin, we can buy 2 lots of Nifty futures worth of Rs 16 lakhs. However, the future expires every month on last Thursday, so we have to roll it over every month.
Now we can buy LEAPS (Long term equity Anticipation Securities), is nothing but an insurance for portfolio, we need to buy a long dated put option of Dec 2021 Nifty PE at 800, multiply by lot size 75, we get Rs 60k. That makes it Rs 1.2 lakhs for 2 lots of protection.
We are left with Rs 11.8 lakhs (15-3-1.2), simply keep it in a liquid fund till Dec 2021 yielding 5% approx, this will fetch us cash flow of about Rs 90k for one and a half year at 5%.
The idea is simple, we need to fund our protection (LEAPS) with the cash flow from liquid fund. The LEAP is costing us 7.4 % for one and a half year, roughly 5% per year, which we are funding from liquid fund.
Generally, when we roll over Nifty futures we pay 25 to 30 points premium, since the forward future is more expensive than the current one. Normally, the cost of rolling Nifty futures comes out to be 3-4% per year and the cost of LEAPS also is around 4%, the net cost to us is 7%. However since last 3 months, we are getting paid for rolling over Nifty futures. The LEAPS are a little expensive currently due to high volatility and uncertainty in the markets.
The pay off for this strategy is we don’t lose money if Nifty falls below 10500 and if Nifty kind of gains 12% from here, we can make about 10%, not bad at all.
It’s like heads we win, tails we don’t loose!
A lot of big institutions, hedge funds, banks, etc use this simple strategy.
If you are an investor, you can also hedge your portfolio by buying LEAPS. However, the volatility and standard deviation of your portfolio should mimic the volatility and standard deviation of our benchmark Nifty 50.
To put it simply, if you have a large cap dominated portfolio, LEAPS would do okay to protect your capital, however, if you have a small cap dominated portfolio, it might not work in your favor every time.
This simple strategy can give you Nifty’s upside return over the long term with a little volatility on the downside.
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Happy Investing,
Bhuvan P Batra
Disclaimer: The above information is for educational purpose only, and should not be considered as investment advice. Kindly consult your advisor before investing!
