Freeing the speculator from the investor


For most things that are a bit difficult to understand, people usually have a very standard approach. The approach is to view them with suspicion. If there is an alternative to it, then that naturally becomes popular choice, by virtue of it being simpler to understand.

It is no different in stock markets. We have the investors, the elite class. And then there are the speculators, the second class citizens. The investing community and their custodians loathe the fact that the speculator gives scant regard to valuations, or fundamental reasoning and trade numerous times, all of which are huge turn off for a classic investor. In reality, most people do not belong to either category. They begin as investors, and trade multiple times in a short period, willing to use broker’s leverage or margin funding facilities, as long as those trades generate profit. But as soon as they see losses, they retire to their “investor” shell, and hold on to their positions for a longer time frame, expecting the losses to be recouped on its own. For them, it is not just investment or trading; there is only money making.

Dr Jekyll and Mr. Hyde: Investor and speculator

Most people do not understand how algos, technical traders, bargain hunters, swing traders etc. make their money. Aren’t they all speculators?

Speculation is inherent to any investment, plainly because, fair price is a sum of several moving parts. To value the stock and arrive at a finite figure, the fundamental analyst or the classical investor invariably speculates on any or each of those components that make up the price expectation. May be that, the present market price of a stock is not fair reflection for the stock’s potential, or that the broad market sentiments will be strong enough to give an extra price multiple in addition or and above the stock’s fair price, or about the raw material prices sticking to historical trends, or about its management staying the same. And so on. Trading, on the other hand, is a skill. It is a play on the speculator that the investor is. It requires courage, discipline, knowledge about market and tools, and the presence of mind that comes with experience, to conjure a winning move or exit unscathed when things go south. And while they are at it, they deepen the market with their high volume trades, bringing bid asks closer, making them the salt of stock markets. So, if there is a stigma attached with those investment approaches that are not based on book value, PE or P&L, it is not because such approaches are not easily discernible, but it is because some of them are also shady or unscrupulous. It is this aspect that SEBI has vowed to confront head on, with its recent interventions.

SEBI changes the music for the derivative trader

If you go by SEBI’s statistics, the Indian equity derivative market is among the most speculative in the world. The primary contention for this observation is that the derivatives turnover has grown sharply since 2004, and at a much faster pace than the cash segment as per data compiled by SEBI. At 15.59, the ratio of equity derivative turnover to cash market turnover, is obviously among the highest in the world, though this statistic by SEBI’s admission has not included US statistics due to large shares of Electronic Communication Network (ECN), dark pools etc. While a high turnover ratio is not a proper benchmark to deem the derivative market as speculative, it is also in the government’s interest to deepen the cash market participation, with an eye on boosting tax revenues from the cash segment as well as boosting household savings. So, SEBI, in its wisdom, set out to work along the derivative turnover question, along with others like interoperability of clearing corporations etc. The work along derivatives started early this year with single stock derivatives shifted systematically in the subsequent months to physical settlement. By October 2019, all the 149 single stock derivatives were to be physically settled. Prior to this, these stock derivatives were cash settled, which meant that all open positions were squared off on the expiry day and the differences settled on the basis of the underlying’s closing price of the day, with no actual exchange of underlying stock. With physical settlement, all positions that were open in the last week of expiry were deemed to be settled with the underlying. Since derivatives are dealt in lots, rather than individual stocks, this would have meant coughing up of significantly higher amount of money when compared with the relatively small margin amount that was required at the point of initiating the derivative position. The new settlement methodology negated the requirement of the underlying’s closing price, which was in fact a point of contention, as a few stocks were vulnerable to be influenced on the expiry day, by persons acting in concert (PAC).  The higher amount naturally prompted traders to square off their positions prior to expiry. This meant that traders riding on option strategies built on theta (time decay) or option sellers riding on expiry day’s margin benefits had to take their skills elsewhere.

For now, this hasn’t quite killed the volatility, at least just not yet, but has just shifted places. It is now visible on the last Monday, or Friday before expiry, but it will be a while before a trend is visible. In this context it is noteworthy to look at how another change at exchange end, threw open a few beneficial outcomes. This is the introduction of Nifty weekly contracts. Not only did it deepen the Nifty derivatives market, by easily generating more volumes than the monthly expiry contract, but also ensured that volatility on monthly expiry doesn’t go overboard. The volatility is still there, but is spread across other Thursdays, when each of the weeklies expires. There has been a couple of useful outcomes for the trader too. Every week, one can take a short term view (with the weekly) and a long term view (with the monthly). And more importantly, Nifty option spectrum of the current week, studied along with the carry over or build-up of positions in the next weekly or monthly gives a good reading of the evolution of trend. This, in my own experience, is a fairly accurate leading indicator towards broad market moves.

The right price – A mirage

Price target of a stock, whichever way you arrive at it, is often a moving target, so much so that it is often left to the discerning mind of the investor to figure out, rather than depending on a valuation model to conjure the right number. Which is why If you, track the latest market disruptors, after setting aside regulatory interventions, or track where smart money has gone into the industry in recent times, you can see that latest efforts are not in search of arriving at the best fundamental valuation model or price target. Discount brokers, who have changed the playing field for both investors as well as traditional brokers, have become popular because, they chose to challenge the physics of investment, by reducing the gap between the investor and price information, with the aid of technology and by keeping cost low. The upshot of this is that the investor today is able to liberate the speculator in him.


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