Case 1: Karthik, a stock market investor, reads in newspaper that oil prices will go up because there is talk of war going on in media. There are predictions that US might impose severe sanctions on Iran on nuclear issue. This is further supported by rhetoric by politicians of both sides. Karthik has been waiting to invest in Oil India but could not do it in past because of various reasons. He thinks this is the right time to buy Oil India as the stock prices will go up because of oil prices. Karthik buys 1000 stocks of Oil India at 1200 per share and invests 12 Lakhs.
In next 3 months, the war rhetoric is controlled. America realizes that it cannot afford another sanction and disappoint Middle East as its rating has seen deterioration in last 10 years. Iran also slows down its nuclear program and agrees for an international oversight on its nuclear facilities.
The prices of Oil India do not go up because of this. In fact, the prices come down to 1110 per share. Karthik decides to sell off his holding. His loss is (1200 – 1110) / 1200 = 7.5%
Case 2: Rajiv, a commodity trader, hears about the bumper crop of sugarcane this year that will glut the market because rain is good. There has been heavy sugarcane production. This will be cut, processed, and sold in the market in next 3 months. Rajiv holds 10,000 shares of Renuka Sugar bought at Rs 60 a share investing 6 lakhs. He doesn’t want to incur any loss and hence decides to sell the stocks at current market price at Rs 65 a share.
In next 3 months, there is heavy rain that destroys a significant portion of sugar crops. The production of Sugar is going to be 20% less than stipulated. The demand of sugar goes up and Renuka Sugar’s share price shoots to Rs 80 a share. Rajiv, by selling it early, makes a notional loss of Rs 15 a share.
Questions: How can Karthik and Rajiv avoid these situations? How can they insure against any eventuality where their projections about stock prices go wrong?
Possible Scenarios: One way would be to place the stop loss order. For example, in the first case, Karthik places a stop loss order at 1170. This means the broker will sell the stocks automatically when the price goes down to Rs 1170 a share. He will not have to keep an eye on the share prices if he places the stop loss order. Essentially he has capped his loss to (1200 – 1170) / 1200 = 2.5%.
In the second example, Rajiv places a stop loss order at Rs 70 a share. This means if the prices go above Rs 70 a share, he buys it. Essentially Rajiv doesn’t miss the rally and still gains Rs 10 a share and partially offsets the notional loss.
Problem with stop loss order
We know that stock market is volatile and hence prices of shares keep going up and down in short term. Suppose in first case, there is some other crisis (say North Korea / South Korea tension) and America’s attention goes to Korean peninsula. The rhetoric between America and Iran cools down. The prospect of oil prices looks good and Oil India stock goes down to Rs 1160 a share. This means Karthik’s stock is sold at Rs 1170 a share whenever Oil India share touches this price.
In next 1 month, China and America flex diplomatic muscles and convince North Korea and South Korea to resolve the differences. The focus goes back to Iran’s nuclear issue. The issue flares up and oil prices start moving up in the anticipation of sanctions and possibly war. Oil India’s share price touches all time high of Rs 1340 a share in next 1 month. However, by this time, Karthik doesn’t have share to sell and hence he cannot take part in the rally. He may not want to buy now since the prices have already gone up.
Take the second example. Suppose there is heavy rain and it really destroys a significant portion of sugar crops in next 1 month. Hence prices start moving and touch Rs 70 a share in next 1 month. This compels the brokers to buy more shares of Renuka Sugar for Rajiv. He buys another 10,000 shares by investing 7 lakh.
The Government realizes the production loss of Sugar and eases the import restriction. The Government essentially allows sugar imports in a big quantity from Pakistan. This brings down sugar prices to the original level and there is anticipation that prices can fall further. This brings down the share prices of Renuka Sugar to Rs 60 a share. Rajiv has lost further on his investment of 7 lakhs. His total notional loss is 1 lakh. He may not want to sell it now to realize the loss.
What are the options we have to save us from these situations?
Surprisingly there are options to save us from these situations and even more surprisingly they are called options.
An option is a right to buy or sell but not the obligation. There are two types of options, namely call and put options. A call option is right to buy but not the obligation to buy. A Put option is right to sell but not the obligation to sell.
We will discuss options in more details in our next article. Keep reading.
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Pankaj Priyadarshi
Pankaj Priyadarshi is an author at Lastbull.com. He has 11 years of international and domestic experience in the areas of Finance, Management, and Business Analysis in the USA and India.He is a co-founder of 'Vertical Grass', a consulting initiative in the area of finance. A Graduate from IIT(Engineering) and ISB(Management).
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