Option Strategy Follow up (Jan 29 2010)

This is the follow-up of the options strategy discussed here.
This month was like a feast for option sellers if someone has followed the strategy discussed earlier.

During the first week of January when the market was touching 5300 I sold the following call options of February
5700 Call option at a premium of 28 Rs (20x number of options)
5600 Call option at a premium of 45Rs (15x number of options)
5400 Call option at a premium of 79Rs (3x number of options)5200 Call option at a premium of 210Rs (x number of options).

The x in brackets is the distribution of options I have sold. I have given this to demonstrate how you can change your risk profile and return ratio.

Here the 5200 option carries the maximum risk, and that’s the reason why I got maximum premium for that. As I mentioned that I am a medium risk taker this market from my point of view has gone up far ahead of its fundamentals in the short-term. This is the reason I want to capitalize on any short term aberrations in valuations. My breakeven point for this option is 5410. This means if the market were to go up above 5410 on a closing base on Feb 25th I will have loss in the 5200 call option selling.

To mitigate this I sold higher out of the money call options of 5400 (break even at 5479), 5600 call option (breakeven 5645) and 5700(break even 5728). Also I sold more of 5700 call options since it carries less risk.

All these options have been sold around Jan 1st week and second week with an expiry of Feb 25. Now after the crash all these options are reduced to a minimum because of the time decay and the adverse market conditions.

Given below is the current value of all these options.

5700 Call option – 2.5 Rs
5600 Call option – 3.45Rs
5400 Call option – 7.90Rs
5200 Call option - 26Rs

Given the market conditions I am almost sure most of these options will expire unexercised

You can calculate the returns from this kind of a trade. The margin for selling one lot is around 18000Rs (And this is almost same for 5200 and 5700 options). So if I calculate the least returns on a 5700 Call say for 2 months (you can also cover it now if you want) it will be around 1400Rs for an investment of 18000 for 2 months. This itself is around 45% returns per annum with a very low risk strategy.

And for this you do not have to shell out money as I have mentioned. Pledge your existing shares and pool the margin money and reinvest the premium got.

Since all these options have reduced to penny Friday I have reversed the trade I covered the 5700 and 5600 call options so that I can release my margin and sold some out of the money put options.

4600 Put option at a premium of 70Rs (x number) (breakeven 4530)
4500 Put option at a premium of 35Rs (5x number)(breakeven 4465)
4400 Put option at a premium of 23Rs (10x number)(breakeven 4377)

Even though I am bearish on the market in the short term I do not expect it to touch 4500 by February since the budget event will keep the tempo of the market slightly high.

Now lets see what is the fate of these options :-)

Maximize your returns using Options !!

If you read my Investment Philosophy I am sure I do not feel like a trader or speculator who dances to the tune of the market. Yet my next post is how to effectively use index options to maximize your returns in the market.

Even though I prefer to invest in companies after lot of research, eventually I am in this market to make money. So it really does not make any investment sense to put restrictions like only generate returns by investing long term in the market. In fact I have figured out a way to generate some very handsome short term returns by effectively using index options without sacrificing by long term goal of good returns from stocks. (I have not applied for patent for this strategy yet :-) since it is a very common strategy used by many people)

And the returns are pretty handsome anywhere between 35% and 60% per annum depending on your risk profile. And more over this will come as a byproduct of your existing investment in stocks which will eventually add up to the returns that your stocks make.

Now before I discuss this strategy I would advise you to read my Disclaimer. This is because what I will be discussing now will qualify has a high risk strategy for some people. My risk profile is above average and all my strategies are aligned towards that risk strategy. So this goes as a special note of caution. Please do not follow this option strategy if you are not aware of the basic concepts of option trading. This strategy will expose you to very high risk some times. And at least once or twice in a year you are likely to face huge losses if market moves in one direction strongly (Like a Black Friday, or a golden Monday etc).

This article assumes that you are you are aware of the basic concepts of futures and options. This article is not a refresher to Futures & Options strategy.

A strategy where you can make unlimited loss and limited profits!!

Yes this strategy is all about selling options where theoretically you can make unlimited loss and limited profits. I know half of the people will stop reading this ridiculous post after the first line after all who wants to hear a strategy where your profits if any are limited and loss is unlimited. And moreover what is this all about selling of options, we as a conservative investors know only to buy options as a protection against market volatility and play safe.

Most of the investors think the same about options. These are safe way to play the market you pay a premium to buy a call or put option depending on the market conditions and make money from favorable market movements.

However how many of us including me has lost the money while buying options due to any of the following condition.

• My option simply expired as the market did not move as expected
• My option expired since market moved in the opposite direction.
• Market moved in the direction as I expected still I made a loss as the premium I paid for the options was high.

Options are very brutal instruments where the time plays a key factor in deciding the value of options. We call it time decay. Time decay can destroy the value of your options under the following conditions even if the market moves against you but not in the same pace.

Confused!! No problem I have illustrations please be patient.

Now what if we can make this time decay favorably on our side and make some profits instead.

The Strategy

Simple sell far out of money call / put options and pocket the premium in advance and wait for the time decay :-)

All of us know for buying the options we need to pay a premium and the seller of the options will get the premium upfront and will assume all the risk in case the buyer wishes to exercise the option in his favor. This is what I meant by unlimited risk earlier.

So what if there is any option which I can sell where there is very less chance of getting exercised? In that case I can pocket my premium upfront and wait for that option to expire.

However the key to this strategy to workout properly is the timing of selling the options. This timing can determine at the end how much you make as profits every month.

Sell Call Option when market is going up and Put option when it is going down

The idea behind this strategy is to capitalize on the market fatigue after it has made a move. Market will always over react on its way up and way down. You can find instances of this over reaction every monthJ. For example in the first half of this month the market was about to touch 5300 and most of the people in the market were predicting 5500 by the end of January. You open CNBC and you will be flooded with analysts who were predicting a level of 5500 as an immediate target for Nifty. The most surprising fact is that even though the markets were rising steadily for last two months from 4700 to 5000 to 5250 many people simply forgot the basic principles of life – “What goes up will come down”. You throw a stone up, depending on the speed that you throw it will go up initially covering more distance with less time and slowly the fatigue starts kicking in the speed reduces and there will be a position where it is in no position to go up and the only way is to go down. This is the same case with the market. When markets where at 5300 people were expecting it go to 5500 so the best thing to do over here is sell the 5600 call option and pocket the premium (say 50Rs).

If you have sold the Jan 5500 call which was quoting at around 50Rs during Dec the current price for that is around 0.6Rs (yes 60 paisa). You do not need to cover it even now just wait for 2 more days it will expire (means the price will reach zero).

The same is applicable for put options also. In just 3 days the market has retraced from 5270 to 5000 now. If you see 4500 Feb put option it is trading at around 25Rs. If you believe that the market can go down but not to 4500 in Feb then you can sell this option and pocket the premium.

Biggest margin of safety while selling Call options

I like selling call options than put options. One of the main reasons behind this is that there is very little chance of making absolute loss if you follow some steps.

• Always keep the margin for selling call options as stocks and not as cash

Normally for selling one lot option the retail margin is anywhere between 17000 to
20000Rs. And this can vary from broker to broker. Most of the brokers will have an option
to keep this margin either as cash or as pledge of equal value of stocks. So in worst case
scenario even if the market rises to your option level your stock price will also rise (the price of the pledged shares)

• Your pledge stock price also rises with the market giving you more room to sell options at higher levels.

Finally

So that’s all about this strategy as of now. I am thinking of a section where I can discuss every month which option are sellable from my point of view. Let me know what you think of this so that I can plan for this.

So for me this is just a way to maximize the returns of the stocks which I hold for long term where I pledge those shares create margin money and use that margin to sell the options. A simple calculation shows the returns from this strategy anywhere between 55-60% per annum if you execute these trades smartly. And more importantly never try this strategy in stock options as there will always be a stock specific risk

Kale Consultant, 3rd Qtr Results Update

Results on track!!

Please read the initial analysis here

Kale 3rd Qtr results are out and the best part is there are no surprises!!. Kale continues its steady growth in the 3rd Qtr also.

Kale reported a consolidated turnover of 43Cr for the Qtr with a PAT of 5.6Cr. The EPS for the 3 months ending Dec is now 14.5Rs.

*Includes an exceptional item of Rs. 2.18cr
QoQ there is a steady growth and no surprises. Typically I do not like companies where there is lot of earning surprises. The company continues its momentum with its steady rate of customer wins this time it is Jet Airways, India’s leading pvt airline.

Projection for the 4th Qtr ( My estimates )
Typically for Kale the 4th Qtr is the best I expect the 4th Qtr consolidated earnings between 45-48Cr and the consolidated NP between 6-6.5Cr (If there are no exceptional items).

Which will bring the March-FY2010 earnings to 164-167Cr. The NP is expected to be between 20.5 – 21Cr range.

There was a reporting mistake in my earlier report where I projected it as 30Cr (I miscalculated the exceptional item from last Qtr). So I am slightly upping my revenue target from 160Cr earlier to 165Cr and the NP target to 26Cr from 30Cr.
The FY 10 projected EPS is around 20Rs and the stock at 95Rs is trading at a PE of less than 5.

The stock should do well after the results and any price which is less than 80 is a very good entry point now.

Kale Consultants , On its way to become great !

Investment Highlights

• One of the leading providers of revenue recovery and audit services to airlines globally
• Kale's audit platform is endorsed by IATA (The only one endorsed by IATA) and is the preferred audit provider to the Star Alliance group of airlines
• Has more than 100 clients across 5 continents, including 12 of the top 20 airlines
• It is estimated that over 300 airlines will use the SIS initiative by IATA when it goes live in 2010. SIS (Simplified Interline Settlement) is being developed by Kale.
• The hosted service model offered by Kale helps airlines to streamline its noncore processes with minimum upfront investment
• The recent study conducted by Kale for technology adoption in Indian logistics industry pointed out that only 0.26 % is spent on IT by the Logistics ecosystem as against the global standard of 2-3%. This shows a huge untapped market waiting to explode.
• Less than 1% of the logistics industry in India is organized and there is lack of industry-wide standards, processes, and established technology solutions that creates an opportunity to establish the benefits of technology.
• Also it is estimated that the demand for technology solutions in logistics industry in India is set to cross Rs. 1000 crore by 2013.
• At CMP of 90 Rs this market leader is trading at a valuation of just 120cr.
• Company is at the verge of an inflation point with a reasonable valuation
• The company has been growing consistently for last 5 years even during global downturn.
  [Source: Some of the figures mentioned above are sourced from the study conducted by Kale Consultants. For more details refer the company’s web site http://www.kaleconsultants.com/]
  

Introduction

I always think that why the book "Good to Great" by the celebrated writer Jim Collins always have a great influence when it comes to my investment decisions. In that book Mr Collins has systematically analyzed many companies and who have transformed from a good company to a great company. Some of the concepts that he described like the flywheel effect, hedgehogs are worth mentioning.
Kale Consultants to my mind is one such company which is slowly exhibiting those behaviors and is on the way to become great.
For the benefit of the readers who are new to the book "Good to Great" I will just explain the concepts. This is just an introduction and I would suggest that you read that book.
Refer to: http://www.jimcollins.com/

First Concept: The flywheel effect
After analyzing many successful companies that became good to great as per the parameters described in the book Collins found that there is no dramatic incident / change in any of these companies which overnight transformed them in to great companies. Most of these companies were simply mediocre companies who slowly mastered their business and became best in their business over a period of time.

The whole process of transformation is described as rotating a giant flywheel.

You take great effort to push the flywheel for the first time. With each rotation things are getting better for you and there reaches one stage where your every push has a multiplier effect on the flywheel. Now you really cannot tell which push caused the flywheel to rotate that fast (was it the first push or the last push?..No every push is important).

And more important is the focus and the direction of the effort. You are not reversing the flywheel push every time. And with every push you figure out the best way to push the flywheel , so that you are more comfortable and which gives maximum benifit.By doing the same task every time you are mastering the art of pushing the flywheel and also you are setting new targets every time with every push.

Apply this to the companies you know and you may spot a good to great company which can give you dramatic returns over a period of time.

Second Concept: The hedgehog advantage

A hedgehog is the boring animal that you ever see. It moves slowly, it’s ugly and full of thorns. All these things make the life of a hedgehog very challenging. On the other hand fox is a very cunning animal, very fast and intelligent. But every time the fox tries to catch a hedgehog the poor hedgehog knows only one thing to do

It just bends its body to form a circle or like a ball with all its thorns pointing outwards. The fox tries all sorts of techniques that he knows to catch the hedgehog, every time coming up with an intelligent and innovative idea to catch the hedgehog. But at the last moment the hedgehog does what it knows best to safeguard itself. Only one thing which he is best at doing.

Apply this to the great companies that you see around. Every one of them has a similar hedgehog concept which it can do best. They usually do not try too many things or diversify in to unrelated areas. It keeps on improving its core competency every time improving its efficiency.

Normally it takes years of effort, time and dedication to know and understand your hedgehog concept. Once you identify it work on it, improve it and be the best in it. This is exactly the same thing successful companies across the world are doing. The fox over here is the competitors and the environment in which they operate in.[Source: Good to Great by Jim Collins]

About the company

The company that we see here today is a small cap company: Kale Consultants, a leading solutions provider to the global Airline, Logistics and Travel (ALT) industry. Let me first of all make things clear this is not a software company, it is a solutions provider for airlines, travel and transportation industry who provide solutions in partnership with the industry bodies and customers

The company has been in this business for over 10 years now and now slowly moving up the value chain by providing solutions for the travel and transportation industry. The company over a period of time has acquired great domain knowledge in the travel and transportation industry mainly airlines (which is their hedgehog) and is now slowly moving towards the logistics industry leveraging the business knowledge it has acquired over the years.

This deep business knowledge has helped Kale to work closely with the main Industry body for air travel IATA. In partnership with IATA, Kale is developing many standards based solutions for the airline business. And in majority of the cases Kale is the sole vendor or preferred vendor for IATA. Naturally all major airlines which are part of IATA, looks for any process improvements / efficiency naturally select Kale’s solutions.

Performance Snapshot

If you look at the 5 years starting from 2004-05 to 2008-09 it is more of a steady growth for Kale. That time can be considered as the base setting times were Kale was trying to identify and grow its hedgehog concept. Like other software companies at that time Kale also was there in to every aspect of software services business. It operated an enterprise division which created products and solutions to the Banking and Airline industry. Later they found out that their core strength is in the airline business and not in the banking division. So they sold the banking division to Onward technologies in 2003. From then onwards they were continuously working on their core competency and created a niche in that. The company progressed from a mediocre software service provider for the airline industry to a full fledged solutions provider for the airline, transport and travel industry.

The performance of the company during this phase of growth is given below (Remember the initial push of the giant flywheel).

[Source: Company annual report 2008-09]
Now to me it has come to a phase where the company has entered in to the next level of growth. The estimated figure for the year 2009-2010 is given below
Consolidated revenue: 160Cr*
Consolidated Net Profit: 30Cr
EPS: 22Rs*
* These are my estimations and is subjected to my knowledge levelThis is what I referred to as the explosive growth going forward. The flywheel has reached that stage where your efforts are having a multiplier effect on the movement.

Business Prospects

Globally airline business is going through a very rough patch. Very few airlines in this world are profitable with majority of them have a bleeding balance sheet. This case is almost the same with the logistics industry due to the global economic slowdown.
Most of the airlines are trimming down and trying to cut down unnecessary expenditure to stay afloat in business. Same is the case with non core activities of airlines like Revenue accounting, Revenue recovery and Audit services.

An industry estimate states that about 2-5% of revenue is lost every year due to inefficiency in the system and with channel partners. Also when it comes to airline business it is very common that most of the airlines work through their channel partners and inefficiency at the partner level means a direct revenue loss to your business. These include revenue losses due to ticketing, under-collection of fares and incorrect application of fare rules on tickets issued by the travel agents, inaccurate settlement between other airline partners, either intentionally or erroneously. About 0.7 - 1% of this is directly attributable to ticket sales related errors.

Another area of concern is the process related inefficiencies in the airline business. Kale is working with many airline bodies to remove these inefficiencies in the system itself which can save lot of money for the airlines. For example kale is working with IATA for developing its industry-wide interline settlement platform Simplified Interline Settlement (SIS).At its steady state 3 years from today, SIS will handle over 1 million invoices per year, be used by over 300 airlines, support over 3,000 users around the globe and facilitate settlement of approximately USD 50 bn per year for the industry. And more importantly this will save USD 500 mn annually for airlines.

Most of kale's solutions for the airline industry is derived from its deep knowledge of the industry practices and knowledge of pain points that globally airlines face. This has resulted in better solutions for the airlines resulting in process improvements.

Hosted Business Model

One of the USP (Unique selling proposition) for Kale's solutions is its hosted model. Airlines that wish to improve any of its processes do not have to buy or invest in systems to get this solution. Instead they can subscribe to Kale's hosted solutions and pay based on the transactions they do. This will takes out lot of risk from a system implementation perspective and make airlines in a comfortable position. There are no huge upfront costs they just have to pay as they use it.

Also it is now more aligned to their business conditions. When they make less money they have to spend less for their IT budget as most of the Kale's solutions are on a pay / per transactions model.

They can also outsource their entire backend process through kale’s MPS (Managed Process Service) where Kale take the responsibility of entire business process including People, Operating process & methodology & Underlying software & technology. Here also the airlines save huge upfront costs.

Now for Kale this assures revenue visibility over a long term. Such customers typically have long term contracts, with every possibility of renewing their contracts with Kale. Why the reason is simple – They don’t have a choice :)

Initially an airline looks to save the costs while selecting such solutions and later they realize the benefits of process outsourcing and will outsource more of their backend services. And at some point of time they realize that they themselves do not have expertise in these noncore processes and have no choice but to outsource it to the industry leader Kale.

Any Customers till now?

Very valid question. All these become invalid if the airlines do not see any value in their offerings

Kale's audit platform (Zero Octa’s audit) is endorsed by IATA and is the preferred audit provider to the Star Alliance group of airlines. Have more than 100 clients across 5 continents, including 12 of the top 20 airlines.

Recently Jet Airways has selected Zero Octa to audit its passenger accounting results. Jet Airways, JetLite and Jet Airways Konnect, its all-economy, no-frills service, have a combined fleet strength of 111 aircraft and operate over 410 flights daily.

Cathay Pacific Airways, world’s third largest cargo carrier also choose AMBER, the revenue accounting package from Kale.

J. M. Baxi India’s leading logistics provider selects Kale’s Freight Management System.

What I quoted here are only recent customer wins and there are many more.

Valuation

No analysis is complete without a discussion on the valuations. This year (Year ending March 2010) Kale is expected to post around 160Cr in revenues and around 30cr in profits. This will give an EPS of around 22Rs by March 2010. The market cap is around 120 cr and the stock price is around 95Rs

Last year during March 2009 crash the stock has given an excellent opportunity when it crashed to below 20Rs. From there it has been almost a 5 bagger.

[In fact I would have written about it if this blog would have been up :-). However I was fortunate enough to buy this at that time (Disclaimer)]

There is still very much scope for appreciation even from the current levels as this is still trading at 4 time of its 2010 March earnings which is quite reasonable. The real benefit will come if the flywheel effect which i mentioned at the start of the report kicks in. These kinds of stocks will give maximum benefits when the stock goes from an initial stage to a market discovered stock stage. Given the kind of business Kale is in I would not be surprised if it trades at 10-15 times forward earnings in another 2-3 years time.

Now it’s up to you to see how much is that. For me it’s a buy at 95 levels with a time frame of 2-3 years.

My Profile

I have been associated with the market for over 14 years now. Pleasedo not think that i am very old market veteran :-) ( I am just 30 years ).

I started my association with the market when i was at 8th standard since my father was very interested in the market. I have personally experienced the change in the way market functions from the old floor based trading to BOLT ( BSE Online Trading Terminal ).

I have seen or experienced many stock market crashes and bull phases from the Harshad Mehth scam ( unfortunately i only remember from the scam) to Kethan Parekh ( Both rise and fall ) to the recent Bull run and fall in the market.

I myself have transformed from a speculator / trader , investor , value investor and now a growth investor.

In all these years i have seen how market make or break people. I have seen how people lost huge money in the market. I myself have lost once heavily in the market. I will not forget those learnings that i had with the market (and i do not believe in free learnings :-) )

My strategy/thoughts are based on my learnings and now i am sharing it with you.

Disclaimer

Please read the disclaimer very carefully before going through the posts

I am not an investment advisor nor i want to become an investment advisor. This blog is just my thoughts on investing and some stocks that i like. Please do not buy / sell stocks purely based on the thoughts written in this blog. I may or may not be holding the stocks written in this blog.

It is recommented that you always consult a certified financial advisor before dealing in stock market.

I am also not respnsible for the losess that you make in stock market if you blindly follow the posts in this blog. Nor i would come and claim my share if you make profit. For a wrong investment decision i take i am only answarable to my wife. So please take care of your money yourself..

My Investment Philosophy!

Every serious investor in this market should have an investment philosophy which he should use as a guiding tool for his behaviour in the market. This is very important because as time goes on you learn many things and fine tune your investment guidelines which suites best to you.

All investment strategies are good ie Long term , short term , Value buyer , Growth buyer, Trader , Jobber ... The point here is you should have one. :-)

Now here goes my investment strategy. This is very important for a reader as you will understand the background from which i am writing on the stocks i like.

I am a growth investor. That dose not mean that i will buy some stocks and sleep on it for ever. I am always looking for companies that are growing always irrespective of market conditions. I do not invest in already discovered ideas for the simple reason that there is not much to expect from it when it comes to returns.

My risk profile for investing is above average. On a scale of 1-10 my risk taking ability is around 7. Which also means that i dont mind investing in a high risk - high return company if i get it at a reasonable valuation.

I love sustainable / recurring revenue stories with a slight high entry barrier in terms of setup cost or technology availability. I am willing to pay a high multiple for such companies.

I do not like highly leveraged companies (high debt equity ratio) or companies with negative cash flows.

I normally do not invest in commodity companies as these are normally cyclical in nature. I also do not like real estate companies as i still could not digest their business model and also due to transperrency issues.

As such i do not have any dislike for trading but i rarely does it. Infact i will share with you some option trading strategy which i religeously follow every month :-)