How To Be A Value Trader

Here are some strategies that will help you time the market better

Warren Buffet may have time-bombed derivatives in his latest address to investors but that doesn't excite investors world-wide. Since March 2000, the 45 per cent decline in S&P 500 has not only crushed portfolios but also the hopes of investors. On the other hand, traders might have been wealthier by buying rallies and selling declines during the same period.

The respective Index rallied five times by more than 10 per cent (avg. 19 per cent). It registered six declines around the rallies (avg. 22 per cent) since March. The average length of the rallies was only 74 days before the market dipped 10 per cent. This was in contrast to the seven straight years of rise from October 90-97 . No wonder many people came to believe in buy-and-hold investing.

The trade-off is pretty clear; the temptation to trade the market on one hand or sticking to the process of diligent stock selection on the other. In other words buying a RIL future (RIL Call) for a 45-day period or holding RIL till the time the stock surges above the Rs 310 mark. The possibility is that you can get to trade the respective stock a couple of times before it actually crosses that Rs 310 mark. And even if it does cross the level, how much capital appreciation are we looking at from there?

The logic is pretty simple. The valuation stories are few and a majority of investors are going to ride just the top five per cent of the price movement. Only the aggressive churning of a portfolio can make profits today. As investment horizons have become longer, wishful thinking may never get you that exit.

How to time the entry and exit is the key question; basically trading the bottoms and the peaks. Put simply, how to become a value trader. How to become an investor who is not a day trader but looks at shorter time frames from 3-45 days. Indian derivatives markets offer enough liquidity for the time period in discussion.

Value trading evolves around an existing portfolio of carefully selected stocks with an investment horizon of more than a year. The strategy starts with identifying the market trend. Is the trend up, down or neutral? All the stages will have typical characteristics. An uptrend will have increasing volumes, increasing open interest, a higher advance-decline ratio etc.

And this will be true not for one stock but for a majority of heavyweights. Long futures (long Calls) can be purchased in such a market. Even bull spreads, which have a lower risk-return profile, can be reasonably profitable if the trader can catch the trend correctly. A bull spread involves buying a cheaper strike price and selling a higher strike price. Both Call and Put bull spreads can be created.

A downtrend on the other hand will have opposite characteristics. Lack of confirming signals like decreasing price with increasing volumes, or increasing price with declining volumes, are the hallmarks of a downtrend. There will also be a marked divergence in the behaviour of the Index heavyweights.

For example, though the pre-Budget sentiment was positive, a majority of Index heavyweights were not confirming the strength. Value traders could have bought Puts to their benefit. Bear Call and bear Put spreads were also recommended strategies.

Bear spreads primarily involve buying an expensive strike price (E.g. 300 RIL Call) and selling a cheaper strike price for the same month (E.g. 290 RIL Call). The value trader should, however, keep in mind that there is a reasonable depth in the traded option.

For a neutral market, the characteristics are stagnant volumes, low volatility along with stagnant prices. Market stagnancy can be the intermediate phase between a bullish and bearish dip, and hence is the toughest period to trade in. Covered calls are derivatives strategies for a stagnant-to-mildly positive markets and can give more than risk-free returns on existing portfolios.

I have ignored exotic strategies keeping the derivatives toolbox limited to simple long-short futures, Call, Put purchases and some spread strategies. With stoplosses in place you will be surprised to know that futures turn out to be more profitable than any other derivatives strategy.

Forecast for this week

As we have said, market trends are swift and since volumes are broadly decreasing along with the outstandings and price, the downtrend seems to be losing steam. And with the US and European markets up by around 5-6 per cent, by the time you realise you're in a short bull trend, three-quarters of the rise may be over.

Though much of the rally in the US might be attributed to short covering, the current levels on the Nifty and some Index heavyweights too deserve a trading look. ATM Calls, long futures can be initiated this week.

Technical analysis is important for a value trader. He needs to understand the supports and resistance along with MACD's and Stochastic. After all, generating a multiple return over a simple buy-and-hold has got to be aggressive.