The 4% Rule - Financial Freedom

Introduction

This blog outlines how effective is the 4% rule also known as SAFE WITHDRAWAL RATE or simply the rate at which you can spend your money without ever running out of money.

This is an easy way to calculate how much money an individual will need to retire and stay invested to not run out of money. It was created using historical data on stock and bond returns over a 50-year period.

Understanding the 4% rule

The 4% rule is a rule of thumb used to determine how much a retiree should withdraw from a retirement account each year. This rule seeks to provide a steady income stream to the retiree while also maintaining an account balance that keeps income flowing through retirement. Experts are divided on whether the 4% withdrawal rate is safe, as the withdrawals will consist primarily of interest and dividends.

The Four Percent Rule helps financial planners and retirees set a portfolio's withdrawal rate. Life expectancy plays an important role in determining if this rate will be sustainable, as retirees who live longer need their portfolios to last longer, and medical costs and other expenses can increase as retirees age.

What about inflation?

While most individual stick and abide by the "Four Percent Rule" of keeping withdrawal rate constant, some do increase the rate to keep pace with inflation. Possible ways to adjust for inflation includes:

1. Setting a flat annual increase of 2% per year.
2. Adjusting withdrawals based on actual inflation rate.

When 4% rule should be avoided?

There are several scenarios where 4% rule might fail. A severe market downturn can erode the value of high-medium risk investments much faster like COVID pandemic where Nifty fell by 30% by end of Q1 2020 compared to Q4 2019 (which results in downfall of most of the index funds, exchange traded funds etc).

The rule also fails if an individual is not disciplined and violates the rule by doing a major purchase since it can bring down the principal invested which directly impacts the compound interest that retiree depends on for sustainability.

Thinking beyond the 4% rule

The biggest mistake one can possibly make with the 4% rule is thinking that you have to follow it to the letter. It can be used as a starting point—and a basic guideline on how much to save for retirement—25x (or the inverse of 4%) of what you’ll need in the first year of a 30-year retirement from your portfolio. But after that, it is better adopting a personalized spending rate, based on your situation, investments, and risk tolerance, and then regularly updating it.

Here are few suggestions;

• Spread your portfolio in multiple layers. Invest in large cap, mid-cap, small cap and hybrid mutual funds.
• Invest time to learn about stock market and invest a portion of your saving in trading in futures and options too (Read - https://simplifyingoptions.blogspot.com/2020/10/options-play-book-for-nifty-and.html).
• Based on your age, choose the right mix of debt and equity exposure in mutual funds.

Short guide for mutual fund investment

Short note on Scripbox

Gone are days where investment in mutual fund used to be a half day process of filling never ending forms and submitting it to mutual fund advisors or brokers. With 'Scripbox' buying or investing in mutual funds can be done with few clicks on mobile.

Scripbox use advance tools, helps in comprehensive planning, customizes to our investment style and will track the progress plus suggest to move to lower risk investments as our goal approaches.

To open account with scripbox, click here --> https://l.scrpbx.in/a/71B5467

Short note on Groww

Groww helps in investing in direct mutual funds. You can earn upto ~1.5% higher returns by switching to direct plan. Regular plan has upto ~1.5% extra  commission for agents  while Direct plan has zero commission.

To open account with groww, click here --> Use Groww for Direct Mutual Funds

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Account opening links:

To open account with scripbox, click here --> https://l.scrpbx.in/a/71B5467https://l.scrpbx.in/a/71B5467

To open account with groww, click here --> Use Groww for Direct Mutual Funds

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Disclaimer:
Investing in stocks/mutual funds or any other instruments are subject to market risks. Any strategies or trades that are described here are only for educational purpose. Please do your own research or consult your financial advisor before investing

 

 

 

 

Options - Play Book for Nifty and BankNifty

 

INTRODUCTION

If you are looking for a secondary source of income apart from your regular Full Time job, you have reached the right page. Often investment journey of an individual investing in stocks recommended by so called well wishers or misleading-TV channels or financial advisors. It is needless to say that 95% of the folks invest in stocks with little or no knowledge. I hope this write-up will help such investors to re-think and invest time in learning options which will help them to earn sort of rental income every month with little investment capital as low as one lakh rupees.

With options it is possible to see profits even when stocks are going up, down or sideways. With options you can cut losses, protect gains and control large chunks of stocks with a relatively small cash outlay. 

Important note: On the other hand, option strategies sometimes are complicated and risky. If you cannot control your greed, you might end up losing the entire capital and some strategies may expose you to theoretically unlimited losses. So risk management with stop loss and mind management to control greed with play an important role.

This blog also gives essential 'Tips' which clarifies important concepts or will show you extra advice on how to implement particular strategy.

I certainly hope you will enjoy reading Options Playbook for Nifty and BankNifty

Cheers, 

FFRE Team
(Financial Freedom and Retirement Early)

OPTIONS BASICS FOR ROOKIE INVESTOR

What Are Options? 

Options are contracts that give bearer a right, but not the obligation, to either buy or sell an amount of some underlying asset at a pre-determined price at or before the contract expires.  

Options belong to a larger group of securities known as derivatives. A derivative's price is dependent on or derived from price of something else. Options are derivatives of financial securities; their value depends on the price of some other asset. Examples of derivatives include calls, puts, futures, mortgage-backed securities, among others

Key Option Terminology

• Index options: These options have index as the underlying. In India, we have European style settlement. Eg. Nifty options, Bank Nifty options. 

• Stock options: There are options on individual stocks. It gives the holder right to buy or sell an underlying share(s) at specified price. They have an American style settlement. 
  

• Buyer of an option: One who by paying option premium buys the right but not the obligation to exercise his/her option on seller/writer.

• Writer / seller of an option: One who receives option premium and is thereby obliged to sell/buy the asset if buyer exercises on him/her.

• Call option: It gives holder right but not the obligation to buy an asset by a certain date for a certain price.

• Put option: It gives holder right but not the obligation to sell an asset by certain date for a certain price. 

• Option price/premium: It is the price which option buyer pays to option seller. It is also referred to as the option premium.
  

• Expiration date: It is the date specified in options contract. Indexes have weekly expiration and stocks have month expiration.

• Strike price: It is the price specified in options contract.

• In-the-money option (ITM): It is an option that would lead to a positive cash flow to the holder if it were exercised immediately. An ITM call option stands at a level higher than the strike price (i.e. spot price > strike price). A deep ITM call option is much higher than the strike price, the call is said to be deep ITM. In case of put ITM, the index is below strike price.

• At-the-money option (ATM): It is an option that would lead to zero cash flow if it were exercised immediately. An ATM call option stands equals the strike price (i.e. spot price = strike price)

• Out-of-the-money option: It is an option that would lead to a negative cash flow if it were exercised immediately. An OTM call option stands at a level which is less than the strike price (i.e. spot price < strike price). A deep OTM call option is much lower than the strike price, the call is said to be deep OTM. In case of put OTM, the index is above strike price.

Visual representation of ITM, ATM and OTM:-

• Intrinsic Value: The amount an option is in-the-money. Only ITM options have intrinsic value. 
  

• Time Value: The part of an option price that is based on its time to expiration. If you subtract amount of intrinsic value from an option price, we get time value. If an option has no intrinsic value (i.e. it’s OTM) its entire worth is based on time value.
  

• Exercise: This happens when owner of an option invokes the right embedded in the option contract. In simple words, it means the option owner buys or sells the underlying stock at strike price, and requires option seller to take other side of the trade. 
  

• Standard Deviation: Let us assume stocks have a simple normal price distribution, we can calculate what a one-standard-deviation move for the stock or Index will be. In general any stock will stay within plus or minus one standard deviation roughly ~70% of the time in a year span. This helps investors to figure out the potential range of movement for a particular stock or Index.

 Index Options vs. Equity Options 

1. Index options cannot be exercised prior to expiration whereas equity options can be exercised.

2. Every thursday is the expiry day for Nifty and Bank Nifty (Index) options (weekly expiry for Index). For equity it is the last thursday of every month (monthly expiry).
   

3. Index options are cash-settled, but equity options result in stock changing hands.

 

Understanding Greeks

What is Delta?

It is the amount an option price will move with every one point move in Index/Stock. ATM options usually have a delta of 0.5. If stock/index moves up one point then price of ATM options will go up by ~0.5. ITM options have more delta that ATM. Deep ITM options move almost 1 to 1 with the stock/index.

What is Gamma?

Gamma controls delta or in other words is rate of change of delta. With movement in stock/index price something has to change the value of delta as option moves from ATM to OTM or ATM to ITM.

What is Theta?

Theta is the time decay value. It is the time factor in option premium. Time factor moves towards zero as expiration approaches. Theta is the amount the premium will decrease for one day change in the time to expiration.

What is Vega?

It is the volatility which reflects the amount option prices change for one point change in implied volatility.

What is Rho?

It is the current interest rate offered by banks for a FD of 1 year. It is the amount option value will change with percentage change in interest rate.

Market Participants

As a market trader it is important to know who might be buying or selling options on the other end of your transaction. Generally below are the list of market participants;

1. FIIs - Foreign institutional investors.
2. DIIs - Domestic institutional investors.
3. Pros - Professional investors.
4. Clients - Retail investors. 

In option market, we have to deal with four different entities: retail investors, institutional traders, broker-dealers and market makers. "Trader” is often used interchangeably for any of these players. 

Orders generated by each player goes through “exchanges”. Let us not get into the details of how exchanges work since figuring out just how options change hands can be a little confusing. We will just look at who each player is, then we’ll look at how your option orders get executed.

  

FEW MISTAKES TO AVOID WHILE TRADING OPTIONS

1. Have well defined exit plan: We have definitely heard and read this multiple million times before. However, we continue to be liberal on loss making traders hoping that scenario will reverse. It is very critical in trading to control emotions and greed. Always have a definitive plan and ensure you stick to your plan. No matter what your emotions are telling you to do, never ever deviate from the plan. More often than not entries are overated and exits are under rated.
   
2. Trade smart - Easier said than done: Plan should not confide to just exiting and it isn’t just also about minimizing loss on downside if things go wrong. You should have an exit plan, period – even when a trade is going your way. Please always choose your upside exit point and downside exit point in advance. Options are a decaying asset and that rate of decay accelerates as your expiration date approaches. Remember the classic statement, "if you are long in options then stay short in time and if you are short in options then stay long in time".
3.  Never try to make up for past losses by doubling up: We always have armor-plated rules: “I will never buy deep OTM options” or “I will never sell deep ITM options”. However we always break the rule and it’s quite funny how these absolutes seem obvious; until we find ourselves in a trade that’s moved against us. How often we all have faced scenarios where a trader does precisely the opposite of what we expect. “Doubling up” on options strategy almost never works. Options are derivatives, which means their prices don’t move the same way or even have the same properties as the underlying stock. 
   Close the trade, cut your losses, and find a different opportunity that makes sense now. It’s a much wiser move to accept a loss now instead of setting yourself up for a bigger catastrophe later.
4. Don't wait too long to buy back short strategies: If your short option gets way out-of-the-money and you can buy it back to take the risk off the table profitably, then do it. Don’t be cheap. For example, if you sold a short strategy for 100 and you can buy it back for 20 few days before expiration, you should jump on the opportunity.

 

OPTION STRATEGIES - BASIC

•  Covered Call:

This strategy is well suited if an individual owns a stock and the view on the stock is neutral to bearish and you are willing to sell stock if it reaches a specific price. 

Setup:
- You are the owner of a stock.

- Sell a call at strike price A.

- The stock price will be below strike price A.

Reward:
You will be profitable if the stock price stays below strike price A. The profit is limited to the premium received from selling the call.

Example: Tata motors CMP is 133.20. You can sell a CE152.5 at 3 Rs premium. If stock price stays below 152.5 by month end expiry you will receive a profit of 3X5500 (1 lot size) = 16500 Rs profit.

Risk:

You receive a premium for selling the option, but most downside risk comes from owning the stock, which may potentially lose its value. However, selling the option does create an “opportunity risk.” That is, if the stock price skyrockets, the calls might be assigned and you’ll miss out on those gains.

•  Cash Secured Put:

This strategy is well suited if an individual owns a stock and the view on the stock is neutral to bullish.

Setup:
- You are the owner of a stock.

- Sell a put at strike price A.

- The stock price will be above strike price A. 

Reward:
You will be profitable if the stock price stays above strike price A. The profit is limited to the premium received from selling the put. 

Example: Tata motors CMP is 133.20. You can sell a PE120 at 3 Rs premium. If stock price stays above 120 by month end expiry you will receive a profit of 3X5500 (1 lot size) = 16500 Rs profit.

Risk:

Potential loss is substantial, but limited to the strike price if the stock goes to zero. (If the puts are assigned, potential loss is changed to a “long stock” position.)

 

 

• Collar:

This strategy is well suited if an individual owns a stock and the view on the stock is bullish.

Setup:
- You are the owner of a stock.

- Buy a put at strike price A

- Sell a call at strike price B.

- The stock price will be between strike price A and B.

Reward:

Profit is limited to strike B minus current stock price minus the net debit paid, or plus net credit received.

Risk:

Risk is limited to current stock price minus strike A plus net debit paid, or minus the net credit received.

OPTION STRATEGIES - Advanced

• Long Call:

A long call gives you the right to buy the underlying stock at strike price A. This strategy is well suited if an individual owns a stock and the view on the stock is bullish.

Setup:
- Buy a call at strike price A

- The stock price will be at or above strike price A.

Reward:

There’s a theoretically unlimited profit potential, if the stock goes in the upward direction.

Risk:

Risk is limited to the premium paid for the call option.

• Long Put:

A long put gives you the right to sell underlying stock at strike price A. This strategy is well suited if an individual owns a stock and the view on the stock is bearish.

Setup:
- Buy a put at strike price A

- The stock price will be at or below strike price A.

Reward:

There’s a substantial profit potential. If the stock goes to zero you make the entire strike price minus the cost of the put contract. Keep in mind, however, stocks usually don’t go to zero.

Risk:

Risk is limited to the premium paid for the put.

• Long Call Spread:

This is also called as vertical spread or bull call spread.

A long call spread gives you the right to buy stock at strike price A and obligates you to sell the stock at strike price B if assigned. This strategy is well suited when you have a bullish view and an upside target.

Setup:
- Buy a call at strike price A

- Sell a call at strike price B

- The stock price will be at or above strike price A and below strike price B.

Reward:

Potential profit is limited to the difference between strike A and strike B minus net debit paid.

Risk:

Risk is limited to net debit paid.

• Long Put Spread:

This is also called as vertical spread or bear put spread.

A long put spread gives you the right to sell stock at strike price B and obligates you to buy stock at strike price A if assigned. This strategy is well suited when you have a bearish view and downside target.

Setup:
- Sell a put at strike price A

- Buy a put at strike price B

- The stock price will be at or below strike price B and above strike price A.

Reward:

Potential profit is limited to difference between strike A and strike B, minus net debit paid.

Risk:

Risk is limited to the net debit paid.

• Leveraged Covered Call:

This is also called as leaps diagonal spread.

Buying leaps call gives you the right to buy the stock at strike A. Selling the call at strike B obligates you to sell the stock at that strike price if you’re assigned. This strategy is well suited when you have mild bullish view.

Setup (for Index):
- Buy ITM call at strike price A (for weekly expiry in case of index)

- Sell OTM call at strike price B (for next week expiry in case of index)

- The price will be close to strike B than strike A.

Reward:

Potential profit is limited to  premium received for sale of the front-month call plus the performance of the LEAPS call.

Risk:

Potential risk is limited to debit paid to establish the strategy.

 

 

OPTION STRATEGIES - ADVANCED (FOR SEASONED)

• Short Call Spread:

This is also called as bear call spread or vertical spread.

A short call spread obligates you to sell the stock at strike price A if the option is assigned but gives you the right to buy stock at strike price B. This strategy is well suited when you have bearish view.

Setup:
- Sell a call at strike price A.

- Buy a call at strike price B.

- The price will close below strike A.

 

 

 

Reward:

Potential profit is limited to the net credit received when opening the position.

Risk:

Risk is limited to the difference between strike A and strike B, minus the net credit received.

• Short Put Spread:

This is also called as bull put spread or vertical spread.

A short put spread obligates you to buy the stock at strike price B if option is assigned but gives you right to sell stock at strike price A. This strategy is well suited when you have bullish view.

Setup:
- Buy a put at strike price A.

- Sell a put at strike price B.

- The price will above strike B.

Reward:

Potential profit is limited to the net credit you receive when you set up the strategy.

Risk:

Risk is limited to the difference between strike A and strike B, minus the net credit received.

• Long Straddle:

In long straddle, the call gives you right to buy stock at strike price A and put gives you the right to sell stock at strike price A. This strategy is well suited when you are anticipating swing in stock price but not sure which direction it will go.

Setup:
- Buy a put at strike price A.

- Buy a put at strike price A.

- The price will be at strike A.

 

Reward:

Potential profit is theoretically unlimited if the stock goes up. If the stock goes down, potential profit may be substantial but limited to the strike price minus the net debit paid.

Risk:

Potential losses are limited to the net debit paid.

• Short Straddle:

A short straddle gives you obligation to sell stock at strike price A and obligation to buy the stock at strike price A if the options are assigned. This strategy is well suited when you are anticipating minimal movement in the stock.

Setup:
- Sell a call at strike price A.

- Sell a put at strike price A.

- The stock price will be at strike A.

Reward:

Potential profit is limited to the net credit received for selling the call and the put.

Risk:

If stock goes up, your losses could be theoretically unlimited. If stock goes down, your losses may be substantial but limited to strike price minus net credit received for selling the straddle.

 

 

• Long Strangle:

A long strangle gives you the right to sell the stock at strike price A and the right to buy the stock at strike price B. This strategy is well suited when you are anticipating swing in stock price but not sure which direction it will go.

Setup:
- Buy a put at strike price A.

- Buy a call at strike price B.

- The price will be in between strike A and strike B.

 

 

Reward:

Potential profit is theoretically unlimited if the stock goes up. If stock goes down, potential profit may be substantial but limited to strike A minus the net debit paid.

Risk:

Potential losses are limited to the net debit paid.

 

• Short Strangle:

A short strangle gives you the obligation to buy stock at strike price A and obligation to sell the stock at strike price B if options are assigned. You are predicting the stock price will remain somewhere between strike A and strike B, and the options you sell will expire worthless.

Setup:
- Sell a put at strike price A.

- Sell a call at strike price B.

- The price will be in between strike A and strike B.

 

Reward:

Potential profit is limited to the net credit received.

Risk: 

If the stock goes up, your losses could be theoretically unlimited.stock goes down, your losses may be substantial but limited to strike A minus net credit received.

 

 

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Account opening links:

To open account with zerodha, click here --> https://zerodha.com/?c=BR8317 

 

To open account with angel broking, click here --> https://tinyurl.com/y3pqj339

 

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Acknowledgement:

This blog is an outcome of all the knowledge i acquired over the years from many different sources. Special thanks to Brian whose content on Options Strategies has had a significant contribution to my trading journey.

 

Disclaimer:
Investing in stocks/mutual funds or any other instruments are subject to market risks. Any strategies or trades that are described here are only for educational purpose. Please do your own research or consult your financial advisor before investing.

 

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