You have heard the hype surrounding the stock market's extraordinary returns. However, it is practically impossible to provide exceptional returns over a long period of time. Over the course of 50 years, even the most well-known investor, Warren Buffet, has generated 18–20% CAGR!
To put it in perspective with an 18% CAGR, your money would double in 4 years if you were successful in generating this kind of return. Your money will therefore have quadrupled after eight years.
Let's examine the business example now. You are an entrepreneur who invested 9 lakh in a business at the start. Your net profit is 1.8 Lakh or 20% of your initial investment in a year. It's a fantastic deal if you're able to reinvest this sum and get an equivalent return.
Let's change one thing: instead of investing the full 9 lakhs, you will only contribute 4.5 lakhs as equity funding and borrow 4.5 lakhs. Additionally, the interest rate is 10%, translating to 45,000 a year. Your profit, which was 1.8 lakhs earlier, has now been decreased to 1.35 lakhs. However, as you can see, the ROI is 30%(135000/450000). Therefore, you are able to generate an additional 10% point in return without doing anything more.
As you can see from the examples above, leveraging(debt) allows you to make spectacular returns even while your overall earnings stay the same.
However, because you must pay the interest cost regardless of the earnings, your risk is also increased. As a result, in order to employ leverage successfully, risk management must follow certain guidelines.
Now let's see the same thing in Futures and Options.
We use Nifty Futures which are bought or sold in lots of 50.
Nifty is currently trading at roughly 18000, and a lot size of 50 equals 9,00,000 (18000*50).
If you invest 9 lakh in the Nifty Index and make a 12% return over a long period of time, your ROI is 12%.
Another advantage of using the futures and options is that you don't have to pay the full amount if you choose to purchase the 9 Lakh Nifty future for the current month. To take the position of 9 lakh in the Index, you only need to pay a 'margin' money of 1.1 lakh.
You can see that even though the underlying instrument is producing an ordinary return (12% instead of 20%), by utilising leverage, you can produce an outstanding return.
However, it also increases the risk, which can be observed in the Max DD. It will sharply increase, which raises the chance of capital wipeout. The Nifty Index fell 58% from its peak in 2008. You could have been completely wiped out with that kind of loss.
Therefore, in order to employ the derivative efficiently, risk management is required. And this is exactly what Nifty Long-Short is doing. Find out more about it by reading this.
Therefore, in order to employ the derivative efficiently, risk management is required. And this is exactly what Nifty Long-Short is doing. Find out more about it by reading this.
