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Stocks: Opt for a buy and hold strategy

Devangshu Datta in New Delhi | October 27, 2008 11:06 IST

In any business, the ideal strategy is to buy low and sell high. But it is also acceptable to buy high and sell higher. A manufacturer with rising material costs must do this. It is also possible to reverse timelines and sell, intending to buy in future. This occurs for example, when a shipyard books new orders. Some portion of the price (maybe 100 per cent) is paid upfront and used to procure raw materials.

'Reversed timeline' transactions also occur in services. A consultant who is IT-enabling a business may ask for the payment or a portion of it upfront. That is used to hire people to deliver on the contract.

It is only when one is dealing with equity and related financial instruments that people imbue such transactions with moral considerations. This is partly due to the lack of apparent value addition, unlike in manufacturing or services transactions where there is obvious value addition.

But the lack of apparent value addition in a secondary market equity transaction should not make a difference in the way one thinks about the transactions themselves. The transactions could still be buy now, sell later or sell now and buy later. Since all these are legitimate in other businesses, they should be legitimate in equity markets.   

The value addition in equity transactions is that the buyer thinks the going price underestimates the value. The buyer is therefore prepared to hold stocks in inventory until the extra value can be converted. It is the same in a futures transaction except that there is a strict time limit on the inventory period.

Note that these are zero-sum transactions -- the profits of one party are always balanced by the losses of the other. If the buyer is right and prices rise, the buyer's profits balance the losses of the seller and vice versa when prices fall.  

But these transactions tend to be considered legitimate only when the buyer is right! This is especially true about sell now, buy later transactions, where the short seller makes a profit only if prices fall in future.

Such a reaction is understandable when it comes from a disappointed buyer angry at the loss incurred. But this attitude is often shared by regulatory authorities. When prices are falling, it is somehow morally wrong to profit by short selling.

The irrationality goes deeper. It is okay for a buyer to 'talk his portfolio up' by the dissemination of good news. It is manipulation for a short seller to 'talk his portfolio down' by dissemination of bad news. This discrimination is especially irrational when neither buyer nor seller is actively involved in running the business and can't be held responsible for news, either good or bad.

In practical terms, this attitude skews the equation against short sellers who are always liable to be at the receiving end of regulatory action. In mathematical terms, the risk: reward equation is skewed against short selling anyhow. A buyer can see an infinite upside since prices can rise indefinitely. A short seller will at best, see prices come down by a maximum of 100 per cent.

A short seller is also committed to a reverse transaction. The process therefore guarantees liquidity and puts a floor on prices since the short-covering activity creates demand. Whenever short selling is banned, the regulator essentially forces the execution of reverse trades from existing shorters within a set timeframe. This forces prices up temporarily during that timeframe. A long trader buying during that period can make profits.

But once the shorts are out of the market, liquidity also disappears. A low liquidity situation usually leads to more price declines and without a shorting mechanism, there is no price floor left. 

Indian regulators and the political establishment are now trying to talk overseas short sellers into reversing transactions. If they are successful, there will be a price pullback. But the price pullback won't last since volumes will disappear.

If you operate inside that timeframe of transaction-reversal, you can make trading profits. Otherwise, if you favour the safe philosophy of buying low and selling high, this is a good time to buy in terms of valuations. But your inventory period could be quite long.

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