We have come a long way in understanding how leveraging works in the stock market. We have learnt how leverage is a great ally when used well (remember our double-edged sword?).
In our 'Talking 'Badla' with a vengeance' , we discovered how traders like Harshad Bhai get to borrow funds at rates determined by the market while lenders like Munshiji fund their positions. Our stock market has a great mechanism called 'badla', which allows traders to carry forward their positions across settlements.
We have also gone a step ahead to learn how higher badla positions and badla rates pull the market down.
Now, lets get down to more basic questions. Can the market as a whole keep borrowing and investing to take the Sensex up endlessly? How does the market work? How do bubbles get created in it? How does the party end? What happens to traders who are heavily leveraged?
Oh! A lot of questions indeed.
Let us answer all these questions by simulating a market. Academicians will call this a 'thought experiment'.
We have three people to help us out - Mr. Operator, Mr. Small Fry and Mr. Sucker.
Mr. Operator is a seasoned stock trader who has access to information and has a nose for good stories that can generate interest in the market. He picks his stock early, takes big positions in the stock, whips up sentiment in the stock, and actively trades in the stock. He takes all these big chances because he is in it for big money.
Mr. Small Fry is also a stock market veteran. However, he is a little unsure of his abilities to take big bets. He keeps track of price movements in the market. He spots any high level of activity in a stock very early and jumps in. He also keeps an eye on Mr. Operator's actions and tries to follow him. Mr. Operator is aware of Mr. Small Fry piggy- backing on him, and always tries to shake him off his back. Anyway, that is a different story altogether.
Mr. Sucker, on the other hand, has a love-hate relationship with the market. He cannot resist watching stock prices going up and others making money. He is eager to get a piece of the action. However, he normally arrives just when the 'money making' part is about to get over. He then starts hating the market for losing money on his trading positions. Yet, tomorrow is always another day for him.
Let's get started on the experiment...
In May 1999, there was a lot of hype in the market over pharma stocks. Indian companies were discovering molecules. MNC pharma companies were doling out big payments for these molecules...
During those exuberant times, our friend, Mr. Operator was travelling business class to New Delhi. The passenger next to him was Mr. C.E. Om Prakash, head of a pharma company, Example Drugs Ltd. (Neuters Code: EgDg). During the course of their conversation, Mr. Operator got to know that Mr. Om's company had just discovered a new drug.
June 7th 1999 (Monday): Neuters: EgDg 100
Mr. Operator has done some homework. He is very excited about Example Drugs Ltd. He asks his dealers to buy every share available. The stock is quoting at Rs100. He has Rs10lac of capital. There is carry forward facility available for Example Drugs Ltd. and our friend builds up a position worth Rs66.67lac (at 15% margin, the Rs10lac capital can be leveraged). The stock closes for the week at Rs135 (eventually the hawala rate for 'badla'.)
| Table 1 | |||||||||
| Mr. Operator | His Capital 1000000 | ||||||||
| 1999 | Eg. Ltd. Mkt. Pr. | Org. Cap. | Org. Expsoure | P & L | Add. Exp. | Add. Exp. | Total Exp. | Net Cash Flow | |
| | | | Marked to Mkt. | (Hawala Diff.) | | (Marked to Mkt) | | | |
| 7Jun | 100 | 1000000 | 6666667 | | | 0 | 6666667 | -1000000 | |
| 12Jun | 135 | 1000000 | 9000000 | 2333333 | | 0 | 9000000 | 1333333 | |
| 14Jun | 140 | 1000000 | 9333333 | | 2333333 | 15555556 | 24888889 | -1000000 | |
| 19Jun | 165 | 1000000 | 11000000 | 4444444 | | 15555556 | 24888889 | 3444444 | |
| 21Jun | 171 | 1000000 | 14000000 | | 4444444 | 29629630 | 41029630 | -1000000 | |
| 26Jun | 180 | 1000000 | 12000000 | 2159454 | | 29629630 | 41629630 | 1159454 | |
| 28Jun | 185 | 1000000 | 12333333 | | 2159454 | 14396361 | 26729695 | -1000000 | |
| 3Jul | 155 | 1000000 | 10333333 | -4334545 | | 0 | 10333333 | -5334545 | |
His position is worth Rs90lac now (Refer Table 1). As we had seen in our 'badla' sessions, the higher hawala rate means that Mr. Operator will realize a fresh cash flow of Rs23.33lac (the profit on his position). Of course, the learned ones among you will note that he will have to pay 'badla' charges. However, in order to simplify our learning, we are assuming that the 'badla rates' are zero. After all, our objective is to understand how it all works and not to figure out the amount of money that our friend makes.
June 14th 1999 (Monday): Neuters: EgDg 140
Mr. Operator has had a great weekend. He is back with renewed energy. He decides to use his improved cash flow of Rs23.33lac to build a fresh position worth Rs155.55lac (remember the hawala difference that he pocketed? We suggest you read our previous 'Badla' write-ups to understand how it works).
Meanwhile, our friend, Mr. Small Fry has spotted the sharp rise in the share price of Example Drugs Ltd. (EgDg). He, too, has done his homework. As he walks into his office, one of his dealers tells him how he had overheard Mr. Operator's dealer recommend EgDg to another person. Mr. Small Fry rushes to the dealing room to build a position worth Rs6.67lac (He has a capital of Rs1lac to spare for this).
The stock closes for the week at Rs165. There are reports that this stock has also been bought by some mutual funds. In any case, both our friends are happy. The higher closing for the week has ensured that both of them have inflows again due to the higher hawala difference. Mr. Operator has got inflows of Rs44.44lac (Refer Table 1)! Mr. Small Fry, on the other hand, has got an inflow of Rs1.19lac. (Refer table 2)
| Table 2 | |||||||||
| Mr. Small Fry | His Capital 100000 | ||||||||
| 1999 | Eg. Ltd. Mkt. Pr. | Org. Cap. | Org. Expsoure | P & L | Add. Exp. | Add Exp. | Total Exp. | Net Cash Flow | |
| | | | Marked to Mkt. | (Hawala Diff.) | | (Marked to Mkt) | | | |
| 14Jun | 140 | 100000 | 666667 | | | 0 | 666667 | -100000 | |
| 19Jun | 165 | 100000 | 666667 | 119048 | | 0 | 666667 | 19048 | |
| 21Jun | 171 | 100000 | 666667 | | 119048 | 793651 | 1460317 | -100000 | |
| 26Jun | 180 | 100000 | 666667 | 76859 | | 793651 | 1460317 | -23141 | |
| 28Jun | 185 | 100000 | 666667 | | 76859 | 512392 | 1179059 | -100000 | |
| 3Jul | 155 | 100000 | 666667 | -191199 | | 0 | 666667 | -291199 | |
June 21st 1999 (Monday): Neuters: EgDg 171
Inspired by the jump in his company's share price, Mr. C.E. Om has called a press conference to announce that his company is unveiling a new molecule.
Mr. Operator is even more excited about the prospects of this stock. He has every right to be as the stock price has climbed 70% in 15 days. He deploys the Rs44.44lac that he made from the hawala difference to build an additional position of Rs2.96cr. His overall exposure to EgDG has gone up to Rs4.1cr. Mind you, he has done that with just Rs10lac! (The 'power of leveraging'?!) Mr. Small Fry has also done the same. He has used the profits of the previous week to increase his exposure in the same stock.
The stock closes for the week at Rs180. Not a great jump compared with the previous week's figures, but a gain all the same. Anyway, the inflows from the market have dropped for both. Mr. Operator has got just Rs21.59lac (Refer Table 1) while Mr. Small Fry has got Rs76,859. A disappointing week, but how long can the stock just keep going up?
June 28th 1999 (Monday): Neuters: EgDg 185
The Investors Guide section of a widely read business paper carried a story on Example Drugs Ltd. They have recommended a 'Buy'.
Mr. Sucker, our third friend, reads this on his way to work. Everything falls in place now! He has been watching this stock price climb up, and has not been able to figure out why. The rational investor that he is (at least he thinks so) finally finds the reason. He pulls out his mobile phone and calls up his broker to place a buy order. The dealer confirms the trade at Rs185. Mr. Sucker starts thinking of how he will sell this stock at Rs220 on Friday.
July 1st 1999 (Thursday): Neuters: EgDg 175
EgDg Ltd. reported its first quarter results. The company has shown flat growth in sales. Profits have dropped...
There is chaos in the counter for this stock. Two funds are trying to sell their holdings. Mr. Operator is trying to dump his position. Mr. Small Fry is also caught in between. The stock has crashed all the way to hit the lower circuit.
The stock closes for the week at Rs155. For the first time, the hawala difference has turned negative. Mr. Operator has to pay up Rs43.34lac (Refer Table 1). Mr. Small Fry has to pay up Rs1.91lac (Refer Table 2). Our poor friend Mr. Sucker, who had great plans of selling it at Rs220, is left reeling and bewildered.
Can you help him?
EgDg Ltd. is up 55% since Mr. Operator bought it. But, Mr. Operator has lost money on it at the end of the day. In order to pay up his dues of Rs43.34lac, he will have to sell his original position. Even then, he will not be able to break even. Mr. Small Fry has lost his capital. Can you imagine what will happen on the next trading day when Mr. Operator tries to unwind his position?
Our simulation had some simplifications. However, it is a very good snapshot of the way speculative 'booms' and 'busts' happen in the market. It also shows at a collective level how leveraging can turn vicious.
Next time, we will see how the imposition of volatility margins by an exchange actually helps and protects people like Mr. Small Fry and Mr. Sucker.
After all, our friend Mr. Operator is a smart guy. In reality, he foresees events and creates the top himself. But that is another story.
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