A Tale of 2 Situations

Once there was an investor,  who one fine day entered the holy gates of big bad city called Stock Markets.  To help me in this city he found there were various types of people. The most talked ones were the high priests who sat in high temples of finance, and eulogised about everything and anything. Then there were a lot of traders, merchants who helped him in navigating the city on weekly, daily and hourly basis and finally there were the outcasts, who said generally spoke less and did all contrary things.
After meeting all of them and getting fairly acquainted with the city our hero decided to venture where few went, to the den of alchemists who made money without taking risk. They did this by finding special situations which nobody would see.

There he met a gatekeeper who gave him 2 tests and said that he had to go through to them to meet the alchemists.

Gatekeeper: Company Name: IGL Ltd
The price of the company was going all over the place (some times variation is as high as 30-40% in a day) as the company was engaged in a legal battle with a government body on pricing of gas prices. The ruling for the case is coming on 10th August and CMP is 250 . What will you do?
Hero: Interesting since company can either win or lose the case I will do the following:

• Buy a put option of August Expiry with strike price of Rs.220. The present price of such an option is Rs. 0.78 and lot size is 1000 my cost will be Rs.780
• Buy a call option of August Expiry with strike price of Rs. 270. The present price of such an option is Rs. 2.79 and lot size is 1000 my cost will be Rs. 2790

So by paying total of Rs.3570 i have given a wager on both positive and negative decision for company. If ruling goes against, stock price falls by around 20%  and i make a killing on my put option. Similarly, if it is in favour i make a killing on call option.

Gatekeeper:  Good. Now let me take you to the courtroom and you can see how things pan out. 

In the courtroom, as our hero waits anxiously proceedings begin and end in 5 minutes. The ruling is neither positive or negative but has been deferred till November 31st. 

Hero: Horror! Horror! this cant happen to me. I never thought of this scenario and now i will lose a fair bit of my wager as a lot of people would have bet on either side and now they will sell.
Gatekeeper: Aye Aye Sir! You will lose money but more importantly learn these 2 lessons

• A special situation is really "special" only if the outcome is known. Else, it has speculation involved in it.
• Always do a probabilistic analysis of all scenarios. For example, in this test all 3 scenarios of favorable, unfavorable and status quo were equally probable. 

Now let bygone be bygone, let me give you another test:

Gatekeeper : Company Name: Muthoot Finance Ltd- The company has a zero coupon bond maturing on 11th Oct 2012. The maturity value of this bond is Rs.1132. Suppose today is 7th Sept 2012 and value is Rs.1115. What will you do?

Hero: Aha! this is a simple one. As in previous test i know the outcome and also there is only 1 scenario of company paying me back. Although another scenario could be of company defaulting on its bond, but past track records and recent performance of company tell me that this is has a negligible chance. So, I will buy this bond at Rs.1115 and then on maturity i will get Rs. 1132. If i use the XIRR function my return is around 16.5% p.a, which is far higher than bond investments.

Gatekeeper: My friend you take things too simplistically. Did you consider the brokerage and tax? Suppose your brokerage is 0.3%, then your purchase price becomes Rs. 1118.3 and returns lessens to around 13%. Add short term taxation to it and returns further fall to around 9.1%.  Does it look that exciting now?

Hero: Hmm...no it surely dose not, but i never thought that these things impact returns.

Gatekeeper: As i said there are no mistakes only lessons. The lessons here is that Returns in special situations are moderate, so always consider transaction costs and tax and then take a decision.

That is it from me for now.

Hero: So now can i go in? 

Gatekeeper: Of course you can. The fact that you have taken tests is good enough. Now proceed to the real alchemists who reside here and here.

Regards,
Saurabh
PS- The protagonist was yours truly, and gatekeeper in one case was Kiran.