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27 September 2020

Trading Strategies

Different Strategies of Index Trading :

An investor having a portfolio of scrips can use index futures in an attempt to reduce his portfolio risk. As an owner of the scrip, the investor is exposed to firm specific and market specific risk. By diversifying his investment into different companies covering different industries, the investor can minimise his firm specific risk. To minimise the market specific risk, Index futures is an alternative.

Logic behind the hedging strategy :

When an investor is long in the Stock Market, he should take a short position in Index futures contract to obtain a hedge. This is because, when the market falls, the value of his portfolio also decreases. The fall in the value of index is accompanied by the fall in the value of index futures.Thus even though the investor incurs a loss in the cash market his position is hedged by taking an offsetting position in the index futures contract.

Thus, the two When an invest strategies for hedging the market risk are
1. When long in Stock Market, go short in Index Futures Contract; and
2. When short in Stock Market, go long in Index Futures Contract.

Hence, Index Futures Contract can be used as a Risk Management technique to minimise the loss arising out of Market risk. The return from the portfolio is thus ensured using these strategies.

Practical Aspects of the Strategy :

One has to ascertain how much position one must take in Index Futures contract so that he has optimally hedged the market risk, which his stock market position is exposed to. A normal measure of a stock market risk is the stock's beta. The beta of a stock shows how the market price of that stock is likely to change relative to a change in value of the stock index. For example, a stock with beta 1.2 would mean if stock index moves up by 1%, the price of this stock would go up by 1.2%. A beta greater than one indicates that the stock is more volatile than the market and a value of less than one suggests that the stock is less volatile than the market. For an optimal hedging, one should take into account the beta of the scrip. Beta of a portfolio is weighted average beta of the scrips included in the portfolio. Thus, an investor having Rs. 10 lakhs worth long position in stock market and intending to have a complete hedging should have a short position equivalent to (Beta x Portfolio Value). If Portfolio beta is 1.5, the investor should take a short position of (1.5 x 10) lakhs = 15 lakhs worth contract value.

There are eight basic strategies of Index Futures trading:

Hedging Strategies:

1. Long in Stock Market, Short in Index Futures;
2. Short in Stock Market, Long in Index Futures;
3. Have Portfolio, Short in Index Futures;
4. Have Fund, Long in Index Futures;

Speculative Strategies:

5. Bullish Market, go long in Index Futures;
6. Bearish Market, go short in Index Futures;

Arbitrage Strategies:

7. Have money, lend it to Market
8. Have securities, lend it to Market
Highlights on remaining six strategies:

Have Portfolio, short in Index Futures :

Supposing an investor is holding stocks and is planning to dispose off the same within three months. He is clear of his Portfolio value at the current market rate but is quite uncertain about his Portfolio value by the end of third month. At the current market value, he is quite satisfied with the return but for some reason he does not want to dispose his portfolio now, itself. He wants to retain his portfolio till the end of third month. He is therefore intending to ensure the receipt of return at current market price after three months. In other words, he wants to lock the current market price for three months.

Strategy to adopt :

An investor has a portfolio, which he wants to sell after three months. To lock the market, he should go short in the three month Index Futures, valuing his portfolio value at the current market price. After three months, he can dispose off his securities in the stock market. As he disposes off his portfolio, he should simultaneously cover his short position in Index Futures by buying back Index Futures equivalent to the value of scrips sold. By the time he sells his complete portfolio of scrips he would have covered his entire position in Index Futures.

In the falling market, the investor would incur loss in his portfolio but since he is short in Index futures he would profit by covering his short position at the lower rate. Thus loss in Stock Market gets offset by the gains in Index Futures.

In the rising market, the investor would get profit from his portfolio but he will have to forego the same as he would be incurring loss in Index Futures.

Thus, Index Futures is a risk management technique used to reduce market risk and therefore no profit and no loss from the market movements.

Have Fund, go long in Index Futures :

Supposing an investor is going to get some fund in a short span of time which he intends to invest in stocks. He also requires time to analyse the stocks. He is quite bullish about the market. He prefers to purchase the stocks at the current market price but he has not received the fund. If he waits for the fund to arrive, the market may go up and therefore his cost also would go up. To avoid this he wants to lock the market at the current price. He should go long in Index Futures immediately. As he receives the fund and buys the scrips, he should simultaneously reduce his exposure in the Index Futures by selling the Index Futures.

In the rising market he would have to pay more to get the securities, which he would get back from Index Futures.

In the falling market he would get the scrips at cheaper rates but he will have to pay off the loss in the Index Futures.

Speculative Strategies :

In the absence of the Derivatives Market, when an investor is bullish about the market he immediately assumes long position in any of the scrips thinking that the scrips will definitely reflect the market trend.

With Index Futures Contract in place when an investor thinks the market is bullish he can buy the market itself by going long in Futures Index. Similarly if he is bearish about the market he can sell the market by going short in Futures Index.

Arbitrage Strategies :

Have Fund, lend them to the market

Have Securities, lend them to the market

In the liquid market, one can get an attractive bid and offer and a trade can take place at less impact cost. By taking into account the bid price, offer price and the duration of the contract, one can at any point of time analyse and see if one can lend money at an attractive interest rate or if one can receive money from the market by lending securities in the market.

Have Fund, lend them to the market :

Suppose the Nifty spot is at 1000 and the two month futures are at 1040 and suppose the transactions costs involved are 0.4% per month. Then the rate of return in loaning money to the market shall be 1040/1000 over two months, ie., 1.9% per month less 0.4% = 1.5% per month.

Thus buy spot and sell Index Futures and earn 1.5% per month a risk free return

Procedure involved in doing this arbitrage is as follows: To buy Nifty spot one has to buy one share each of all the scrips in the Index. A simultaneous short position of Index Futures will completely hedge (nullify) the market exposure. The investor will pay to the Stock Exchange and receive scrips on which the investor may get dividend, an additional income. At the end of the two month period, the investor will sell off all the scrips and receive back the fund. Simultaneously, the position in the Index Futures will get automatically closed out at the spot Nifty.

Have Securities, lend them to the market

Suppose that Nifty spot is 1100 and the two-month futures are trading at 1110. The spot futures basis (1110/1100) is 0.9%. Suppose cash can be invested risk-free at 1% per month, over two months, funds invested at 1% per month yield 2.01%. Hence, the total return that can be obtained in stock lending is 2.01% - 0.9% = 0.4% or 0.71%, over the two month period.

Spread Trading :

NSE and BSE offers another attractive trading method involving less risk and thereby attracting less initial margin of nearly 1%. An investor can assume spread position. Taking simultaneously two opposite positions in two different expiry months, viz., creates a calendar spread,

1. A long position in Nifty Index futures in any calendar month and
2. A short position in Nifty Index future in different calendar month.
Example of Calender Spreads - Long in June Nifty Futures and Short in August Nifty Futures.

Procedure involved :

The investor can assume a calendar spread position today. After some days or before one of the Index Futures gets expired, the investor would close out the spread position by reversing both the legs simultaneously.

Receiving the spread involves buying near month futures and simultaneously selling far month futures and Paying spread position means selling near month futures and buying far month futures.

When spread received is greater than spread paid the investor gets profit and when spread received is lesser than spread paid he incurs a loss.
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