Market movements have been horrible the last few weeks and taking a view on individual stocks has been downright disastrous! While we may get into long monologue on what may happen (To be fair, read https://twitter.com/PLIndiaOnline tweets and blogs where we always cautioned readers right from January 2018 about being careful on markets overall and non Largecaps especially), we are sure this weekend you are wondering how to earn back the money you lost! There may just be one such trade if you believe history repeats itself.
Hedge Funds worldwide take sovereign index bets – however, they hedge themselves from disaster scenarios by creating a long and short on two indices – its called becoming “neutral”. The long gives them the exposure to the index they prefer , versus the short (Example MSCI India Long vs MSCI EM Ex Japan Short) but at the same time, prevents calamitous events from wiping out capital as if the long collapses and creates losses, chances are the short would collapse too and recover profits!
And if the view on relative outperformance is right, the profits on the relative position would be higher than the losses on the short. Didnt get it?
Let’s see how that happens!
Lets say you are bullish on Index A compared to Index B.
One way to exercise this judgment or opinion is to buy A and sell B from the portfolio but what if A /B are impacted by news and events that weren’t predicted earlier – therefore you would suffer a loss (even if you were right and B collapsed further as you had predicted). This means you were right on your view but were wrong on the trade!
Instead, imagine if you were to create a derivatives position where you went Long A and Short B – that is, you want to capture the relative outperformance and not absolute returns –
Scenario 1: World Markets collapse and A moves down 5% while B moves down 7%. If you were long and short same values, the short would give you a profit of 2% (lost 5% but gained 7%)- thus you are in profit!
Scenario 2: World markets go through a ripper of a rally! A moves up by 15% while B moves up by 12%. Again here as long as you were long and short equal values, the long gives you a profit of 15% and the short delivers a loss of 12% but on actual basis, you remain in profit of 3%.
BANK NIFTY VS NIFTY
The Bank Nifty has had a tremendous performance over the past few years and almost doubled as a % of the Nifty index – Eaxactly 7 years ago, the Nifty was at 4900 while the Bank Nifty was at 9100 indicating that the relative ratio (9100 divided by 4900) stood at 1.9 times or 1.9x.
From then on, it went to make a relative low of 1.6x and a high of 2.51x – with an average during this period of 2.12x, it means the relative variation from the average by about 0.4x (or an outperformance of 20% – in bull markets, Bank Nifty outperforms Nifty by 20% and in bear markets, its vice versa).
Since the actual movement of the index doesn’t matter – and therefore the absolute levels are irrelevant, what if one could profit from this trade? One is targeting only relative outperformance and not actual index levels so the chances of losses are limited. Even if both the indices hit the circuits tomorrow, one profit would tend to neutralize losses on the other!
CONSTRUCTING THE TRADE
Our trade scanners (Basic Bollinger Band envelopes created around some averages to show momentum and generate signals) show that we had a SHORT BANK NIFTY signal earlier on in the year when the relative price ratio hit a multi-year high at 2.5x. This went exactly as the scanner showed hitting a low of 2.26x in late September 2018. Since then the ratio seems to have stabilized and creeping upwards back into normal territory – generating a buy signal.
The way to construct this trade is very simple – go long Bank Nifty and short Nifty in equivalent values and keep track of SEBI circulars on the lot sizes overnight when you roll over trades!
As of now, it requires 40 units of Bank Nifty and 75 units of Nifty to execute this trade giving you an exposure of Rs 9.78 lakh in Nifty and Rs 7.8 lakh in Bank Nifty (which means you will be net short Nifty). You may buy another 20 units of Bank Nifty as and when available OR go long a basket of Bank Nifty stocks in your trading account to cover up the rest of the 2 lakh deficit – giving you equal exposures. Read our latest banking recommendations at www.plindia.com/
The chart below shows the ratio has begun to recover from below the volatility line and may continue its journey upwards.
HOW MAY THE TRADE PAN OUT
Well, both indices are averages of sentiments across 50 stocks! So on a volatility basis it will be much less risky than a stock based trade.
Tactically, stocks in the private banking space have collapsed and are attempting to regain composure while stocks in the IT , FMCG, Oil and Gas and Engineering space may plateau or even correct if the markets dip further. Of course some components may continue to outperform – example, Pharma and IT depending on currency movement depth but the overall market will keep the Nifty under check especially if the INR continues to be under pressure.
Alternatively, its likely that the Nifty has bottomed out and may resume sharp rallies. If you are in that perennial bull club, the bank space is likely to run up much faster as this club is typically more homogenous than other sectors (People tend to go any and all banks longer faster than other sectors where they may often take calls on individual stocks versus the sector)
Also remember the Bank Index itself is a major part of the Nifty index itself so to that extent, you get an inbuilt hedge- if you are wrong on your view, the losses are slowed down because the Nifty itself will move alongwith Bank Nifty on most volatile days giving you time to exit, average or stop loss trades without panicking.
If the chart above is accurate , it means you should be easily able to make 7%-10% on this trade over the next few months without worrying about individual days and market movements! Of course, like any other trades, always maintain a stop loss- so maybe a stoploss of Rs 25000 odd per trade would be ideal – so you are targeting an upside of about Rs 1 lakh and a stop of Rs 25000 per lot. Margins may be much smaller so if you are right, the returns on these trades are crazy on the actual margin blocked!
Of course the above is not a recommendation and the article is for readers who are wondering whether there are any more ways left to make money! We have just presented historical evidence , what the data says and how the trade may work– the rest, as they say, is conviction!
Remember – There is nothing called a surefire trade – but there is always one that can work with a high probability!
The PL Mobile App (www.plindia.com/plmobileapp) allows you to create a watchlist of these indices and live updates if you have executed trades. In addition, our dealers and officers across our national network can assist you with these trades so please feel free to call any of them (www.plindia.com/contactus.aspx) or email us at customerconnect@plindia.com
Connect with our Algo Desks at TEA@Plindia.com for system generated ideas or to open an account.
And if you like directional trading, do visit www.plindia.com/Algofirst for a strategy that takes a bold momentum views for you 24 x 7 on the Nifty and Bank Nifty!