Trading strategies for IT stocks

This is ‘tech fortnight’. TCS will follow Infosys in declaring its quarterly results and the other Information Technology (IT) majors will also queue up with respective numbers and advisories. Analysts will fine-tune their projections accordingly. All stocks in the IT sector will see higher volumes and higher price volatility. Since many IT stocks are listed in the F&O segment and IT has appreciable weight in the broader market indices, those trends will influence overall market movements.

It can also be predicted that analyst and trader focus will switch successively from one major to another, as results flow. What we can’t tell for sure is directional trend. However, the fundamentals of most IT companies are well-aligned and share movements tend to be correlated. If the majors are doing well, (or badly), smaller companies also do well (or badly).

This is characteristic of cyclical industries though some IT businesses will, of course, do better than others. Smaller players also have room for higher growth due to the lower base effect. But very few listed IT companies actually buck industry trends. This is because they all have very similar exposures both in terms of verticals as well as regions.

Given the guarantee of ample stock futures leverage and liquidity, how does a trader approach stocks in the IT industry during this period? The index itself (the CNXIT) doesn’t have much futures liquidity. Nor is there option liquidity for any of the stocks. So, standard hedges cannot be worked out, though IT stocks can be hedged in cumbersome fashion versus the Nifty.

Paired trades can work if the trader goes long on one IT stock while shorting another. Since IT stocks are well-correlated, the price differentials between given stocks tend to remain within restricted ranges.

In a paired trade, only the price-differentials count. When the differential between two stocks is expected to widen, short the lower-priced stock and go long on the higher priced. Vice-versa, short the higher and go long on the lower, when the differential is expected to narrow.

A well-organised paired trade carries less risk than any naked trade. But executing pairs can be quite complex. The trader has to equalise lot sizes, do a statistical analysis of likely differential ranges, and also calculate stop losses in terms of the differences. This is tricky.

Another trading strategy is cruder but it does have logic and history in its favour. If Infosys develops a trend over the next two or three sessions and TCS follows suit, it is statistically very likely the trend will repeat in HCL Tech, Wipro, Polaris, etc. As of now, Infosys appears to have disappointed the market. If the pattern repeats, there might be a series of lucrative, successive shorts in IT stocks through the settlement.

The author is a technical analyst