Index trading strategies

Although the average day-trader prefers to dabble in momentum stocks and stock futures, serious derivatives trading is usually focused on index futures and options. The underlying indices, especially the ones which have high liquidity, are followed with most interest.

In India, just two-and-a-half equity indices are worth trading. The Nifty generates much more volume than any other underlying. The Bank Nifty also offers highly liquid futures markets and an acceptable amount of options liquidity. The CNXIT futures have some liquidity but the CNXIT options chain is not liquid.

The industry indices influence the Nifty. Recently, when Infosys released disappointing FY results and guidance, the CNXIT dropped sharply and took the Nifty down with it. Sometimes in the past, the moves have gone the other way, when bullish IT performances have energised the Nifty. Similarly, the Bank Nifty is often either a bullish or bearish influence on the Nifty.

 

How correlated are the three indices? Since January, the Bank Nifty has shown up as highly correlated to the Nifty. It has a correlation coefficient of around 0.88. This means the Bank Nifty and the Nifty move in the same direction practically all the time.

The CNXIT is also significantly correlated to the Nifty, with a correlation coefficient of 0.7, but this is a less strong relationship. The Bank Nifty is not very correlated to the CNXIT – the correlation between the two is just 0.5.

In terms of beta, the Bank Nifty has a beta of 1.2 while the CNXIT has a beta of 0.85. This means the Nifty is “sandwiched” between the financial and the tech index in terms of volatility. All three move the same way much of the time but the Bank Nifty moves the most and the CNXIT moves the least.

How can a trader use this information? Sometimes, in technical analysis, the industry indices give a clearer signal than the Nifty. In this case, the high correlation helps traders because the Nifty is very likely to run a similar trend.

Another possibility is to exploit the difference in betas. For example, substitute the Bank Nifty futures for the Nifty futures when taking unhedged trades with directional bias. The Bank Nifty will move more than the Nifty but almost always in the same direction. So, returns (or losses) are more with this strategy. Another possibility is paired trades. For example, trade the Nifty-Bank Nifty combination (one long, one short) with the Bank Nifty held in the direction of bias. This assumes that, if the bias is correct, the Bank Nifty will outperform and the pair gives a net positive return. If wrong, the Nifty makes enough profits to reduce losses. A similar paired position would use the Nifty -CNXIT as a long-short combo with the Nifty held in the direction of bias.

One caveat – these relationships can change over time and need to be monitored continuously. Nor are such correlated-paired trading strategies risk-free though they do seem to reduce risks.

The author is a technical and equity analyst