Arbitrage trades and their impact on spot market pricing

Here is the textbook definition of how Arbitrage Funds earn money: “Arbitrage fund leverages the price differential in the cash and derivatives market to generate returns. The fund simultaneously buy shares in the cash segment and sell futures in the derivatives segment of the same company as long as the futures are trading at a reasonable premium.”

This would mean they do no-risk trades. Though there would be transactions costs (may be taxes as well), this arbitrage would still generate positive return with a very high probability. This opportunity exists as long as premiums on futures remain high creating a spread between spot price and its futures.

First we need to ask why there is a premium on the futures. Because there is a hope that underlying stock would gain, buyers of Futures are willing to pay a premium. But at the expiry, hope meets reality and the spot price converges with futures price resulting the premium to become zero. This cycle repeats every month.

Beginning of the new series as the premium is high, these funds enter the trade and when there is no premium to earn (at expiry or before), these trades end with square-off in futures and selling in cash market. They would earn at least 1-2% month per trade.

It is good for Arbitrage funds. But for rest of the traders, these trades might give false impressions of what is happening. As those funds buy in the sport market, demand goes up so will be the spot price. But they are creating a short position in futures market simultaneously. When they want to square-off the derivative they hold, they sell in spot market which causes pressure and the spot price declines. So this creates a price range and within that a stock would move multiple times.

Source: Moneycontrol.com

You might think all of the trades in the spot market are not arbitrage trades. Looking at the data shows that majority of the trades are indeed done by these arbitrage funds. They contribute significantly to the volume. Take example of IDFC Bank stock. The number of shares owned by Arbitrage funds in this stock is a lot higher than long term mutual funds hold and also higher than its daily or monthly average trade volume in the spot market. These funds are not long term investors but only interested in pocketing the premium and they do not care about the underlying direction of the stock. Since they would win anyway, they do not shy to create a stampede while selling or would not mind to create a hysteric demand taking the price up and increasing the arbitrage opportunities for themselves.

When they are buying, price levels see an increase beyond what it would be possible if these arbitrage funds were not present. Once their trades are set, they stop buying and the price drops as demand drops too. At this stage, arbitrage funds might decide buying again increasing the Open Interest levels or they can square-off exiting spot market too. And in the process they would damage the price to an extent of 1% to 10% depending on the depth of the market. But the fall won't be forever as they need to create hope for buyers to pay a premium which would happen with fresh buying. That is to sell futures at higher premium. This cycle repeats at least once a month and sometimes more within a month.

When a stock (traded in F&O) sees a sharp up move and then just passes time for the rest of the month, you know now who profits from it. Now that we are aware of their presence, how do we get to know their actions and how we can profit from it? I would write about that in a future blog post.

Book Review: The Gene

As the sub-title of this book describes, it is an intimate history of development of biological science with focus on genomics which is now getting prominence for its potential benefits to mankind.

The book begins with a prologue in which author (who originates from West Bengal, now resides in US) describes about three persons in his family over two generations diagnosed for mental disorders and could not lead normal lives. It is believed that genes carried these defects or the disease causing mechanism making it a hereditary disease. The blood of parents is not lost in you. However, defects may not come to surface in every member but yet it would use them as vehicles to come to life again in the next generation.

Then the next few chapters explore the efforts of scientists like Gregor Mendel to Charles Darwin (and many other scientists) in understanding the process of evolution and natural selection. These chapters are a fascinating read as the book touches most of the literature, theories developed and experiments devised over a period of few centuries and it establishes how this stream got developed into a full-fledged science and how each scientist built on the foundation laid by their predecessors.

Then the detailed study of genes follows through. Efforts to understand why they are sequenced in a particular way and how each is influencing the characteristics, be it in plant, animals or human beings. There is explanation of how the evolution played a role and how the nature nurtures this mechanism of passing the genes to their off-springs. If and how genes can be engineered to get the desired results and similar discussions form the rest of this book, which cannot be summarized in a blog post and I believe it requires reading full 500+ pages of this book. If this subject interests you, get it on your study table soon (if not done already).

Though this is a science non-fiction, this book uses a simple language and keeps the readers interested, thanks to the literary skills of the author cum scientist Dr. Siddhartha Mukherjee. He won the Pulitzer award for his previous book on the study of cancer. This book in an extended study of his previous book and would become one of the foundations pillars in the historical study of genes.

I wish Dara Shikoh was not killed

He was the eldest son of Mughal emperor Shah Jahan and also his favorite. He was the crowned price and an able administrator. He was rational. He was on a spiritual conquest. He tried to understand the meaning of life. He got Upanishads translated into Persian. He respected all religions. People loved him. Army generals hated him. Spirituality and wars, they do not get along well. Dara Shikoh lacked the skills of an able warrior. He understood the secrets of religious texts but failed to understand the secret plots his younger brothers. He went to war to fight his brother Aurangzeb who was everything that Dara was not. Dara lost the battle and ran away for life seeking help. He never got it. He was hungry for days, his wife died on the way. He was easily conned and handed over to his brother. An enlightened man had to meet a brutal death along with his son. You can call it fate or destiny, but it is all history. Dara was dead and religious extremism was born.

I wish things have had happened otherwise. I wish Dara was less spiritual. I wish Dara knew how to fight a war. I wish Dara knew moves of enemies. I wish Dara had got help. I wish Dara was not killed. I wish Dara had become the emperor. I wish people had understood what Dara knew very well. I wish there was only one religion. I wish Dara gets another opportunity.

Income from your investments

Lots of us have bad experiences investing in the stock markets directly so would prefer the route of Mutual Funds. That is fine. The only problem I see is, Mutual Funds are skewed towards companies with higher market capital. That is to balance the risk-reward profile. As the assets of the fund grow, they find it difficult to earn higher returns than the index as their portfolio gets wider too. And each fund house has their own bias too. That is counter-productive. So all of this will lead to returns generated by mutual fund is almost comparable to index. Stock concentration gives higher returns than the market but can increase risk profile too. Is there a way, individual investors can manage their portfolio risks? Yes, if we can harness our emotions and invest with a sane mind.

o Have realistic expectations: We want to earn higher returns than benchmark index but we do not aim at windfall gains. Higher expectations makes us take higher risks and increase the chances of losing out. Capital protection is as important as growth.

o Give time: Think of portfolio creation like constructing a building. You cannot have rental income from a building which is not complete and it may take many months to years to complete and until then you are not expecting a return. And you are not judging the valuation of the building on daily or monthly basis during that period.

o Due diligence: Choose stocks wisely. Identifying fundamentally good stock with growth potential is a primary filter. Revenue and earnings growth have to be consistent and any deviation should have valid reasons. Risks in balance sheet should not be unhealthy. Cash flows have to be sensible and should triangulate with the state of business. Strategy as explained in investor presentations, conference calls, public interviews by the management should invoke confidence. Look at co-investors through share-holding pattern. Before you put money, spend time studying the company, their business, products, customers and competitors. The more time you invest here, higher is the quality of your portfolio.

o Techincals: Learn to identify supports and resistances. You may use chart patterns or look at option-chains or any other technical tools. Buy only at support levels. This will give a good start. If the stock falls after you buy and hits the stop-loss, it is better to get out. You did not study it well or you could not get the rhythm of that stock. Averaging it would potentially become a trap. Journey has to begin positively. Cut your losses at the first instance and retain those you get it right.

o Add only when there is price difference (and not every month): Do not buy in bulk but invest in small amounts. You will buy the next lot only when the stock moves up significantly and not periodically. If a stock stays at same level for months, there is no point in investing in it every month. We do not know the next move, it could be break-out or break-down. We are in the stock market to earn money which comes with price difference. Unless the positive price difference comes, it does not make sense to put additional money in the same stock. You may lose out on the initial rise if stock does well immediately after your purchase because your volumes were not high but you also avoided big loss potential too.

o Keep moving the stop loss level up:  This is to safeguard your profits. Since you have added more quantity only when the stock has moved up, there is a positive difference between your average price and the current market price. There is a always cushion of profits for your portfolio. But when the fundamentals change and you decide to exit, you should do so without incurring losses. Revising the stop loss levels up helps us to retain profits and realize them.

o Portfolio mix: We do not want to hold 50-100 stocks in our portfolio but wish to have around 10 stocks any given time. These stocks should not be from the same sector (for example, all should not be banking stocks or cement stocks). Ensure they are un-related, that would reduce industry risk. If regulator or the Govt. makes any policy changes, it should reduce the impact on the portfolio if the mix is not concentrated.

o Keep good cash: Keep some-thing like 30-40% of your portfolio in cash (it could be in the form of deposits or bonds or demat gold). Since stock markets surprise us often and give discount buying opportunities, we need to have cash (or equivalent) to make use of the opportunity. During your portfolio building years, you would not invest more than 70% of your money in equity. Once it begins to perform, you would book profits regularly to keep the cash levels at 30-40%. This may not look like efficient when the going is good but when there are shocks to market, the discount buying opportunities produce higher returns, this would give you an upper hand in the overall returns of the portfolio.

If you study the points listed above, we are doing everything right from identifying the quality stock, to entering at the right price, to managing the risks (credit risks, industry risks, portfolio risks) and also making good use of the opportunities.

If are too enthusiastic, you are likely to lose the money in the market so invest enough time until the euphoria is replaced with balanced perspectives. Then your investments will begin to produce positive cash flows. This journey will take at least five years. And you don’t learn to manage any business efficiently in lesser time than that.

Leave to Live!

Purna Chandra Tejasvi, a noted writer had said in a casual conversation that Bangaloreans, when they die, directly go to heaven as there would be no hell worse than Bangalore in which they had spent their life time. Well, he had said that a long time ago, and it was a dark humor with a warning then. Now that has become reality.

Ask any resident who has stayed in Bangalore for long about how it is transforming, you will realize how a paradise gradually turned into a hell. Ponds and lake beds became space for public utilities and residential townships. Green cover had to be sacrificed for roads and highways. Natural resources got depleted at an alarming space. Now how and why do you expect Bangalore to remain cooler?

Around 15 years ago, it was possible go around Bangalore in a bike like how one would do in any other town. But if you attempt it now, you would return home not just exhausted but with extreme rage and uneasiness. It won’t be a surprise if you woke up next day coughing which won’t leave you for days.

Bangalore is one of the fastest growing cities in this world. It kept growing for its ingredients. In the post-independence era, Bangalore became home to many public sector companies like, BHEL, HAL, BEL, BEML and many more. Industry got developed. There was Indian Institute of Science and good number of Engineering colleges attracting and growing the talent feeding the developing industry. Then came the IT wave which changed the geography of Bangalore completely. Sleeping farm estates of Whitefield turned into a silicon valley of India. People came to Bangalore and they never returned as they built there home here.

It was difficult for Govt. machinery to cope as they had not anticipated this kind of growth. Coupled with their inefficiency, temporary measures adopted by the residents such as improper disposing of waste, drilling deep bore-wells along with unscientific ways adopted by the construction industry including sand mafia helped accelerate Bangalore reach the present state. All of us living in Bangalore, directly or indirectly have contributed to this mess. There are many videos being circulated in social media and numerous articles being published on newspapers and magazines on how Bangalore would become unlivable soon. As we just keep talking and not do what is necessary, we would consciously walk into the reality of unlivable Bangalore.

Then what? Many of us would be forced to leave Bangalore and build home elsewhere. Our employers would change their base. Government may move out some of its offices too. Before that happens, lots of residents would be losing their health for the ill-effects of pollution of every kind – water, air and noise primarily.

So why not leave early? Don’t we deserve a better a life? Of course, there are practical issues like job opportunities are not there outside Bangalore. But for those of us who can find an alternative, it would be worth considering. Cities are harsh on daily life leading. Higher the time spent in commute, lower the time available to do anything else. Higher is the exposure to pollution, lower is the life expectation. Higher earning in Bangalore would also mean higher costs with health deteriorating and reduced ability to earn or remain in job over a long period. Considering the opportunity costs, it would become economically viable to leave the high-paying job in Bangalore to lower earning but a simple life of a small town.

To me (and to some like-minded) this discussion is making sense. I hope I would be able to leave Bangalore before I am forced to.