Directional bets do not always mean taking a long or a short position. Sometimes, you could take relative bets. You could simultaneously take a long position and a short position in two different securities that are related to each other. This week, we discuss the characteristics of this relative value trade using futures contracts.
Relative performance
Suppose you have a view that an underlying, a constituent of the Nifty Index, is likely to outperform the index. You expect that returns on the underlying is likely to be greater than the returns on the index. If you want to take advantage of this view through futures contracts, you should go long on the near-month futures of the underlying and short the Nifty Index futures.
The above position can be gainful in three scenarios. In scenario one, just as you expected, the single-stock futures price goes up more than the Nifty futures price. The gains on the single-stock futures will be more than the loss on the Nifty futures price. Note that the benefit comes from two factors. One, the single-stock futures price moves faster than the Nifty Index. And two, the contract multiplier for the single-stock futures is greater than that of the Nifty Index. In scenario two, the single-stock futures price goes up and the Nifty Index declines. This offers the maximum gains because both positions move favourably. In scenario three, single-stock futures price declines but Nifty futures price declines more. This will generate gains only if the decline in the Nifty futures is significantly greater than the single-stock futures price, given the difference in contract multiplier. The position will generate losses if Nifty futures price moves up and single-stock futures price declines. Or if single-stock futures price declines more than the Nifty futures price, which is a greater risk.
So, how should you select the underlying? Logically, the stocks that can outperform are the ones that have lower weights in the index. Why? If heavy-weight stocks move up, they are likely to move the index along with them. So, the outperformance may not amount to much. Therefore, you should shortlist light-weight stocks and study their relative performance against the index. You could also analyse the Relative Rotation Graph® that we discussed previously in this column.
Optional Reading
The above strategy is typically set up as long-bias position. The long position has greater exposure than the short position. You could also set up the trade adjusting the rupee value of the position; rupee value of your long position to be equal to the rupee value of your short position. At the extreme, you could set up the beta of the long position to be equal to the beta of the short position. The objective then would be to make the set-up beta neutral so that the position only gains from relative value. Note that you will have to post initial margins for both futures contracts.
(The author offers training programmes for individuals to manage their personal investments)
