For example at the end of day 1st March : Market price of underlying asset in Rs. On the expiration date, suppose price in Rs. Suppose price in Rs. In real life, the transaction cost has to be considered like the brokerage, service Tax, Securities Service Tax etc. Here, it may be interesting to look at the risks these arbitragers carry. Even if the systems are seamless and electronic and both the legs of transaction are liquid, there is a possibility of some gap between the executions of both the orders.
If either leg of the transaction is illiquid then the risk on the arbitrage deal is huge as only one leg may get executed and another may not, which would open the arbitrager to the naked exposure of a position.
Similarly, if contracts are cash settled in both or one of the markets, it would need reversal of trades in the respective markets, which would result in additional risk on unwinding position with regard to simultaneous execution of the trades. These profit focused traders and arbitrageurs fetch enormous liquidity to the products traded on the exchanges. This liquidity in turn results in better price discovery, lesser cost of transaction and lesser manipulation in the market.
Uses of Index futures Equity derivatives instruments facilitate trading of a component of price risk, which is inherent to investment in securities. Price risk is nothing but change in the price movement of asset, held by a market participant, in an unfavourable direction. This risk broadly divided into two components - specific risk or unsystematic risk and market risk or systematic risk. This risk is inseparable from investing in the securities. This risk could be reduced to a certain extent by diversifying the portfolio.
Systematic Risk An investor can diversify his portfolio and eliminate major part of price risk i. Thus, every portfolio is exposed to market risk. This risk is separable from investment and tradable in the market with the help of index-based derivatives. When this particular risk is hedged perfectly with the help of index-based derivatives, only specific risk of the portfolio remains. Therefore, we may say that total price risk in investment in securities is the sum of systematic risk or market risk and unsystematic risk or specific risk.
Before we get to management of systematic risk with index futures, we need to understand Beta - a measure of systematic risk of a security that cannot be avoided through diversification. Suppose a stock has a beta equal to 2. In order to calculate beta of a portfolio, betas of individual stocks are used.
It is calculated as weighted average of betas of individual stocks in the portfolio based on their investment proportion. For example, if there are four stocks in a portfolio with betas 0. Information on beta of individual stocks is readily available in various financial newspapers, magazines and information vending networks like Bloomberg, Reuters etc.
Now, let us get to management of systematic risk. Assume you are having a portfolio worth Rs. You see the market may be volatile due to some reasons. You are not comfortable with the market movement in the short run. At this point of time, you have two options: 1 sell the entire portfolio and buy later and 2 hedge by the use of Index futures to protect the value of this portfolio from the expected fall in the market.
As an investor you are comfortable with the second option. If the prices fall, you make loss in cash market but make profits in futures market. If prices rise, you make profits in cash market but losses in futures market. Now, the question arises how many contracts you have to sell to make a perfect hedge? Perfect hedge means if you make Rs. Readers may note that for simplification purpose, beta of futures index vis-a- vis cash index is taken as one.
Let us assume, Beta of your portfolio is 1. Assume one Futures contract has a lot size of You will have to hedge using Since you cannot hedge 2.
You have to pay the broker initial margin in order to take a position in futures. A portfolio has different relationships with different indices used for hedge hence the hedge ratio would change with the change in the index.
This may result in some difference between actual and expected numbers. Similarly, we can use single stock futures to manage the risk of the equity investment in cash market. For instance, use of single stock futures would hedge the market participant against the whole risk in the equity investment because these futures are comparable with underlying positions. Only difference between an underlying position and single stock futures is on settlement front; in case of cash transactions, settlement takes place immediately and in case of single stock futures contracts, settlement is deferred.
Important terms in hedging Long hedge: Long hedge is the transaction when we hedge our position in cash market by going long in futures market. For example, we expect to receive some funds in future and want to invest the same amount in the securities market.
We expect the market to go up in near future and bear a risk of acquiring the securities at a higher price. We can hedge by going long index futures today. On receipt of money, we may invest in the cash market and simultaneously unwind corresponding index futures positions. Any loss due to acquisition of securities at higher price, resulting from the upward movement in the market over intermediate period, would be partially or fully compensated by the profit made on our position in index futures.
Further, while investing, suitable securities at reasonable prices may not be immediately available in sufficient quantity. Rushing to invest all money is likely to drive up the prices to our disadvantage. This situation can also be taken care of by using the futures. We may buy futures today; gradually invest money in the cash market and unwind corresponding futures positions. Similarly, we can take an example from the commodity market, if there is a flour mill and it is expecting the price of wheat to go up in near future.
This would also be an example of long hedge. Short hedge: Short Hedge is a transaction when the hedge is accomplished by going short in futures market. For instance, assume, we have a portfolio and want to liquidate in near future but we expect the prices to go down in near future. This may go against our plan and may result in reduction in the portfolio value. The amount of loss made in cash market will be partly or fully compensated by the profits on our futures positions.
Assume Company C is into export and import business. Company expects some dollars to flow in after say 6 months. Director Finance of the company is expecting the depreciation in dollar vis-a-vis local currency over this period of time. This selling would protect company against any fall of dollar against the local currency. Cross hedge: When futures contract on an asset is not available, market participants look forward to an asset that is closely associated with their underlying and trades in the futures market of that closely associated asset, for hedging purpose.
They may trade in futures in this asset to protect the value of their asset in cash market. This is called cross hedge. For instance, if futures contracts on jet fuel are not available in the international markets then hedgers may use contracts available on other energy products like crude oil, heating oil or gasoline due to their close association with jet fuel for hedging purpose. This is an example of cross hedge. Indeed, in a crude sense, we may say that when we are using index futures to hedge against the market risk on a portfolio, we are essentially establishing a cross hedge because we are not using the exact underlying to hedge the risk against.
Hedge contract month: Hedge contract month is the maturity month of the contract through which we hedge our position. Similarly, if we hedge say risk on crude oil price with the help of Mar.
Trading in futures market Traders are risk takers in the derivatives market. And they take positions in the futures market without having position in the underlying cash market. These positions are based upon their expectations on price movement of underlying asset. Traders either take naked positions or spread positions. A trader takes a naked long position when he expects the market to go up. Money comes by reversing the position at higher price later.
Similarly, he takes a short position when he expects the market to go down to book profit by reversing his position at lower price in the future. For instance, if one month Sensex futures contract is trading at and trader expects the cash index at the maturity of the one month contract should settle at a level higher than this, he would take a long position in index futures at a level of When they expect the market to go up, they may take long position in these futures and when they expect the market to go down, they may take short position in single stock futures.
If market moves in the expected direction, trader would end up making profit. Here, it may be noted that if market does not move in the expected direction, trader may also incur a loss.
Because, a position is as exposed to loss as profit, it is called the speculative position. Naked position is long or short in any of the futures contracts but in case of a spread, two opposite positions one long and one short are taken either in two contracts with same maturity on different products or in two contracts with different maturities on the same product. Exchanges need to provide the required inputs to the system for it to recognize any kind of spread. At present, in equity market, the system recognizes only calendar spreads.
In commodities market, system recognizes inter-commodity spread between specific commodities like Gold and Silver; Soybean, Soybean meal and Soybean oil, etc. Calendar spread position is always computed with respect to the near month series. A has say 3 contacts short in one month futures contract, 2 contracts long in two months futures contract and 3 contracts long in three months futures contract, he would be said to have 2 calendar spreads between first and second months and 1 calendar spread between first and third month.
Further, his position in remaining 2 three months contracts would be treated as naked. As spread positions are hedged to a large extent because they are combinations of two opposite positions, they are treated as conservatively speculative positions.
Arbitrage opportunities in futures market Arbitrage is simultaneous purchase and sale of an asset or replicating asset in the market in an attempt to profit from discrepancies in their prices. Important point to understand is that in an efficient market, arbitrage opportunities may exist only for shorter period or none at all. The moment an arbitrager spots an arbitrage opportunity, he would initiate the arbitrage to eliminate the arbitrage opportunity.
Arbitrage occupies a prominent position in the futures world as a mechanism that keeps the prices of futures contracts aligned properly with prices of the underlying assets. The objective of arbitragers is to make profits without taking risk, but the complexity of activity is such that it may result in losses as well. Well-informed and experienced professional traders, equipped with powerful calculating and data processing tools, normally undertake arbitrage.
These three positions are elaborated with the help of examples. To simplify the calculations, it is assumed that there is no resistance like transaction costs, impact cost, taxes etc. In a simplified world of the kind described by our assumptions, actual futures prices are assumed to be exactly equal to the fair price or theoretical price, which is spot price plus cost of carry.
Thus, unless there are obstacles to such arbitrage the activities of the arbitrageurs would cause spot-futures price relationships to conform to that described by the cost of carry formula.
On rare occasions, however, there is an arbitrage opportunity that exists for some time. Practically, an arbitrage is feasible and will be undertaken only if it provides net cash inflow after transaction costs, brokerage, margin deposits etc.
Illustrations: Cash and carry arbitrage The following data is available on stock A as on August 1, Cash market price Rs. Going by the theoretical price, we may say that December futures on stock A are overvalued. To take advantage of the mispricing, an arbitrageur may buy shares of stock A and sell 1 futures contract on that at given prices.
This would result in the arbitrage profit of Rs. Let us look at the following data on stock A as on December 1. Otherwise, also, if the trader carries his position till the expiry, it will yield him an arbitrage profit. The assumption in implementing this arbitrage opportunity is that the arbitrager has got the stock to sell in the cash market, which will be bought back at the time of reversing the position.
If stock is not available, arbitrager needs to borrow the stock to implement the arbitrage. In that case, while analyzing the profitability from the transaction, cost of borrowing of stock would also be taken into account. Assuming the contract multiplier for futures contract on stock A is shares. To execute the reverse cost and carry, arbitrager would buy one December futures at Rs. Position of the arbitrager in various scenarios of stock price would be as follows: Case I: Stock rises to Rs.
Our assumption in the above example is that both the positions i. Let us understand this point with the help of an example. If in the above example of reverse cost and carry, on any day in December before the maturity date, spot price of stock A is Rs.
Inter-market arbitrage This arbitrage opportunity arises because of some price differences existing in same underlying at two different exchanges. If August futures on stock Z are trading at Rs. The positions could be reversed over a period of time when difference between futures prices squeeze. This would be profitable to an arbitrageur. It is important to note that the cost of transaction and other incidental costs involved in the deal must be analyzed properly by the arbitragers before entering into the transaction.
In the light of above, we may conclude that futures provide market participants with a quick and less expensive mode to alter their portfolio composition to arrive at the desired level of risk. As they could be used to either add risk to the existing portfolios or reduce risk of the existing portfolios, they are essentially risk management and portfolio restructuring tool. Some market participants desired to ride upside and restrict the losses.
Accordingly, options emerged as a financial instrument, which restricted the losses with a provision of unlimited profits on buy or sell of underlying asset. The party taking a long position i. The option buyer has the right but no obligation with regards to buying or selling the underlying asset, while the option writer has the obligation in the contract.
Option terminology There are several terms used in the options market. Let us comprehend on each of them with the help of the following price: Quote for Nifty Call option as on September 30, 1. Instrument type : Option Index 2. Expiry date : October 28, 4. Option type : Call European 5. Strike Price : 6. Open price : High price : 8. Low price : Close price : Traded Quantity : No of Contracts : Open Interest : Underlying value : Option type : Put European 5.
Low price : 84 9. For example options on Nifty, Sensex, etc. Stock option: These options have individual stocks as the underlying asset. Buyer of an option: The buyer of an option is one who has a right but not the obligation in the contract. In India, Index options are European.
In our examples, option price for call option is Rs. Premium traded is for single unit of nifty and to arrive at the total premium in a contract, we need to multiply this premium with the lot size.
Lot size: Lot size is the number of units of underlying asset in a contract. Lot size of Nifty option contracts is Accordingly, in our examples, total premium for call option contract would be Rs. In our example, the expiration day of contracts is the last Thursday of October month i. Spot price S : It is the price at which the underlying asset trades in the spot market. In our examples, it is the value of underlying viz. In our examples, strike price for both call and put options is In the money ITM option: This option would give holder a positive cash flow, if it were exercised immediately.
A call option is said to be ITM, when spot price is higher than strike price. And, a put option is said to be ITM when spot price is lower than strike price. In our examples, call option is in the money. At the money ATM option: At the money option would lead to zero cash flow if it were exercised immediately.
Therefore, for both call and put ATM options, strike price is equal to spot price. Out of the money OTM option: Out of the money option is one with strike price worse than the spot price for the holder of option. In other words, this option would give the holder a negative cash flow if it were exercised immediately.
A call option is said to be OTM, when spot price is lower than strike price. And a put option is said to be OTM when spot price is higher than strike price. In our examples, put option is out of the money. Intrinsic value: Option premium, defined above, consists of two components - intrinsic value and time value. For an option, intrinsic value refers to the amount by which option is in the money i. Therefore, only in-the-money options have intrinsic value whereas at-the-money and out-of-the-money options have zero intrinsic value.
The intrinsic value of an option can never be negative. Thus, for call option which is in-the-money, intrinsic value is the excess of spot price S over the exercise price X. Thus, intrinsic value of call option can be calculated as S-X, with minimum value possible as zero because no one would like to exercise his right under no advantage condition. Similarly, for put option which is in-the-money, intrinsic value is the excess of exercise price X over the spot price S.
Thus, intrinsic value of put option can be calculated as X-S, with minimum value possible as zero. Time value: It is the difference between premium and intrinsic value, if any, of an option. Open Interest: As discussed in futures section, open interest is the total number of option contracts outstanding for an underlying asset.
Exercise of Options In case of American option, buyers can exercise their option any time before the maturity of contract. The issue of assignment of options arises only in case of American options because a buyer can exercise his options at any point of time.
When you are short i. All option writers should be aware that assignment is a distinct possibility. Now, let us understand each of these positions in detail: Long Call On October 1, , Nifty is at You buy a call option with strike price of at a premium of Rs.
A Call option gives the buyer the right, but not the obligation to buy the underlying at the strike price. So in this example, you have the right to buy Nifty at You may buy or you may not buy, there is no compulsion.
If Nifty closes above at expiry, you will exercise the option, else you will let it expire. If Nifty closes at , you will NOT exercise the right to buy the underlying which you have got by buying the call option as Nifty is available in the market at a price lower than your strike price.
Why will you buy something at when you can have the same thing at ? So you will forego the right. In such a situation, your loss will be equal to the premium paid, which in this case is Rs. In this transaction you will make a profit of Rs. So If Nifty were to close at , you will exercise the option and buy Nifty at and sell it in the market at , thereby making a profit of Rs. But since you have already paid Rs. This table is used to draw the pay off chart given in the next page.
Strike Price X Premium The maximum loss for such an option buyer would be equal to But as seen from table and chart you can reduce your losses as soon as nifty goes above Long call position helps you to protect your loss to a maximum of Rs. Short Call Whenever someone buys a call option, there has to be a counterparty, who has sold that call option.
If the maximum loss for a long call position is equal to the premium paid, it automatically means that the maximum gain for the short call position will be equal to the premium received. Similarly, if maximum gain for long call position is unlimited, then even maximum loss for the short call position has to be unlimited.
Lastly, whenever, the long call position is making losses, the short call position will make profits and vice versa. Hence, if we have understood long call pay off, short call pay off chart will be just the water image of the long call pay off. Thus at Nifty, When long call position makes a loss of Rs.
Similarly for , when long call makes a profit of As Nifty starts rising, short call position will go deeper into losses. Maximum gain for an option seller, as explained earlier, will be equal to the premium received as long as Nifty stays below strike price whereas maximum loss can be unlimited when Nifty starts moving above BEP.
BEP is independent of position long or short , it is instrument specific call option. Premium is received by the seller of the option. However he has to pay the margin. This is because the option seller has an obligation and since his losses can be unlimited, he can be a potential risk for the stability of the system. Long Put On October 1, , Nifty is at You buy a put option with strike price of at a premium of Rs.
A put option gives the buyer of the option the right, but not the obligation, to sell the underlying at the strike price. In this example, you can sell Nifty at When will you do so? You will do so only when Nifty is at a level lower than the strike price.
So if Nifty goes below at expiry, you will buy Nifty from market at lower price and sell at strike price. If Nifty stays above , you will let the option expire.
The maximum loss in this case as well like in long call position will be equal to the premium paid; i. What can be the maximum profit? Theoretically, Nifty can fall only till zero. So maximum profit will be when you buy Nifty at zero and sell it at strike price of The profit in this case will be Rs. Breakeven point in this case will be equal to strike price — premium X — P. In our example breakeven point will be equal to — Thus when Nifty starts moving below The pay off chart for long put position is drawn using the below table.
A put option buyer need not pay any margin. This is because he has already paid the premium and there is no more risk that he can cause to the system. A margin is paid only if there is any obligation.
An option buyer either buyer of a call option or a put option has no obligation. Just the opposite of that of the put option buyer. When long put makes profit, short put will make loss. If maximum loss for long put is the premium paid, then maximum profit for the short put has to be equal to the premium received. If maximum profit for long put is when price of underlying falls to zero at expiry, then that also will be the time when short put position makes maximum loss.
An extra column is added to the above table to show positions for short put. The pay off chart is drawn using this table. As can be seen above, options are products with asymmetric risk exposure i.
For example, under a call option, when a stock price goes down, the loss incurred by the buyer of this option is limited to the purchase price of the option. In contrast to this, futures have symmetric risk exposures symmetric pay off.
Opening a Position An opening transaction is one that adds to, or creates a new trading position. It can be either a purchase or a sale. Closing a position A closing transaction is one that reduces or eliminates an existing position by an appropriate offsetting purchase or sale. Note: A trader does not close out a long call position by purchasing a put or any other similar transaction. A closing transaction for an option involves the purchase or sale of an option contract with the same terms.
Leverage An option buyer pays a relatively small premium for market exposure in relation to the contract value. This is known as leverage. In our examples above long call and long put , we have seen that the premium paid Rs. A trader can see large percentage gains from comparatively small, favourable percentage moves in the underlying equity.
Leverage also has downside implications. Options offer their owners a predetermined, set risk. A short option position has unlimited downside risk, but limited upside potential to the extent of premium received 4. The question is from where did we get these values? On what basis did market participants come to these values of the premiums?
What are the parameters that affect these values? Are these fixed by the stock exchanges or by SEBI? The answer lies in understanding what affects options? Prices are never fixed by stock exchanges or SEBI or anybody for that matter.
In fact price discovery is a very critical and basic component of markets. Each variable has its impact on an option. The impact can be same or different for a call and put option.
As explained in the earlier section, option premium is the sum of intrinsic value and time value. As long as the option is not expired, there will always be some time value.
Time value of the option in turn depends upon how much time is remaining for the option to expire and how volatile is the underlying.
Spot price of the underlying asset The option premium is affected by the price movements in the underlying instrument. If price of the underlying asset goes up the value of the call option increases while the value of the put option decreases.
Similarly if the price of the underlying asset falls, the value of the call option decreases while the value of the put option increases. On the other hand, with all the other factors remaining constant, increase in strike price of option increases the intrinsic value of the put option which in turn increases its option value.
It affects both call and put options in the same way. Higher the volatility of the underlying stock, higher the premium because there is a greater possibility that the option will move in-the-money during the life of the contract. Time to expiration The effect of time to expiration on both call and put options is similar to that of volatility on option premiums.
Generally, longer the maturity of the option greater is the uncertainty and hence the higher premiums. This is also known as time decay. It is also interesting to note that of the two component of option pricing time value and intrinsic value , one component is inherently biased towards reducing in value; i. So if all things remain constant throughout the contract period, the option price will always fall in price by expiry. Thus option sellers are at a fundamental advantage as compared to option buyers as there is an inherent tendency in the price to go down.
Interest Rates Interest rates are slightly complicated because they affect different options, differently. For example, interest rates have a greater impact on options with individual stocks and indices compared to options on futures. To put it in simpler way high interest rates will result in an increase in the value of a call option and a decrease in the value of a put option. Options Pricing Models There are various option pricing models which traders use to arrive at the right value of the option.
Some of the most popular models are briefly discussed below: The Binomial Pricing Model The binomial option pricing model was developed by William Sharpe in It has proved over time to be the most flexible, intuitive and popular approach to option pricing. It is one of the most popular, relative simple and fast modes of calculation.
Unlike the binomial model, it does not rely on calculation by iteration. This measures the sensitivity of the option value to a given small change in the price of the underlying asset. It may also be seen as the speed with which an option moves with respect to price of the underlying asset. Delta for call option buyer is positive.
This means that the value of the contract increases as the share price rises. Delta for call option seller will be same in magnitude but with the opposite sign negative.
The value of the contract increases as the share price falls. Delta for put option seller will be same in magnitude but with the opposite sign positive.
Therefore, delta is the degree to which an option price will move given a change in the underlying stock or index price, all else being equal. The knowledge of delta is of vital importance for option traders because this parameter is heavily used in margining and risk management strategies. The delta is often called the hedge ratio, e. This is called a second derivative option with regard to price of the underlying asset.
It is calculated as the ratio of change in delta for a unit change in market price of the underlying asset. Theta is the change in option price given a one-day decrease in time to expiration. It is a measure of time decay. Theta is generally used to gain an idea of how time decay is affecting your option positions.
Other things being equal, options tend to lose time value each day throughout their life. This is due to the fact that the uncertainty element in the price decreases. An increase in the assumed volatility of the underlying increases the expected payout from a buy option, whether it is a call or a put.
Among other things, a trader must also consider the premium of these three options in order to make an educated decision. As discussed earlier there are two components in the option premium — intrinsic value and time value. In case of at-the-money or out-of-the-money options there is no intrinsic value but only time value.
Hence, these options remain cheaper compared to in-the-money options. Therefore, option buyer pays higher premium for in-the-money option compared to at-the-money or out-of-the-money options and thus, the cost factor largely influences the decision of an option buyer. Let us consider call options with strike prices of , , and A call option buyer will buy the option and pay the premium upfront. The premiums for various strike prices are as follows: Strike Price Premium Hence the option premium will always be at least equal to this value.
The remaining portion of the premium is the time value There is no intrinsic value here. The entire option premium is attributed to risk associated with time, i.
The greatest loss will be for option with strike price Rs. The choice of option would be better understood with return on investment ROI. In each case, ROI is defined as net profit as a percentage of premium paid by the option buyer.
Pay offs for call options with different strikes and premiums X Nifty Closing P A person bearish on the Nifty can buy a put option of any strike available. The premiums for each of these are given below: Strike Price Premium 69 98 In case of the strike option, the intrinsic value is — For the other two options, the entire premium is the time value Pay offs for put options with different strikes and premiums X Nifty Closing P 69 98 Thus, trading on equity can earn outsized returns for shareholders, but also presents the risk of outright bankruptcy if cash flows fall below expectations.
In short, earnings are likely to become more variable when a trading on equity strategy is pursued. Because of the increased variability in earnings, a side effect of trading on equity is that the recognized cost of stock options increases. The reason is that option holders are more likely to cash in their options when earnings spike, and since trading on equity leads to more variable earnings, the options are more likely to earn a higher return for their holders.
The trading on equity concept is more likely to be employed by professional managers who do not own a business, since the managers are interested in increasing the value of their stock options with this aggressive financing technique.
A family-run business is more interested in long-term financial stability, and so is more likely to avoid it. The company is not using financial leverage at all, since it incurred no debt to buy the factory.
Trading on equity is also known as financial leverage, investment leverage, and operating leverage. Corporate Finance. Treasurer's Guidebook. College Textbooks. Accounting Books. For any trading strategy, it is important to pick the right stocks to trade, and right time to enter and exit. A cursory look at the data shows that in months stock market provides fairly good returns.
This hints at carrying out technical analysis of positional trading in the stock market in the months. Also considering that the derivatives market is active over the nearest one to three months helps. In positional trade, not always right but on the average more right than wrong, helps to cut loses and run profit.
It is difficult to find the bottom, only in hindsight would one know about it. Mean reversion is one of the great truisms of capitalism. When an investor focuses on short term investments, he should observe the variability of the portfolio, not the returns. An investment and trading operations are one which upon thorough analysis promises safety of principal and a satisfactory return. We are replacing complex analysis with beta, debt-equity ratio, and mean reversion trading, and yet we believe that it will not undermine the result especially for investors given the reasons stated above.
All scientific theories are unrealistic simplification. It is by breaking down the complexity of reality to unrealistic models that science progress. Thus no absolute law or theory is being proposed but a plausible guideline for investment and trading strategies is suggested.
In investment it is important to play a test match of the Sunil Gavaskar caliber. Lots of patience, respect for the bowlers and the pitch, and not losing your wicket capital in case of investment. Trading is T match where you take probabilistic decision on each ball and on the average try to score or make some trading gains.
The free float market capitalization data and one year beta are collected from the official website of sharekhan, whereas debt-equity ratio is collected from moneycontrol. The prices series for all the stocks under consideration are adjusted to splits and bonus uniformly. The sample period is five years, a period where the world economy was attempting to emerge from one of the worst financial crises. Also, taking into consideration 92 of companies individually the diversification of stocks enhances the power of analysis.
The study sticks to the basic and uses very simple methods like trend analysis, simple and weighted averages, CAGR, standard deviation, et cetera.
Empirical Analysis and Discussion of Results The list of 92 companies considered for empirical analysis is provided with broad indicators, viz. The estimate of the beta of each stock is a potential candidate for inclusion in a portfolio. The error in measuring the true beta and the possibility of real shifts in beta over time may justify the limitations of beta under consideration in the present study.
We have profiled the stocks on the basis of beta and debt-equity ratio from highest to lowest respectively in table 2 and table 3. It is clearly visible that there is positive correlation between beta and debt-equity ratio. The study considered beta and debt-equity ratio as important factors explaining the returns of stock.
The average beta and D-E ratio of these stocks are 0. Therefore, we have carried out a separate exercise for this sector and presented the result in table 5. Barring three stocks, all others have beta value greater than one indicating high risk stocks.
This is presented in tables 4 and 5. The CNX generates 0. The stocks in of first category generate on an average return of 0. The stocks with low beta and low debt-equity ratio category 1 generate around 16 percent return based on 5 year CAGR with range from The stock CILPA generates negative returns in the short run one year but in the long run 5 years it generates positive return of over 7 percent.
The average return of the stocks in the second category stands at 0. The return based on 5 year CAGR ranges from The NTPC generates negative returns both in the short run and long run.
The third category of stocks with high beta and high debt-equity ratio generates very low return of 0. See table 4 c.
There are respectively three and four stocks generating negative return based on 1 year and 5 year CAGR calculations. An average stock provides negative return based on 5 years CAGR though 5 companies out of 9 are generating positive average returns.
The financial services sector generates very low but positive average return of 0. There is the evidence of stocks generating positive returns in the short run and negative returns in the long run, and also negative returns both in the short run and long run. An average stock provides positive returns both in the short run and long run though based on 5 years CAGR though 8 stocks out of 22 are generating negative returns. The result reinforces the fact that it is better to invest in low beta and low debt-equity ratio.
However, on an average, stocks in this category provides 50 percent return from their all time low values and takes about 69 days to generate 50 percent return from their all time low points during the study period. See table 4 a for the detail. In the second category, the UBL bounce back very quickly to generate 50 percent return from its lowest point in only three weeks. This stock generates On the other hand, IDEA generates only It is interesting to see that MCDOWELL-N generates the minimum return in 50 days in the group but surprisingly takes only 26 days to provide 50 percent return from the minimum point.
It is to be noted that NTPC price was lowest on 3rd March and hence we fall short of 50 days to calculate its return from the minimum point, but it has not generated 50 percent return till 31st March , the end period of our study. The average days to generate 50 percent return from the minimum point are only 54 with standard deviation of See table 4 b for the detail. The analysis of category three, the high beta and high D-E ratio stocks are presented in table 4 c. The average stock takes about 50 days with standard deviation This stock also takes the lowest number of days 16 days to quickly bounce back from the bottom and generates 50 percent return.
This is followed by IDFC taking only 18 days to generate return of 50 percent from its bottom and also generates almost percent return within 50 days. The BPCL provides In 50 days from the bottom relatively medium time period , TECHM from first category generates very high of The table 4 shows that, average stock with high beta and high D-E ratio takes less time to recover from the bottom to generate 50 percent return even as compared to average stock from other two categories.
We also find that from the bottom, in 50 days stocks with high beta and D-E ratio generate high average return followed by stocks with low beta and D-E ratio. This is not in the general line and needs thorough examination. The financial services sector on an average generates 75 percent return in 50 days from the bottom and generates 50 percent return from the bottom in about 35 days.
However, the range of return is very high spanning from Conclusion and Policy Implications The fundamental law of investing is the uncertainty of the future. Stock prices express the collective expectations of investors, and changes in these expectations determine the investment success. We study the investment and trading strategies in the Indian stock market considering the selected companies of CNX- Our analysis for investment is to group the stocks with beta and debt-equity ratio.
Following mean reversion principle without advocating for it, we develop the strategy for trading in the stock market.
We find that in the short run one year the average stocks with low beta and low debt-equity ratio provides roughly the same average return of the medium beta and medium debt-equity ratio; however it provides better return than the average stocks with high beta and high debt-equity ratio.
The same trend is visualized in the long run 5 years but the average stocks of first category generate very impressive return of around 16 percent based on 5 year CAGR followed by second category with Remember that the 16 percent and The financial services sector is usually with high beta but provides only 0.
This shows that CAPM does not hold and establishes that stock with low beta generates high return over a period of both one year and 5 years. This is also the case for low beta stocks with low debt-equity ratio as compared to high beta stocks with high debt-equity ratio.
There is further implication that emerges from our study that portfolio returns of the stock cannot be explained by only beta rather it is desirable to consider other factors, the debt-equity ratio is being an important one among them. References Annual Report
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