The Hindu Business Line : Making the most of a range-bound market

Passive investing, beta-based switches across stocks and sectors, and paired trading are some of the ways to beat a volatile market, provided you can handle some risk.

Srividhya Sivakumar

In the long run, most of the uncertainties currently clouding the equity market may clear up. But in the short term, they are here to stay.

That stock prices aren’t going to head steadily in one direction is not good news if you are a short-term investor or trader. This brings us to the question — is there any way to make money in such a volatile market? The answer is yes. A nd here is how you can do it.

Turning passive

All too often, as markets rally, investors tend to buy stocks that performed extremely well in the recent past. This would have been a good strategy had the bulls remained in control. But, now, with a range-bound market at hand, this investing style needs to be changed considerably to survive a market that fails to hold its gains for any length of time.

A switch to passive investing, based on the overall valuation of the market, is one way to reduce downside.

Passive investing involves putting money into either index funds or index constituent stocks that are well-researched and followed. And, in the process, it not only promises average market returns but also reduces the risk of your picking the wrong stocks.

We suggest becoming passive when the CNX Nifty’s price-to-earnings multiple (trailing) edges close to its long-term average of 18 times (PE multiples are available on the NSE Web site). Investors with a higher risk appetite can stretch the point of switch till such time the index nears this year’s average PE of about 20 times.

A passive investing strategy can be adopted by switching your short-term investible money from stocks to index funds or ETFs (exchange traded funds) that mimic their benchmark indices doggedly. Doing this not only spares you the trouble of choosing the right stocks at interim peaks in the market, it also instantly buys you an exposure to a basket of index heavy-weights.

Index stocks may fare much better than the mid- and small-caps, if the market takes a sudden about-turn. If the broader market continues to soar, you get to participate, with lower levels of risk.

This strategy may deliver equally good results if you hold a portfolio of aggressive equity funds. Active funds in India have usually fallen more than the index during bear phases. The only flip side would be that ETFs tend to generate only beta returns (market returns) and will not give you the big out-performance that many equity funds may generate if the market continues to trend up.

If you opt to cut exposures at a Nifty PE of about 20 times, you can also consider taking fresh exposures when the Nifty nears a PEM of 16 times. This is a point at which the index has, over the last two years, found strong support.

Beating Beta

Beta, which captures the extent to which a particular stock will mirror the returns of an index, can also be used effectively to play a volatile market. Depending on which side of the PE range the market is in, switch decisions, either within the sector or between sectors can be made to lower your portfolio’s sensitivity to market moves.

Capital goods, banks and power sector stocks that were in the limelight right through last year, in essence, enjoy a high beta coefficient. Other sectors, such as IT, pharma and FMCG, even after good returns in recent months, are ‘low beta’ sectors. This makes the case for switching to low beta stocks when the market is highly volatile or when you sense a peak.

You can also trim the risk on your overall portfolio through switches within a sector. For instance, buying a BHEL (Beta 1.1) at the lower band of the market PE may yield a decent upside, should the market rise. Diverting that money into a Thermax (beta 0.56) at a peak may curtail downside, if the market reverses from there. But do note that you will have to track market PE (available on the NSE’s Web site) quite closely to implement this strategy.

Another strategy that can pay off in a sideways to bearish market is pair trading. This strategy, which usually involves buying a stock while selling another, thrives heavily on arbitraging opportunities across stocks and sectors.

Pairing-up to gain

Paired trades can be unearthed based on statistical, technical and fundamental factors. The unique advantage of using pair strategies is that they may deliver returns without having to take a directional call on the market.

The statistical technique in paired trading thrives on the belief that anomalies relative to the historic correlation or price ratio between two stocks, will not last for long. For instance, so far this year, the Infosys stock has averaged around 3.6-3.8 times the price of Wipro. Whenever there has been a digression from this, the stock prices have tended to slip back into range.

This suggests that whenever the mean price ratio is exceeded, traders can sell Infosys and buy Wipro; alternatively, if the ratio dips below its average, traders can buy Infosys and sell Wipro. Similar patterns can be discerned between Infosys-Satyam Computers, L&T-BHEL and HPCL-BPCL, to name a few pairs.

There are, however, quite a few caveats before you zero in on any such pairs for trading. For one, since this strategy requires shorting a stock while buying another, it can be best implemented only using stock futures. Therefore, it is suitable only for traders who are well versed with derivatives.

Second, as the strategy entails equal bets on both sides of the transaction (so that you take a market-neutral stand), you may need to balance the long and short transactions. This is because the lot sizes of the stock futures are not same.

Third, sometimes the price ratio may take several days to revert to its mean. This would call for high margin requirements from traders. Most importantly, pair strategies require constant monitoring and strict adherence to stop losses, on both sides, as any change in the outlook for a particular stock can lead to significant losses in no time.

On a fundamental basis, you can use a paired strategy by taking a relative call on the performance of two stocks, based on a macro event. For instance, a long position on Cairn India (an oil producer) and a short on Deccan Aviation (a consumer) can be paired to play a rising oil price outlook. The two stocks share a negative correlation (they tend to move in opposite directions on any given day).

Jet Airways, which is another consumer of oil and has a negative correlation with Cairn, can also be considered.

The price outlook on steel and other commodities can also be used similarly to build pairs of a commodity producer and its user (for instance, Tata Steel and Tata Motors). While integrated steel players such as Tata Steel will benefit from a rise in steel price, companies that use steel as a crucial input in the auto or capital goods sector may face margin pressures from the same event.

But before you begin with your trades, a few words of caution — on the surface, while most of these ideas may appear easy and logical, do not be in a hurry to deploy funds. As these are trading strategies, if your basic assumptions do not pan out, there is a risk of your positions turning in losses. Do spell out strict stop-losses at the outset and stick to them as if your life depended on it.

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Making the most of a range-bound market