Nature of business:

Our business involves Pairs trading using futures and options on National Stock Exchange (NSE) India

Trading:

Trading is the activity of buying and selling securities with the idea of making profits based on expected

movements of the assets

Derivatives Trading

Derivatives

Derivatives, such as futures or options, are financial contracts which derive their value from a spot price,

which is called the “underlying”. For example, wheat farmers may wish to enter into a contract to sell

their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction

would take place through a forward or futures market. This market is the “derivatives market”, and the

prices of this market would be driven by the spot market price of wheat which is the “underlying”. The

term “contracts” is often applied to denote the specific traded instrument, whether it is a derivative

contract in wheat, gold or equity shares. The world over, derivatives are a key part of the financial

system. The most important contract types are futures and options, and the most important underlying

markets are equity, treasury bills, commodities, foreign exchange, real estate etc.

Various types of derivative instruments traded at NSE

There are two types of derivatives instruments traded on NSE; namely Futures and Options :

Futures : A futures contract is an agreement between two parties to buy or sell an asset at a certain time

in the future at a certain price. All the futures contracts are settled in cash at NSE.

Options : An Option is a contract which gives the right, but not an obligation, to buy or sell the

underlying at a stated date and at a stated price. While a buyer of an option pays the premium and buys

the right to exercise his option, the writer of an option is the one who receives the option premium and

therefore obliged to sell/buy the asset if the buyer exercises it on him.

Options are of two types - Calls and Puts options : “Calls” give the buyer the right but not the obligation

to buy a given quantity of the underlying asset, at a given price on or before a given future date. “Puts”

give the buyer the right, but not the obligation to sell a given quantity of underlying asset at a given

price on or before a given future date. All the options contracts are settled in cash. Further the Options

are classified based on type of exercise. At present the Exercise style can be European or American.

American Option - American options are options contracts that can be exercised at any time upto the

expiration date. Options on individual securities available at NSE are American type of options. European

Options - European options are options that can be exercised only on the expiration date. All index

options traded at NSE are European Options. Options contracts like futures are Cash settled at NSE.

Various products available for trading in Futures and Options segment at NSE

Futures and options contracts are traded on Indices and on Single stocks. The derivatives trading at NSE

commenced with futures on the Nifty 50 in June 2000. Subsequently, various other products were

introduced and presently futures and options contracts on the following products are available at NSE:

1. Indices : Nifty 50, CNX IT Index, Bank Nifty Index, CNX Nifty Junior, CNX 100 , Nifty Midcap 50, Mini

Nifty and Long dated Options contracts on Nifty 50.

2. Single stocks - 228 (Keeps varying based on NSE/ SEBI selection criteria)

Why we trade in derivatives

Futures trading will be of interest to those who wish to:

1) Invest – take a view on the market and buy or sell accordingly.

2) Price Risk Transfer- Hedging - Hedging is buying and selling futures contracts to offset the risks of

changing underlying market prices. Thus it helps in reducing the risk associated with exposures in

underlying market by taking a counter- positions in the futures market.

3) Leverage- Since the investor is required to pay a small fraction of the value of the total contract as

margins, trading in Futures is a leveraged activity since the investor is able to control the total value of

the contract with a relatively small amount of margin. Thus the Leverage enables the traders to make a

larger profi t (or loss) with a comparatively small amount of capital.

We use derivatives mainly as a hedging tool in pair trade.

The Expiration Day

It is the last day on which the contracts expire. Futures and Options contracts expire on the last

Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the

previous trading day. For E.g. The January 2008 contracts mature on January 31, 2008.

Contract cycle for Equity based products in NSE

Futures and Options contracts have a maximum of 3-month trading cycle -the near month (one), the

next month (two) and the far month (three), except for the Long dated Options contracts. New contracts

are introduced on the trading day following the expiry of the near month contracts. The new contracts

are introduced for a three month duration. This way, at any point in time, there will be 3 contracts

available for trading in the market (for each security) i.e., one near month, one mid month and one far

month duration respectively. For example on January 26,2008 there would be three month contracts i.e.

Contracts expiring on January 31,2008, February 28, 2008 and March 27, 2008. On expiration date i.e

January 31,2008, new contracts having maturity of April 24,2008 would be introduced for trading.

Margin payable

Margins are computed and collected on-line, real time on a portfolio basis at the client level. Members

are required to collect the margin upfront from the client & report the same to the Exchange.

PAIRS TRADE

The strategy of matching a long position with a short position in two stocks of the same sector. This

creates a hedge against the sector and the overall market that the two stocks are in. The hedge created

is essentially a bet that you are placing on the two stocks; the stock you are long in versus the stock you

are short in.

In Pairs trading what the actual market does won't matter (much). If the market or the sector moves in

one direction or the other, the gain on the long stock is offset by a loss on the short.

We use quantitative analysis to develop profitable trading strategies. In short, a quant combs through

price ratios and mathematical relationships between companies or trading vehicles in order to divine

profitable trading opportunities. During the 1980s, a group of quants working for Morgan Stanley struck

gold with a strategy called the pairs trade. Institutional investors and proprietary trading desks at major

investment banks have been using the technique ever since, and many have made a tidy profit with the

strategy.

Pairs trading has the potential to achieve profits through simple and relatively low-risk positions. The

pairs trade is market-neutral, meaning the direction of the overall market does not affect its win or loss.

The goal is to match two trading vehicles that are highly correlated, trading one long and the other short

when the pair's price ratio diverges "x" number of standard deviations - "x" is optimized using historical

data. If the pair reverts to its mean trend, a profit is made on one or both of the positions.

An Example Using Stocks

The first step in designing a pairs trade is finding two stocks that are highly correlated. Usually that

means that the businesses are in the same industry or sub-sector, but not always. For instance,

cement stocks like ACC and GRASIM can offer excellent pairs trading opportunities.

For our example, we will look at two businesses that are highly correlated: GM and Ford. Since both are

American auto manufacturers, their stocks tend to move together.

Below is a weekly chart of the price ratio between ACC and GRASIM (calculated by dividing GRASIM's

stock price by ACC's stock price). This price ratio is sometimes called "relative performance" The center

white line represents the mean price ratio over the past two years. The yellow and red lines represent

one and two standard deviations from the mean ratio, respectively.

In the chart below, the potential for profit can be identified when the price ratio hits its first or second

deviation. When these profitable divergences occur it is time to take a long position in the

underperformer and a short position in the overachiever. Position size of the pair should be matched by

dollar value rather than number of shares; this way a 5% move in one equals a 5% move in the other. As

with all investments, there is a risk that the trades could move into the red, so it is important to

determine optimized stop-loss points before implementing the pairs trade.

An Example Using Futures Contracts The pairs trading strategy works not only with stocks but also with

stock futures. In the above example, rather than buying and selling stocks, we can do the trades in single

stock futures of ACC and GRASIM.

An Example Using Options

Option traders use calls and puts to hedge risks and exploit volatility (or the lack thereof). A call is a

commitment by the writer to sell shares of a stock at a given price sometime in the future. A put is a

commitment by the writer to buy shares at a given price sometime in the future. A pairs trade in the

options market might involve writing a call for a security that is outperforming its pair (another highly

correlated security), and matching the position by writing a put for the pair (the underperforming

security). As the two underlying positions revert to their mean again, the options become worthless

allowing the trader to pocket the proceeds from one or both of the positions.

Pairs Trading This strategy was pioneered by Nunzio Tartaglia’s quant group at Morgan Stanley in the

1980’s. It remains an important statistical arbitrage technique used by hedge funds. They found that

certain securities were correlated in their day-to-day price movements. When a well established price

correlation between A and B broke down, i.e. stock A traded up while B traded down, they would sell A

and buy B, betting that the spread would eventually converge. This divergence between pairs may be

caused by temporary supply/demand changes, when a single large investor changes position in a single

security. Highly-correlated pairs often (but not always) come from the same sector because they face

similar systematic risks.

Sub Broking: As pairs trading involves buying of one stock/future and selling of another stock future, the trading

volume involved is huge.

For example:

Scrip Trade Date Entry Shares Date Exit Position P/L Position P/L

GRASIM BUY 9/8/11 2081.55 125 9/8/11 2091 261375 1181.25

ACC SELL 9/8/11 989.05 250 9/8/11 997.4 249350 -2087.5 -906

On 9th Aug 2011, we bought 125 shares of Grasim @ 2081.55 and Sold 250 shares of ACC at 989.05.

After some time, when the system suggested we exit the trade, we sold the Grasim 125 shares at 2091

and bought back ACC at 997.4. Overall this pair trade returns a loss of 906 inr

Summary:

Volume= Buy+Sell of ACC and Grasim=10,21,450

P&L=-906

Hence this trading system will have very high trading volume with very low profit or loss. In normal

conditions, for this trade, the broker will charge 200 inr brokerage, resulting in overall loss of 1100. The

broking costs would be very high for pair trades because of high volume

To minimize the broking cost which is a function of trading volume, we have applied for sub-broking

with Motilal Oswal. With subbroking, the broking costs havecome down for us by ~50%