Arbitrage trading is a strategy that can potentially generate consistent profits while minimizing risks. In the context of the Indian stock market, one approach involves trading between Nifty and Sensex indices, which are highly correlated. This blog will explore an arbitrage strategy that focuses on the correlation between these indices, offering an in-depth look at how it works and why it could be a valuable addition to your trading repertoire.

The relationship between Nifty and Sensex is almost identical, boasting a correlation of 99.9%. This means that their movements are closely aligned, as their composition consists of many of the same top companies. Sensex comprises the top 30 companies, while Nifty includes the top 50, with 30 of them overlapping with Sensex. The remaining 20 in Nifty contribute to minor differences in performance.

To begin with, the primary focus of this strategy is capital protection, which is essential in any form of trading. The goal is to minimize potential losses while aiming for steady returns. When executed properly, an arbitrage strategy between Nifty and Sensex can achieve these objectives. For instance, in a one-month period, 11 trades executed with this approach yielded an average return of 2.5% without any significant loss. In net terms, the return was even higher at around 3.5%.

While a 2.5% return may not seem substantial at first glance, the strategy’s low-risk nature is its most significant benefit. When it comes to option selling, a similar return is often expected. However, the added advantage of capital preservation makes this strategy appealing, particularly for those seeking consistent gains.

One of the key elements of this strategy is that it doesn’t involve simply guessing which index will perform better. Instead, the strategy focuses on identifying small discrepancies between Nifty and Sensex, given their high correlation. By taking advantage of these minute differences, traders can engage in simultaneous trades on both indices to profit from their convergence.

The aim is to capitalize on situations where one index slightly underperforms the other. These divergences are rare and usually short-lived, but they offer an opportunity to make modest profits while limiting risk. The strategy is particularly effective because the movements of Nifty and Sensex are almost indistinguishable, making it easier to anticipate their behavior.

It’s important to note that this strategy requires a keen understanding of the market and the ability to act quickly when discrepancies arise. While it can be executed manually, automated trading systems can help traders execute trades efficiently and timely.

Despite the strategy’s potential, it is crucial to manage expectations and not see it as a magic solution. While the correlation between Nifty and Sensex is high, the market is subject to fluctuations, and there is always some level of risk involved. Continuous monitoring and adjustments may be necessary to ensure the strategy’s success.

One aspect worth mentioning is the potential for compounding returns. With consistent 2.5% returns on a monthly basis, the annual returns can add up significantly. Compounding can help boost profits over time, making this strategy even more attractive.

In trading, there are countless strategies to navigate the complexities of the financial markets. One such strategy is arbitrage, where traders seek to capitalize on price discrepancies between similar financial instruments. This blog will dive into the intricacies of an arbitrage strategy involving Nifty and Sensex, two prominent indices in the Indian financial market.

Both Nifty and Sensex move in similar patterns, often mirroring each other’s performance. However, there are times when their prices diverge, creating an opportunity for traders to exploit the gap between the contract values of these indices. The goal is to identify when one index is relatively expensive and the other is relatively cheap, then buy the cheaper one and sell the more expensive one. As the gap between the two narrows, the trader can exit the positions and profit from the difference.

To understand this strategy in detail, we need to look at the current trading prices and lot sizes of Nifty and Sensex. Nifty is trading at a price of approximately Rs. 22,000, with a lot size of 50. This means the contract value of one lot of Nifty is around Rs. 11 lakh (22,000 x 50). On the other hand, Sensex is trading at around Rs. 72,797, with a lot size of 10. This makes the contract value of one lot of Sensex roughly Rs. 7.2 lakh (72,797 x 10).

Given these contract values, a trader needs to determine how many lots of each index to trade to maintain an equal contract value. For instance, if a trader decides to trade 2 lots of Nifty (100 quantity), they would need to trade approximately 3 lots of Sensex (30 quantity) to achieve a similar contract value. By maintaining an equal contract value, the trader ensures that any movements in the market have a comparable impact on both positions.

The next step is to assess the gap between the contract values of the two indices. Let’s say the contract value of Nifty is Rs. 22 lakh, while the contract value of Sensex is Rs. 21.8 lakh. This creates a gap of around Rs. 22,000. If the contract value of Nifty is higher, the trader would sell 2 lots of Nifty and buy 3 lots of Sensex to capitalize on the discrepancy.

The trader’s goal is to wait for the gap to close, ideally to zero, at which point they can exit the positions. Typically, the gap ranges around Rs. 40,000, providing a sweet spot for creating a trade. If the gap narrows from Rs. 40,000 to Rs. 22,000, the trader can exit the position and realize a profit.

However, traders do not usually wait for the gap to reach zero, as this can be time-consuming and the market may not behave predictably. Instead, they might choose to exit the position when the gap narrows to around Rs. 17,000-18,000, capitalizing on the opportunity without taking excessive risk.

The choice of when to reverse the trade is crucial. Initially, the trader might find that Nifty is expensive while Sensex is cheap. At some point, the market conditions might shift, making Sensex expensive and Nifty cheap. In such a scenario, the trader needs to assess whether there is a gap of Rs. 30,000-40,000 to take advantage of the situation.

The decision to trade using futures or synthetic futures is another consideration. While futures might involve higher costs due to Securities Transaction Tax (STT) and other charges, they offer more liquidity, especially in the case of Nifty. On the other hand, synthetic futures may be cheaper but come with the risk of illiquidity, especially in the relatively newer Sensex F&O market.

Liquidity is a key factor when trading Sensex futures. As the instrument is still relatively new, its liquidity might not be as robust as Nifty’s. This can lead to wider bid-ask spreads and higher slippage costs. Therefore, traders are advised to use weekly futures for Sensex rather than monthly ones, as weekly futures offer better liquidity.

When placing trades, traders must take care to use limit orders, especially in illiquid markets, to avoid paying unfavorably high prices. This is particularly important when trading Sensex, as the market may experience sharp movements of 1-2% in either direction.

Margin requirements for this strategy are significant, with traders needing approximately Rs. 5.5 lakh in margin for 3 lots of Sensex and 2 lots of Nifty. Additionally, keeping an extra Rs. 50,000 for mark-to-market (M2M) purposes is recommended, making the total account balance around Rs. 6 lakh.

In terms of returns, traders can aim for percentage-based profits. If you have a total account balance of Rs. 6 lakh, a 1% return would be Rs. 6,000, while a 2% return would be Rs. 12,000. If traders target a return of around Rs. 15,000, they would be earning approximately 2.5% on their capital.

Investment strategies often involve a combination of risk management and profit maximization techniques. This is especially true in the realm of trading equities and derivatives. While some trades may yield quick returns within two days, others may take longer—sometimes up to a week or even 10 days. This variance necessitates a broader time horizon for evaluating performance, ideally around one month.

In some cases, a trade may not immediately turn a profit, presenting a temporary loss. For example, you might enter a trade at ₹22,000, and the market moves against you to ₹42,000, presenting a loss of ₹20,000. At first glance, this might seem alarming. However, experienced traders recognize the opportunity to adjust their positions. By increasing the quantity of the asset in question, the average cost of the position can be adjusted to ₹30,000. This strategic move leverages arbitrage opportunities and can mitigate potential losses.

While the focus should remain on the percentage of returns, the approach requires capital for the initial trade and additional funds for margin requirements. For instance, if you hold ₹5 lakhs, ₹10 lakhs, ₹1 crore, or ₹10 crores in equity, you can use those holdings as collateral to obtain margin from your broker. This means you don’t need to set aside an additional ₹6 lakhs in cash to open positions.

The cash you do require is mainly for mark-to-market (M2M) adjustments. When holding positions, it’s wise to adhere to the 50-50 rule, keeping 50% of the required margin in cash or cash-equivalent investments, such as liquid funds. This reduces your interest expenses and minimizes risk. Each broker may charge different fees, typically around 0.05%, but with careful selection and monitoring, you can manage these costs effectively.

When it comes to returns, you can expect between 12% to 20% annually from your investments. By leveraging these returns, you can boost your overall performance. For example, adding an extra 2% yield on top of your standard 12% annual return results in a compounded return of 24% over 12 months. A higher safe side return of 30% means you can outperform many mutual funds and indices like Nifty.

The compounding effect of a 30% annual return can significantly enhance your investment results over time. It’s important to maintain a long-term perspective. Rapid gains, such as turning ₹1 lakh into ₹1 crore or ₹10,000 into ₹1 lakh overnight, are neither realistic nor sustainable. Instead, focus on practical, proven strategies that ensure steady, stable returns.

While the Indian market is evolving, liquidity issues in certain indices like Sensex may present challenges. A blog written a year or two from now might note improvements in liquidity. For instance, Nifty and Mid Cap indices, which previously lacked liquidity, have since improved. As India continues to emerge as a major market, arbitrage opportunities may diminish, but they remain viable for now.

To optimize trading strategies and reduce brokerage costs, you can employ synthetic futures. Tools like Sensibull allow you to build synthetic long or short futures positions. This method involves purchasing call options and selling put options at-the-money, mimicking a futures contract’s performance with lower costs.

A synthetic long position uses calls and puts to replicate a long futures contract. Conversely, a synthetic short position achieves the same effect as a short futures contract. These strategies are powerful for managing risks and can lower your brokerage expenses. The charges for options trading are typically lower than futures, allowing you to maximize your returns.

For precise management, use Excel or other data tools to track trades and identify trends in the Nifty and Sensex indices. Data analysis can be complex, but using simplified methods, such as the hedge method, can provide valuable insights. Focus on understanding the contract value and monitoring market trends to make informed decisions.

Hedge funds, known for using sophisticated strategies to generate consistent profits, employ similar methods to those described here. These funds are often secretive about their techniques, but the strategies mentioned in this blog can help you navigate the market with confidence.

In summary, the strategies outlined in this blog provide a practical approach to investing and trading. By focusing on arbitrage, managing risks, and using synthetic futures, you can optimize your trading performance. Keep your investments safe and aim for consistent, long-term returns. Sharing this knowledge with others who may be struggling can help them achieve more stable, profitable outcomes in their investment journeys.