News-based trades: Lessons for the small trader

Traders, investors & regulators can glean several insights

Traders, investors and regulators can glean several insights from the recent fluctuations in the price of HDFC Bank. This is one of the most expensive bank stocks in the world and one of the highest market-cap stocks in the Indian universe. It is the highest weighted stock in the Nifty-50 with a weight of 8.2. 

The bank has returned annual earnings growth of over 20 per cent consistently for 15 years and it has averaged over 25 per cent per annum EPS growth in the last five years. Most analysts reckon that it can maintain this pattern. Some say that it could grow even faster if India's GDP growth accelerates.  

The FPIs (foreign portfolio investors) love it. HDFC Bank hit the stipulated 74 per cent limit for all aggregated FPI holdings long ago. The Price-Book Value (P/BV) ratio is currently at 4.8x and the long-term average P/BV is around 4.2x. For a long-term investor, it looks rich at these valuations.  

On Thursday evening, the Reserve Bank of India (RBI) pulled HDFC Bank off the banned list since the aggregate FPI holding was below 74 per cent. On Friday, the stock opened about eight per cent up and it travelled further up, until RBI issued a note at around 1.40 pm saying that the FPI limit had been exceeded. As a result, it lost some ground, dropping about four per cent. Any trades involving FPIs made after 1.40 pm cannot be transferred to the FPIs and hence, will need to be reversed, with attendant chaos.

One point worth noting is that the futures traded consistently at a discount of two-three per cent to the stock price. Anybody who held or bought the stock and sold the future could subsequently reverse both trades (sell stock and buy future) and collect some profit if they timed things well.

Arbitrage funds do this sort of trading as a matter of course. They hold long stock positions and sell futures to maintain a net-zero position and gain on any differentials exceeding the cost of carry between prices of underlying and futures. Arbitrage funds have large holdings of HDFC Bank. In fact, most of these funds did record gains to NAV by taking this trade. 

Arbitrage funds are comfortable with wafer-thin margins. They have automated systems to respond instantly and book profits with heavy volume trades whenever the difference between underlying and future gets large enough to interest them. Whenever the arbitrage funds take their trades, the difference narrows and trends temporarily reverse. In this specific instance, the price of the underlying share fell and the futures price rose, every time the arbitrage funds booked profits.

Cleaning up the situation will be complicated and potentially embarrassing problems for Sebi, the stock exchanges and RBI. Large institutional players were active on both sides. Brokers who bought on behalf of FPI clients after 1.40 pm will be stuck. The mess is for RBI and Sebi to sort out and ideally, set up systems to prevent repeats.

What happens to the small trader who was riding piggyback on the situation? First, due to the action of Arbitrage funds, this chap would have to be very nimble to generate profit. Second, the small trader must understand that this sort of news-based trade can go wrong, even when it seems a "sure thing". The RBI gives and RBI can take away. 

If the small trader wants to play such news-based situations, he or she must be prepared to put down extra margins and also, be prepared to handle sudden sharp changes in prices and news-flow. If it is a stock with heavy FPI and Arbitrage funds presence, the small trader must be especially careful.

The author is a technical and equity analyst