Program trading

Program trading
Q9.1: You say “buying Nifty”. How do you buy a market index?
A: A market index is just a portfolio of all the stocks in the index, where the weightage
given to each stock is proportional to its market capitalisation. Hence “buying Nifty” is
equivalent to buying all 50 stocks, in their correct proportions.
To take one example, suppose Reliance has a 7.14% weight in Nifty, suppose the price
of Reliance is Rs.108 and we are buying Rs.1 million of Nifty. This means that we need
to buy 661 shares of Reliance. ••

Q9.2: Won’t that be a lot of time–consuming typing, placing
50 orders by hand?
A: These orders should not be placed “by hand”. In the time that it would take to place
50 orders, market prices would move, generating execution risk.
A rapid placement of a batch of orders is called program trading. NSE’s NEAT software
(which is used for trading on the cash market) supports this capability. However,
even though NSE is a fully electronic market, the time taken in doing program trades is
quite high (around two to three minutes to do a Nifty program trade). This compares
poorly against stock exchanges elsewhere in the world. •• Also see: Canina & Figlewski
(1995).

Q9.3: Isn’t program trading dangerous or somehow unhealthy?
A: Program trading replaces the tedium, errors, and delays of placing 50 orders “by hand”.
If program trading didn’t exist, these orders would be placed manually. It’s hard to see
how this automation can be dangerous. •• Also see: Kleidon & Whaley

Chapter 10
Choice of index
Q10.1: What makes a good stock market index for use in an
index futures and index options market?
A: Several issues play a role in terms of the choice of index.
Diversification A stock market index should be well–diversified, thus ensuring that hedgers
or speculators are not vulnerable to individual company– or industry–risk. This diversification
is reflected in the Sharpe’s Ratio of the index.
Liquidity of the index The index should be easy to trade on the cash market. This is
partly related to the choice of stocks in the index. High liquidity of index components
implies that the information in the index is less noisy.
Liquidity of the market Index traders have a strong incentive to trade on the market
which supplies the prices used in index calculations. This market should feature
high liquidity and be well designed in the sense of supplying operational conveniences
suited to the needs of index traders.
Operational issues The index should be regularly maintained, with a steady evolution of
securities in the index to keep pace with changes in the economy. The calculations
involved in the index should be accurate and reliable. When a stock trades at multiple
venues, index computation should be done using prices from the most liquid
market.
••

Q10.2: How do we compare Nifty and the BSE Sensex from
this perspective?
A: Nifty has a higher Sharpe’s ratio. Nifty is a more liquid index. Nifty is calculated
using prices from the most liquid market (NSE). NSE has designed features of the trading
system to suit the needs of index traders. Nifty is better maintained. Nifty is used by three
index funds while the BSE Sensex is used by one. ••

Q10.3: Why does liquidity matter for a market index?
A: At one level a market index is used as a pure economic time-series. Liquidity affects
this application via the problem of non-trading. If some securities in an index fail to trade
today, then the level of the market index obtained reflects the valuation of the macroeconomy
today (via securities which traded today), but is contaminated with the valuation of
the macroeconomy yesterday (via securities which traded yesterday). This is the problem
of stale prices. By this reasoning, securities with a high trading intensity are best-suited
for inclusion into a market index.
As we go closer to applications of market indexes in the indexation industry (such as
index funds, or sector-level active management, or index derivatives), the market index is
not just an economic time-series, but a portfolio which is traded. The key difficulty faced
here is again liquidity, or the transactions costs faced in buying or selling the entire index
as a portfolio. •• Also see: Shah & Thomas (1998).

Q10.4: What transactions costs do we see in trading Nifty?
A: It turns out that it is efficient for arbitrageurs to trade Nifty in transaction sizes of Rs.1
million. At a transaction size of Rs.1 million, the one–way market impact cost in doing
trades on Nifty is generally around 0.1%. This means that when Nifty is at 1000, the
buyer ends up paying 1001 and the seller gets 999. ••

Q10.5: Apart from Nifty, what other indexes are candidates for
index funds, index futures and index options?
A: Dollar Nifty (Nifty re–expressed in dollars) is an interesting index, one that reflects the
combination of movements of Nifty and fluctuations of the exchange rate.
Nifty Junior is the second–tier of fifty large, liquid, stocks; they are the best stocks
in terms of liquidity and market capitalisation which did not make it into Nifty. The
construction of Nifty and Nifty junior is done in such a way that no stock will ever figure
in both indexes. ••

Q11.1: Who needs hedging using index futures?
A: The general principle is: you need hedging using index futures when your exposure to
movements of Nifty is not what you would like it to be. If your index exposure is lower
than what you like, you should buy index futures. If your index exposure is higher than
what you like, you should sell index futures. ••

Q11.2: When might I find that my index exposure is not what
it should be?
A: A few situations are:
• You are a speculator about an individual stock or an industry.
• You have an equity portfolio and become uncomfortable about equity market risk
for the near future.
• You expect to obtain funds at a known future date, but you would like to lock in on
equity investments right now at present prices.
• You have underwritten an IPO and are vulnerable to losses if the market crashes
and the IPO devolves on you.
• You are uncomfortable with the vulnerabilities of your business, where cashflows
swing dramatically with movements of Nifty.
••

Q11.3: I am a speculator about an individual stock. What is
my unwanted index exposure?
A: Suppose you have a forecast that the price of INFOSYSTCH will rise. As a speculator
on an individual stock, you have purchased INFOSYSTCH.
This position can go wrong for two reasons:
Core risk You were wrong in your understanding of INFOSYSTCH, and the price fails to
rise.
Extraneous risk Nifty falls owing to some macroeconomic development.
Every stock speculator suffers from the extraneous risk of movements in Nifty. A buy
position on INFOSYSTCH tends to goes wrong when Nifty drops. A sell position on INFOSYSTCH
tends to goes wrong when Nifty rises. This vulnerability to Nifty has nothing
to do with the core interest of a stock speculator, which is valuation and forecasting of
individual stocks.
The position BUY INFOSYSTCH contains an unwanted index exposure embedded inside
it. Every speculator who has purchased INFOSYSTCH is actually BUY INFOSYSTCH
+ BUY NIFTY whereas what he really wants is to only be BUY INFOSYSTCH. ••

Q11.4: What does a speculator on an individual stock do?
A: A person who has forecasted INFOSYSTCH is not interested in being a speculator on
Nifty. He should remove this risk. This is done by selling Nifty futures. The position
BUY INFOSYSTCH + SELL NIFTY FUTURES is a focussed position which is only about
INFOSYSTCH.
This is easily done in practice. Every speculative buy position should be coupled with
an equal sell position on Nifty. Every speculative sell position should be coupled with an
equal buy position on Nifty.
Suppose you are long 100 shares of INFOSYSTCH and the share price is Rs.9,000,
when the nearest Nifty futures is at Rs.1500. The position is worth Rs.900,000. Hedging
away the Nifty exposure in this requires selling Rs.900,000 of Nifty. Translating this into
a position on the index futures market, we have 900000/1500 = 600 nifties. So you would
couple your position of “buy 100 shares of Infosys” with a hedging position: “sell 600
nifties”.
This hedging reduces the risk involved in stock speculation. It is good for the stock
speculator (who faces less risk), for the brokerage firm (which faces a lesser risk of default
by the client), for the clearing corporation (which faces less vulnerable brokerage firms)
and for the economy (the systemic risk in the capital markets comes down, and level of
resources deployed into analysing and forecasting stocks goes up). ••

Q11.5: There are several index futures trading at the same
time – which one should I use?
A: Sometimes, the forecast horizon generates constraints. If you have a two–month view,
then a futures contract that has only a few weeks of life left might be inconvenient.
Another major issue is liquidity. Other things being equal, it is always better to use
the contract with the tightest bid–ask spread. ••

Q11.6: I have an equity portfolio and am uncomfortable about
equity market fluctuations for the near future. What can I do?
A: You can sell Nifty futures.
The Nifty futures earn a profit if Nifty drops, which offsets the losses you make on
your core equity portfolio. Conversely, if Nifty rises, your core equity portflio does well
but the futures suffer a loss.
When you have a equity portfolio and you sell Nifty futures, you are hedged: whether
Nifty goes up or down, you become neutral to it.
This is not a recipe for making money; it is a recipe for eliminating exposure (risk).
••

Q11.7: I expect to obtain funds at a known future date, but I
would like to lock in on equity investments right now at present
prices. What can I do?
A: You can buy Nifty futures today.
This ensures that you get a lock–in on current share prices.
When you get funds, and start getting invested in the equity market, you would closeout
your futures position at the same time. ••

Q11.8: I am uncomfortable with the vulnerability of my business,
where cashflows swing dramatically with movements of
Nifty. What can I do?
A: You can sell Nifty to reduce your vulnerability to Nifty.
Suppose your wealth normally drops by Rs.100,000 for each percentage point fall in
Nifty. A sell position for Rs.10,000,000 in Nifty futures stands to gain Rs.100,000 for
each percentage point fall in Nifty. This gives you a hedge against your core business
exposure.
A similar strategy works for an IPO underwriter who stands to lose if Nifty crashes
and the IPO devolves on him. ••

Q11.9: How can these calculations about index exposure be
done more accurately?
A: Every stock or portfolio or position has a number called “beta”. Beta measures the
vulnerability to the index.
ITC has a beta of 1.2. This means that, on average, when Nifty rises by 1%, ITC rises
by 1.2%. In this case, a stock speculator with a position of Rs.1 million on ITC requires
a hedge of Rs.1.2 million (not just Rs.1 million) of Nifty in order to eliminate his Nifty
risk.
Hindustan Lever has a beta of 0.8. This means that a stock speculator who has a sell
on Rs.1 million on HLL requires to buy Rs.0.8 million of Nifty (not Rs.1 million).
If you know nothing about a stock or a portfolio, it is safe to guess that the beta is
1. The average beta of all stocks or all portfolios is 1. If beta can be observed or measured,
then this hedging becomes more accurate; however, this is not easy since accurate
beta calculations are fairly difficult, especially for illiquid stocks. Tables of betas of all

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