Trading strategies for volatile banking space

Given turmoil in the banking sector, traders will be looking to profit from price swings, as well as trying to hedge high volatility. Every listed bank has highly liquid stocks, and most are available in F&O (futures and options) segment. Typically, a hedger will be looking to use an index like the Nifty or the Bank Nifty to offset volatile bank stock exposures.


The Nifty Bank is the most liquid index after the Nifty. Indeed, it is more liquid in one way, given weekly options for the “Bank”. The Nifty Bank correlation with the Nifty is over 0.98 and it has a beta of 1.12 compared to the Nifty since January 2017.


Hence, over the past 15 months, the two indices have moved in the same direction almost all the time, and the Bank index has a higher movement amplitude. The high-beta, high-correlation behaviour is expected since banking stocks contribute a big chunk of the Nifty’s overall weight.


The Nifty Bank index has 12 stocks. Four of these are PSU banks. However, the Nifty Bank index is dominated by private banks due to the free-float weighting methodology. PSU banks have low market capitalisation and low free-float due to high government ownership. State Bank of India (SBI) is the only PSU bank with substantial weight in the Nifty Bank at 8.9 per cent. In total, the weight of the four PSUs in the Nifty Bank is less than 12 per cent.


The Nifty PSU Bank Index is much less tracked because it doesn't offer liquid F&O contracts. It includes 12 PSU banks. The correlation between the Nifty Bank and the PSU Bank indices is not too high. At 0.43 correlation since January 2017, we can say that the Nifty Bank and the PSU Bank move in the same direction much of the time but there are also deviations in trends.


The correlation between the PSU Bank index and the Nifty is even lower at 0.37. Again, this is expected since SBI is the only PSU bank in the Nifty 50. However, the correlation is positive which means that PSU bank shares and the Nifty tend to move in the same direction. The PSU Bank index has a very high beta compared to the Nifty, it has a beta of 1.7. The beta of the PSU Bank index to the Bank Nifty index is even higher, at 1.8.


Suppose an investor holds a large portfolio of PSU bank shares, and the portfolio approximately mirrors the PSU Bank index. That is, the portfolio has a beta of close to 1 and a correlation of close to 1 versus the PSU Bank index. The investor is afraid the value of the holdings could fall.


That long portfolio of shares can be offset to a degree with long puts in the Nifty, or Bank Nifty. Vice versa, if a trader is shorting the futures of PSU bank stocks, he or she can hedge with long Nifty calls or long Bank Nifty calls. But the high-beta, relatively low correlation of the PSU Bank versus the Nifty and Bank Nifty means that the hedges will not be very efficient.


Due to the high beta, on days when the PSU Bank index moves 1 per cent in either direction, the Nifty or Bank Nifty is likely to move only by about 0.55 per cent to 0.6 per cent, in the same direction. The relatively low correlation also means that there will be days of trend divergence. This means there is a higher degree of unsystematic risk in trading PSU bank futures contracts or shares. Of course, that risk also has an upside in that profitable positions in PSU banks will tend to outscore index returns.

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