There's method in madness

Last Updated: Sun, Nov 18, 2012 19:20 hrs

One of my friends is a dedicated trader with a very unusual, high-risk style. He is only interested in highly liquid stock futures contracts. On average, the margin on a stock futures contract is roughly 15 per cent – about 6.6 times leverage.

My friend is only interested in futures that have lots of 4,000 shares or more. Ideally, he prefers lots of 8,000 shares or more. For a 4,000 lot, a swing of 10 paisa is worth roughly Rs 400, gain or loss, neglecting brokerages. A Rs 1 swing therefore implies a gain or loss of Rs 4,000 per lot. It’s double that for an 8,000 lot and three times as much for a 12,000 lot.

There are 33 stock futures available with lots of 4,000 or more. By the way, these stocks also meet most reasonable standards for diversification. They are all large caps, of course, (like all stocks in the F&O segment) and between them, these 33 cover some 18 sectors.

On an average, a Rs 1 swing is equivalent to 14 per cent of margin for that select group of 33. Not surprisingly, my friend's returns are extraordinarily variable. There are days when he doubles his margin and days when he loses half of it. According to him, he tends to make or lose nearly 20 per cent a day. He makes money a little more often than he loses, and he usually makes more on a winning trade than he loses when he's wrong.

It should be mentioned that he's a horse-racing aficionado, who entered financial markets simply because they have more financial depth than horse-races. So he's got the stomach required to sleep soundly at night while operating at these risks-levels.

Having decided to operate in this fashion however, he has been sensible enough to do his best to eliminate unnecessary losses. He allocates his bets carefully and he never has an exposure of more than 20 per cent of his capital at a given instant. He doesn't ever carry overnight positions.

He has strict stop losses. He never doubles up or averages down. He absolutely ignores all extraneous data. He is not interested where the Nifty is going, or what the European Central Bank is doing and its impact on currency positions. He will not bet on anything outside this group, no matter how tempting it may seem. Given the diversification within the group however, this is not a major constraint. Marketwide or sector-specific moves are usually reflected.

Within the group of 33, he watches everything of short-term interest. This is not so difficult, given the internet and reasonable computer literacy. He has automated alerts for all news pertaining to these 33 stocks. He has constructed an index, which incorporates this population. He runs a colour-coded “map of the group” (red for losers, green for winners) to give him a visual heads-up. He knows the correlations of each of these stocks with the Nifty and their cross-correlations with each other. He runs technical analysis on various parameters to try and isolate the trends within the group. He tracks insider disclosures and FII/DII holdings and buy/sell patterns.

Applying these methods keep him occupied and interested as well as being quite profitable on the whole. These methods are also scalable to a larger population of stocks as well, and to stocks chosen according to less hair-raising volatility criteria.

What may not scale is the almost inhuman discipline. It is one thing to decide, right or wrong, that a given set of instruments will suit your trading style the most. It is entirely another to be able to focus on those instruments to the exclusion of everything else.

I wouldn't advocate using these methods. Even experienced traders might find 20 per cent daily swings scary. Nor are his risk-management methods necessarily the best. But the rigid adherence to a plan is admirable.

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