Being a front-runner

A textbook-perfect market combines efficient trading systems and information-dissemination. In practice, no market approaches perfection. Information spreads in concentric circles.

Company insiders learn about a price-sensitive event first, after that it spreads to large investors and last, it reaches the retail crowd. In India, policy changes are part of price-sensitive events. The inner circle thus includes bureaucrats and ministers.

Insider trading is a crime but the law has no teeth. No company officers have ever been nailed and if Securities and Exchange Board of India even mooted investigating bureaucrats or ministers for insider-trading, the relevant legislation would be rapidly rewritten to neuter the watchdog.

A related action is front-running. This is to anticipate and second-guess trading decisions by the insiders and big players. Front-running is not a crime except in the narrow sense of a fund manager trading a stock on his personal account before his fund buys (or sells).

India's traders are front-runners. That's what "khabar" is. A company is going for a stock split; another is a FII target.

When front-runners get it right, they can make a packet. When they're wrong, they often lose huge sums.

For example, a surge in the shareprices of PSU refiners occurs every time a retail price hike is expected. But refiners will continue to bleed until the subsidy system is reformed and losses are transferred to the GoI's own accounts.

In the opposite direction, cement companies retain excellent profitability after the voluntary" price-cuts by the commerce ministry. But cement shares have been sold down maniacally.

One favourite form of front-running is guessing FII attitude. Since mid-May, the firangis have sold huge amounts of equity and the selling continues in early June.

At the same time, they've gone net positive in the futures market. It's impossible to guess what FII options' attitudes are; the data doesn't distinguish between puts and calls.

The dichotomy is caused by hedging and arbitrage. Between January-April, FIIs were net positive to the tune of Rs 18,475 crore (Rs 184.75 billion) in the spot markets while being net sellers in the futures markets. This was a combination of hedging and arbitrage.

There are two common arbitrage situations where the investor can safely profit. At settlement, futures and spot prices converge. Prior to settlement, futures may trade at either premium or discount to the spot. A certain degree of premium is expected because of the opportunity cost of carrying futures' positions.

In theory, this should be close to the risk-free return. Differentials are caused by expectations of trends and volatility.

When the premium exceeds cost of carry, an "arb" sells the future and buys the spot. At settlement when prices converge, the positions are reversed and the differential collected. When the futures are at discounts (negative carry), the opposite trade works assuming you own or can borrow the stocks in question. On settlement you collect the difference and still re-own the stock.

In a falling market, discounts occur. Arbitrage narrow the cash-future spreads but also perpetrates the primary trend. That is, the selling continues in a market crash like this one because there's free money on the table.

In the short-term, the simple differential between futures' premiums and spot prices provides the best second-guess about FII attitudes. If you're going to be a front-runner, use this information rather than trawling for khabar.

Sensex Rise and Fall: Complete Coverage

Do you want to discuss stock tips? Do you know a hot one? Join the Stock Market Investments Discussion Group