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The NSE recently announced that the permitted lot size of the derivative contracts on the Midcap Select Index will increase from 120 to 140 effective July expiry. This contract has lost nearly a fifth of its value from its peak last October. This week, we discuss how to use derivatives on the Midcap Select Index in your trading strategies.
Near-pure alpha
Alpha is the excess returns a portfolio generates for its appropriate benchmark. Loosely interpreted, alpha relates to the returns you can earn betting on sector-specific and company-specific risk. The Midcap Select Index has 25 constituents. Now, consider Max Health, which carries the largest weight in that index. Suppose you expect that Max Health will outperform the Midcap Select Index. Your objective would be to capture the excess returns that Max Health can earn above the Midcap Select Index; the return that is specific to Max Health. This is important because you are not betting on the directional movement of the underlying. Rather, you are betting that an index constituent will perform better compared to the index to which it belongs, whether the index or its constituents move up or down.
Professional traders would typically go long on the identified stocks and short on the Midcap Select Index. Now, going short is efficient in the derivatives market rather than in the spot market. Also, you must choose a contract that moves nearly one-to-one with the chosen index to capture the near-pure alpha returns on the underlying. Hence, Midcap Select Index futures contract.
The strategy is to choose constituents that you believe are likely to outperform the Midcap Select Index. Then, go long on the single-stock futures contract on these underlyings and short appropriate number of the Midcap Select Index futures. The process of determining the number of index futures to short is somewhat technical. You must create a portfolio of single-stock futures contract and consider the correlation and the standard deviation of the portfolio with the index futures for a certain period in the past. A simple way is to match the value of the portfolio with that of index futures contract. In most cases, you may choose to initiate this trade with just one underlying. You must be mindful that value-matching single-stock futures contract with Midcap futures may not neutralise directional risk; you will have some unintentional directional exposure from single-stock futures or Midcap Select Index futures, whichever price moves faster.
Optional Reading
You can also initiate a covered call strategy on the Midcap Select Index when you identify a resistance level on the index not far away from its current price. Then, you can go long on the near-month Midcap Select futures and short the near-month call option on the index one strike above the resistance level. An advanced strategy could involve determining the relationship between Nifty Index and the Midcap Index and setting up appropriate positions when there is a drift in their long-run relationship.
(The author offers training programmes for individuals to manage their personal investments)
Published on April 5, 2025
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