Profiting from Arbitrage Between TCS and Infosys in the IT Stocks Crash

A flyover is a concept that allows roads to be built over roads to facilitate faster movement of vehicles and people in this age of congested traffic in cities.

But whether you take a flyover or the road under it, they usually run parallel to each other and eventually lead to the same destination.

While taking a flyover usually gets you to your destination quicker, you might have noticed that sometimes, there is an anomaly. Taking the road under the flyover can get you to your destination faster.

Why? Perhaps it's because most people chose to take the flyover on a particular day. Hence, the road underneath has faster moving traffic as opposed to a jam on the flyover.

Or maybe a vehicle has broken down on the flyover causing a massive pile up of vehicles while traffic continues to flow smoothly on the narrow road under the flyover.

But once again the fact remains whether you take the flyover or the road under it, both roads will lead towards the same destination. It is only a matter of time that differentiates one from another.

What do roads and flyovers have to do with stocks?

This may sound like a strange analogy but just like a flyover and road underneath it, certain stocks of the same sector tend to move in a similar fashion or in the same direction. Statisticians call this phenomenon as Correlation.

In general, stock correlation refers to how certain stocks move in relation to one another. This could be because both companies are very similar in certain aspects.

For instance, both companies could have similar products catering to a similar client base.

Further, both could have similar scale and market size, similar regulatory constraints, and any changes in the business environment could affect both companies similarly.

Let us continue with our example and use them as variables -

1. Flyover and the road underneath it could be Stock A and Stock B.
2. The relationship between a flyover and road is basically of two similar pathways leading to the same destination.
   
   Similarly, two stocks of the same sector could move in the same direction, i.e., up, or down because identical factors would affect them similarly.
3. Ideally, people tend to use flyovers to zip past traffic in order to reach their destination quicker. But when too many people choose the flyover on a particular day or a vehicle breakdown occurs, it causes an anomaly where commuters using the road under get to their destination faster.
   
   Likewise, at any point in time, Stock A might change course and there may be a brief breakdown or shift in correlation with Stock B, which is an anomaly but that tends to correct itself once more.

Over the years, savvy investors realised that a strong correlation does exist between certain assets.

This gave rise to a strategy termed as Pair Trading which involves buying and selling two related financial instruments simultaneously in order to profit from the difference in their relative prices.

In pair trading, two assets are chosen that have a high correlation, such as two stocks in the same sector or two commodities with a similar economic purpose. The strategy involves taking a long position (buying) in one asset and a short position (selling) in the other asset.

The idea behind pair trading is to take advantage of market inefficiencies that may exist between the two related assets, which can cause the prices to diverge temporarily from their usual relationship. The trader expects that, over time, the prices of the two assets will revert to their historical relationship, leading to a profit for the trader.

Pair Trading is a trading strategy used to hedge risks.

I used this strategy very effectively in my initial years of trading in commodities such as gold and silver.

Almost anyone who has traded in the bullion markets would have heard or read about the gold-silver ratio. The gold-silver ratio is an expression of the price relationship between gold and silver.

The ratio shows the number of kilograms (kgs) of silver it takes to equal the value of one kg of gold. For example, if the price of gold is Rs 6,000,000 per kg and the price of silver is Rs 75,000 per kg, then the gold-silver ratio is 80:1.

The gold-silver ratio is the oldest continuously tracked exchange rate in history. The primary reason the ratio is followed is that gold and silver prices have such a well-established correlation and have rarely deviated from one another.

Similarly, there are classic examples of stocks which are frequently used for pair trading strategy such as Pepsi and Coca Cola in the US or closer home, Bajaj Auto and Hero MotoCorp or perhaps HDFC Bank and ICICI Bank.

Equity investors can monitor and study stocks in the same sector and industry group and try and identify such highly corelated stocks.

Tracking the deviation in the correlation helps to access opportunities for trading. These may be over a short term or long-term horizon.

Now that you are familiar with the concept of pair trading, let us look at one such opportunity that may be available for investors looking at a market neutral strategy in the current market environment.

Statistical Arbitrage Between TCS & Infosys

In recent times, Indian IT services firms are confronting two challenges simultaneously.

These are a decrease in business growth in important markets like the US, and a decline in the outsourcing of fundamental coding tasks as many businesses adopt Artificial Intelligence systems to automate software programming.

While this weakness in the global macro environment could be transitory, management commentary has begun to turn cautious given fears of a macro slowdown.

This triggered a massive selloff in IT stocks on Monday this week as top companies Tata Consultancy Services (TCS) and Infosys reported lacklustre results for the fourth quarter of FY23.

Infosys was the most affected, seeing a nearly 10% decline in its stock price on Monday. TCS also saw a 1.5% decline.

While investors may be tempted to buy IT stocks after this fall, it may not be very prudent as there may still be some downside over the coming weeks.

From a fundamental point of view, there could possibly be more pain in the coming days due to project cancellations and delays in the deal decision cycle amid a global banking turmoil and recession fears.

Instead, this correction could be an opportunity for investors to look at a more market neutral strategy such as Statistical Arbitrage or Pair Trading in highly correlated IT stocks.

Simply, because such a strategy could work regardless of whether the sector corrects further or moves back higher, i.e., this strategy is not affected by the rise and fall in the market.

Volatility creates an ideal scenario for pair trade due to market inefficiencies, which cause prices to diverge temporarily from their usual relationship.

The current downturn in the IT sector might create such an opportunity for statistical arbitrage in certain corelated stocks.

And what better stocks to track but India's top two IT services companies, Tata Consultancy Services Ltd (TCS) and Infosys Ltd.

After all, both companies are in similar businesses and have over the years moved in tandem.

Infosys vs TCS Business Verticals

	Infosys	TCS
Key Business Verticals	Financial services	Financial services
	Retail	Retail
	Communication	Communication
	Energy and utilities	Manufacturing
	Manufacturing	Life science and healthcare

Data Source: Company Website

In recent times, both TCS and Infosys have grown their brand value to become the second and third most valuable IT services brands respectively in the world.

If one was to look at the stock prices over the last 5 years, it can be established that the price movement has been closely corelated over the years.

Looking at the chart, it's a no brainer. Both stocks move in the same direction on most days. This establishes our criteria for high correlation between two stocks for pair trade.

Next, using the share price data, we looked at the average ratio between the two stocks over a 3-year period.

While some traders might look at a shorter duration of say six months or one year while studying such price charts, we decided to take a longer duration of three years for our study.

A longer duration helps even out any blips or short-term spikes in data that might result in inaccurate readings.

If we look at the price ratio of TCS to Infosys, we determine that the ratio has stayed in a range between 1.93 and 2.96 during the 3-year period of study.

This essentially means that a share of TCS is between 1.93x to 2.96x higher than the share price of Infosys.

But while these two data points are at the extreme levels of the price range, the average price ratio between the two stocks is 2.27 over the last three years.

Armed with this data, we can establish there is a strong correlation between the two stocks and the average ratio the market perceives as normal, is 2.27.

What this implies is if the ratio was to move away significantly from this mean number, one could take positions accordingly in the respective stocks and initiate a pair trade.

For instance, in October 2019, when there was a potential leadership crisis at Infosys due to whistle blowers accusing the CEO of impropriety, the stock plunged 22% within eight trading sessions from Rs 815 to Rs 635.

On the other hand, it was business as usual for TCS where the stock actually gained 5% from Rs 1,987 to Rs 2,082 per share.

This anomaly resulted in the price ratio sharply increasing from 2.4 to 3.3.

Savvy traders would have noticed this divergence and taken the following positions in the derivatives market at the time: Purchased Infosys shares at Rs 635 and sold TCS shares at Rs 2,082 of an equivalent value, booking a pair trade at a ratio of 3.3.

Within a matter of a couple of weeks, the price inefficiency was indeed noticed by market participants and the ratio was down to 2.98 as the price of Infosys rose 11% to Rs 705 while TCS remained flat gaining just 0.8% to Rs 2,099.

At this point, traders would have squared off or reversed their positions and profited handsomely from this hedged trade.

Looking back at the price data, one can notice there have been multiple opportunities over the years for traders to have taken similar positions in these two stocks as the ratios have moved away from the mean.

Basically, traders have to be quick to observe an anomaly in corelated stock prices and latch on to such opportunities for pair trade.

As stock markets are often imperfect, such an anomaly can happen for various reasons.

For instance, there could be higher speculation or interest in TCS for a couple of days which causes a sharp movement in price leading to a divergence from its average ratio.

Or like we saw in 2019 in case of Infosys, there might be some corporate governance issues or a shuffle in the top management which causes prices to tumble of one company while the other stock remains unaffected.

Or perhaps, like we just saw this week, poor results and management guidance suggesting a weak demand outlook can also dent the stock price of a particular company as compared to its strongly corelated peer.

The recent fall in prices of IT stocks might have opened up a statistical arbitrage opportunity for traders looking at hedged positions instead of directional calls.

Since 12th April, the stock price of Infosys has fallen 11.7% from Rs 1,428 to Rs 1,261 as compared to TCS shares declining 7.7% from Rs 3,242 to Rs 3,131.

With this crash, the price ratio has jumped from its long-term average of 2.27 to 2.48 as per yesterday's closing prices on the BSE.

With other IT majors scheduled to announce their results over the coming weeks, market participants expect continued weakness in the IT sector.

This should result in heightened volatility and choppiness, possibly leading to a further increase in the price ratio of TCS and Infosys shares.

Initiating a statistical arbitrage between the two stocks could be safer and potentially more profitable as the ratio diverges further away from the average of 2.27, allowing for higher returns once the volatility settles and stock prices move back towards their mean ratios.

Choosing the right ratio to initiate a trade is subjective to the trader because it depends on their individual investment goals, risk tolerance, and market analysis.

One trader could initiate the pair trade at current levels anticipating prices to reverse immediately while another trader would be more comfortable with a much greater divergence, say initiating a trade only at levels above 3.

Hence, what may be the right price ratio for one investor may not be the same for another.

Please note that the purpose of this article is not to provide a recommendation to initiate a pair trade between TCS and Infosys at these levels or at any given levels in the future.

Rather, we have only used the example of TCS and Infosys to highlight how pair trading works as there is price volatility currently in these stocks due to the ongoing headwinds in the IT sector.

However, these are not recommendations. Investors should do their own due diligence before taking any position in any stock in the market.

Final Thoughts

Pair trading is used extensively by certain traders who are unwilling to take any open or naked positions in a particular stock or sector as they believe this strategy provides them a hedge against downside risks.

Logically, that is true. Here's how...

As pair trading is based on the statistical arbitrage principle, there is an inherent floor for the maximum loss you might make.

However, as one is betting on prices to revert to their mean, this means the maximum profit is also capped in this strategy.

Pair trading in high quality stocks is highly liquid i.e., you can enter or exit your position at any time to book profit or cut losses.

Finally, a lot of traders believe that pair trading is market neutral, meaning you can make money in both an up trending and down trending market.

Generally speaking, this is true.

For instance, a regular investor buying TCS or Infosys could incur significant losses if the BSE Sensex crashed 10,000 points. These shares would likely fall in line with the crash in the benchmark index.

On the other hand, if one had entered a statistical arbitrage trade between TCS and Infosys, it is possible the losses could be much lower as there would be a loss on the stock bought but a similar profit on the stock sold as both prices decline.

If the ratios were to work favourably, the investor could even profit in such a situation as the profit in one stock could outweigh the loss in the other.

However, herein lies a major flaw in this theory of pair trading being market neutral. To be market neutral, you need to be long and short, on the same stock, at the same time.

Hence, pair trading is not market neutral. This is a trading strategy that seeks to take advantage of the price difference between two related stocks.

By simultaneously buying and selling the two stocks, an investor aims to profit from the relative value of the two stocks.

Pair trading relies on the assumption that the two securities being traded have a high correlation. However, this correlation can break down, leading to losses if the securities start to move in opposite directions.

Hence, it is pertinent to note the risks of pair trading as it is not in reality a market neutral strategy.

As always, it's crucial to conduct your due diligence before making any investment decisions. Despite the favourable outlook, don't overlook the significance of sustained research.

Happy Investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...