What is Cash Neutral?

Cash Neutrality is expressed in terms of percentage of cash flow required in comparison to the second symbol.

When trading a pair we need to ensure that the pair is Cash Neutral

 

How to calculate Cash Neutrality?

Calculation

Price1 x lot size
———————
Price2 x lot size

Eg: KOTAKBANK-HDFCBANK

KOTAKBANK- Lot Size 800, Future Price – 804.7
HDFCBANK – Lot Size 500, Future Price – 1394.05

804.7 x 800 = 6,43,760
1394.05 x 500 = 6,97,025

643760/697025 = 0.9235,  in percentile terms it is 92.35%

means KOTAKBANK is 92.35% of HDFCBANK after taking lot size into account.

 

How does Cash Neutrality help in making trade decision?

Cash Neutrality plays very important role in selecting pairs which can be traded

We can categorize pairs into 3 categories based on Cash Neutrality value

1. Cash Neutral Pair (CNP) – Range 90-110%. Eg: KOTAKBANK-HDFCBANK – 92.35%.
2. Semi Cash Neutral Pair (SCNP) – Range 75-90% and 110-125%. Eg: AXISBANK-INDUSINDBK – 77.07%
3. Non Cash Neutral Pair (NCNP) – < 75 and > 125%. Eg: IOC-BPCL – 142.58%

To illustrate the importance of Cash Neutrality, lets presume all stocks have rallied exactly 2% today and we will see what will be the effect on these pairs

1. CNP

1a. HDFCBANK-HDFC(100.9%) – You would have got Rs. 132 Profit, because HDFCBANK is 0.9% more in value than HDFC
1b. KOTAKBANK-HDFCBANK(92.35%) – You would have got Rs. -1065 Loss, because KOTAKBANK is 7.65% less in value than HDFCBANK

2. SCNP

2a. JINDALSTEL-TATASTEEL(116.70%) – You would be in Rs. 3224 Profit,  because JINDALSTEL is 16.7% more in value than TATASTEEL
2b. AXISBANK-INDUSINDBK(77.07%) – You would have got Rs. -3649.2 Loss, because AXISBANK is 22.93% less in value than INDUSINDBK

3. NCNP

3a. IOC-BPCL (142.58) – You would be in Rs. 7570 Profit, because IOC is 42.58% more than BPCL
3b. AXISBANK-YESBANK(61.32%) – You would be in Rs. -7735 Loss, because AXISBANK is 38.68% less in value than YESBANK

Even though all prices went up by 2%, there will be difference in Profit/Loss for each category pairs.

 

Can we trade NCNP pair?

NCNP Pairs are tradable in a trending market.

IOC-BPCL – Can be initiate only in Bull Market
BPCL-IOC – Can be initiate only in Bear Market

It would be riskier to trade NCNP pair.  To neutralize the risk, pair has to be cash neutralized.

 

How to neutralize a pair?

Due to the fluctuating prices and fixed lot sizes, Cash Neutrality changes on a daily basis. You can make a pair Cash Neutral by increasing Lots.  For Eg:

a. AXISBANK-YESBANK (61.3%) – To neutralize this pair we take 2 lots of AXISBANK and 1 lot of YESBANK, so the net CN would be 121%
b. IOC-BPCL (142.58%) – To neutralize this pair we take 2 lots of IOC and 3 lots of BPCL, so the net CN would be 95%.  Some pairs cannot be neutralized by increasing lots.  So we have to do it by taking appropriate Qty in Cash market, but it will increase cost of holding the pair.  So best way to trade those pairs is to analyze the trend of the market and estimate what will happen to the pair if market goes up and what will happen if market comes down.