Pair Trading Strategy in India: A Worked TCS and Infosys Example

What Pair Trading Actually Is

Pair trading is a market-neutral strategy. You pick two securities that historically move together, then bet on the gap between them rather than on the market going up or down. When the gap stretches unusually wide, you go long the cheaper stock and short the more expensive one, expecting the two to snap back toward their normal relationship. Your profit comes from the spread closing, not from the Nifty rising.

This matters in India because the index moves a lot on global cues, FII flows and budget events. A pure directional bet can be wiped out by one bad RBI policy day. A pair trade tries to cancel that out. If both TCS and Infosys fall 5 percent because of a global IT selloff, your long leg loses and your short leg gains roughly the same, and you keep whatever the relative move between them gave you. That is the whole appeal: you are isolating one signal and hedging away the rest.

The catch is that correlation is not a law of nature. Two stocks can drift apart permanently because of a real business reason, for example a large client loss, a margin miss, or a management change. When that happens the spread does not revert, it keeps widening, and your stop-loss is the only thing standing between you and a deep loss. Pair trading is statistical, not guaranteed.

Why TCS and Infosys Is the Classic Indian Pair

TCS and Infosys are the two largest Indian IT services exporters. They sell broadly the same thing to broadly the same clients, earn most of their revenue in US dollars, and react to the same drivers: US and Europe tech spending, USD-INR movements, H-1B visa news, and quarterly deal-win commentary. Because the underlying business engine is so similar, their share prices have historically tracked each other closely, with rolling correlation frequently sitting in the 0.85 to 0.95 band over six-month windows. That high, stable co-movement is exactly what a pair trade needs.

Both also have deep liquidity and active F&O contracts, which is essential. You cannot pair-trade an illiquid stock because the bid-ask spread alone eats your edge, and you cannot hold a short overnight in the Indian cash market. TCS and Infosys both have monthly stock futures on the NSE, so you can hold both legs, long and short, for days or weeks using futures. Liquidity means you enter and exit near the screen price instead of slipping.

Other workable Indian pairs follow the same logic of same-sector, same-driver twins: HDFC Bank and ICICI Bank in private banking, Reliance and ONGC as an energy-linked pair (looser), Maruti Suzuki and Tata Motors in autos (looser still), and SBI and Bank of Baroda among PSU banks. TCS and Infosys remains the cleanest because the two businesses are the most alike.

The Spread and the Z-Score: The Math You Actually Use

The spread is the relationship you track. The simplest version is a price ratio: TCS price divided by Infosys price. A more robust version uses the log price ratio or a hedge ratio from regression, but for a working example the ratio is fine and easy to compute on a spreadsheet. You collect, say, 60 to 90 days of closing prices, compute the daily ratio, then find its average (mean) and its standard deviation (how far it normally wanders).

The z-score tells you how stretched today's spread is in standard-deviation units. The formula is: z = (today's ratio minus the mean ratio) divided by the standard deviation of the ratio. A z of 0 means the spread is exactly normal. A z of +2 means the ratio is two standard deviations above normal, which historically is uncommon and tends to revert. A z of -2 is the mirror image.

• z between -1 and +1: spread is normal. No trade. Sit out.
• z reaches +2: TCS is expensive relative to Infosys. Short TCS, go long Infosys, betting the ratio falls back toward the mean.
• z reaches -2: TCS is cheap relative to Infosys. Go long TCS, short Infosys, betting the ratio rises back toward the mean.
• z returns to roughly 0: the gap has closed. Exit both legs and book the move.
• z runs to +3 or -3 against you: the relationship may have broken. Stop out and accept the loss.

A Fully Worked TCS and Infosys Trade With Real Numbers

All figures below are illustrative and use round, realistic levels to show the mechanics. They are not live quotes and not a forecast. Assume over the last 90 sessions the TCS-to-Infosys price ratio averaged a mean of 2.40 with a standard deviation of 0.05.

On entry day, TCS trades at Rs 3,840 and Infosys at Rs 1,520. Today's ratio is 3,840 divided by 1,520 = 2.526. The z-score is (2.526 minus 2.40) divided by 0.05 = +2.53. That is beyond the +2 trigger, so TCS looks expensive versus Infosys. The trade is: short TCS futures, long Infosys futures, betting the ratio falls back toward 2.40.

To stay roughly rupee-neutral on each leg, you size the legs to similar notional value. Suppose the lot sizes give you about Rs 11.5 lakh of notional per leg. You short 1 lot of TCS futures (illustratively 175 shares at Rs 3,840 = about Rs 6.72 lakh per lot; assume 2 lots to balance) and go long Infosys futures of matching notional. To keep the example clean, take a single balanced unit: short 175 TCS shares-equivalent and long the Infosys quantity that matches the same rupee value, about 442 Infosys shares-equivalent (Rs 6.72 lakh divided by Rs 1,520).

Two weeks later the spread reverts. TCS eases to Rs 3,720 and Infosys rises to Rs 1,545. New ratio = 3,720 divided by 1,545 = 2.408, a z-score of about +0.16, essentially back to normal. You exit both legs. Here is the leg-by-leg rupee result on the illustrative quantities (175 TCS short, 442 Infosys long):

Gross profit is about Rs 32,050 on roughly Rs 6.7 lakh of capital per leg. Both legs won here because the ratio moved cleanly: TCS fell and Infosys rose, which is the ideal convergence. In many real trades only the net of the two legs is positive. Now subtract costs, which is where beginners get fooled.

Costs, STT and Tax: What You Keep After Charges

A pair trade is four executions: enter long, enter short, exit long, exit short. Every execution carries brokerage, exchange charges, GST and STT. On stock futures, STT is 0.02 percent on the sell side of the futures value (effective from October 2024), so both your short entry and your long exit attract STT. Brokerage at a discount broker is typically a flat amount, around Rs 20 per executed order, so four orders cost roughly Rs 80 in flat brokerage plus exchange transaction charges, SEBI fees, stamp duty and 18 percent GST on brokerage and transaction charges.

On the illustrative trade above, total round-trip charges across both legs, including STT on the sell sides, exchange and GST, realistically land in the Rs 700 to Rs 1,200 range depending on your broker. Take Rs 1,000 as a working figure. Net profit before tax is therefore about Rs 32,050 minus Rs 1,000 = Rs 31,050.

Tax is the part most traders get wrong. F&O trading is treated as business income in India, not capital gains. So this Rs 31,050 is added to your other income and taxed at your slab rate, and you can also deduct genuine trading expenses such as brokerage, internet and data costs against it. The 20 percent STCG and 12.5 percent LTCG rates that apply to delivery equity do not apply to your futures pair trade. If you instead run the short leg as intraday cash equity, that intraday equity profit is speculative business income, again taxed at slab, while a delivery long held over a year would face the separate capital-gains regime. Keep the two legs in the same instrument type to avoid a tax and accounting mess.

Cash, Futures or Intraday: How to Actually Place the Short Leg

India does not allow you to hold a short equity position overnight in the cash segment. A retail trader who sells a stock they do not own in cash must square off the same day or face auction and penalties. This single rule shapes every Indian pair trade. You have three practical routes for the short leg.

• Single-stock futures: the cleanest route. TCS and Infosys both have monthly futures. You can short a future and hold it for days or weeks until expiry, then roll. This is what serious pair traders use.
• Intraday cash on both legs: open and close the same day. No overnight risk, lower margin via MIS, but you only capture moves that happen within one session, which is rare for a spread reversion.
• Long cash, short future: hold the long leg as delivery and short the other stock's future. Workable, but the two legs then sit in different instruments with different tax treatment, so keep records carefully.

Most multi-day pair trades on TCS and Infosys are done as future versus future. Remember that monthly futures have an expiry, the last Tuesday of the month for most NSE stock contracts, so if your spread has not reverted by then you must roll both legs to the next series, which adds cost and is itself a small spread risk.

Entry, Exit and Stop-Loss Rules That Hold Up

A repeatable ruleset beats gut feel. Define the numbers before you enter so you are not negotiating with yourself mid-trade. Here is a workable baseline for a TCS and Infosys futures pair, all of which you can and should back-test on your own data before risking money.

The stop-loss is non-negotiable. The danger in pair trading is not a single bad day, it is a spread that keeps widening because something real changed. If Infosys announces a big client loss while TCS does not, the ratio you shorted can run from +2.5 to +4 and never come back. A z = 3 stop caps that. Size each pair so that hitting the stop costs you no more than a small, pre-decided fraction of your capital, commonly 1 to 2 percent per trade.

When Pair Trading Works and When It Quietly Fails

Pair trading earns its keep in range-bound, choppy, or news-driven markets where individual stocks overshoot and then snap back, while the pair relationship stays intact. Indian results season is a rich hunting ground: one IT name beats, the other misses, the spread spikes, then the market re-rates both and the gap narrows. Volatility creates the stretch; correlation provides the snap-back.

It fails in three classic ways. First, a structural break, where a real business event permanently changes the relationship and the spread never reverts. Second, correlation decay, where the two stocks slowly stop tracking each other and your statistics are stale. Third, cost drag, where small, frequent trades look profitable on the screen but the four-execution cost plus STT plus slippage quietly turns a positive gross into a negative net. The TCS and Infosys win above looked clean only because we subtracted costs honestly; many real spreads of 0.5 to 1 percent vanish entirely after charges.

• Best conditions: sideways or volatile market, intact high correlation, a clear statistical stretch in the spread.
• Worst conditions: a strong one-way trend in one stock driven by company-specific news, or fading correlation.
• Silent killer: overtrading small spreads where charges and slippage eat the entire edge.

Common Mistakes Indian Pair Traders Make

• Ignoring that the cash short cannot be held overnight, then getting auctioned. Use futures for multi-day shorts.
• Forgetting STT on the sell side and the four-execution cost, so a trade that looked profitable is actually a net loss.
• Treating F&O profit as capital gains. It is business income taxed at your slab rate, with expenses deductible.
• Not re-checking correlation, so trading a pair whose relationship has already broken down.
• Sizing the two legs by share count instead of rupee notional, which leaves the trade accidentally directional.
• Skipping the stop-loss because the spread 'always reverts', until the one time it does not.

SEBI Rules and Practical Compliance

Pair trading is legal in India and uses ordinary, exchange-traded instruments, but it touches several areas the Securities and Exchange Board of India regulates. The big practical one is short selling: SEBI permits short selling within the rules, but retail cash short positions cannot be carried overnight, which is why futures are the standard tool. Margin rules under SEBI's peak-margin framework mean you must hold full upfront margin on both futures legs, so a pair trade ties up margin on two positions at once, not one.

You must also avoid anything that looks like market manipulation or insider trading. Trading a pair around a results announcement is fine; trading on unpublished price-sensitive information about either company is not. Keep your sizing within your sanctioned limits, confirm current contract specifications and STT rates on the NSE site before trading, and remember that lot sizes and STT rates do change. Treat the figures in this guide as a teaching example and verify the live numbers yourself.

Sources and Further Reading

For authoritative data and current contract specifications, refer to NSE India for lot sizes, futures specs and STT, Zerodha Varsity for cost and tax mechanics, and SEBI for short-selling and margin rules. Always confirm current rates and contract details on the official source before you trade. You can also size and risk-check your legs with our position size calculator and review broader risk management principles.

Sources and Further Reading

For authoritative data and further reading on this topic, refer to NSE India, Zerodha Varsity and Investopedia. Always confirm current rules, rates and contract specifications on the official source before you trade.