The Invisible Czars

Rows of computer screens and a hodgepodge of wires make it look like any common office. Simple folk wearing half-sleeved shirts and sandals peck away at the keyboards without losing thread of their relaxed chatter. Soon a round of milky chai is served. It is difficult to believe that this is the place where a mini stock market legend has unfolded in the recent years.

In India’s fiercely competitive stock derivatives market, where millions of options and futures contracts are traded for the profit of a few paise at a time, there is one name that spells sheer power. Be it options writing or trading for arbitrage between the spot market and futures, market experts point to just one firm as the most formidable and nimble player. And it is not a foreign brokerage or a local big bull. It is actually a name not many have heard of. Dolat Capital.

It is at the nerve centre of this extremely low-key Mumbai-based brokerage — its dealing room is in suburban Andheri — that we are witnessing the 50-odd traders wind up another long-and-short day. We have come here to unravel the mystery of what makes Dolat Capital one of the most successful derivative traders in the country. It is a place no journalist has stepped in before, but Shailesh Shah, one of the four brothers who own Dolat, has agreed to open it up for us.

“Our business is a simple one. There is no big trick in it,” says Shailesh as he checks the final tally of trading positions left open at the end of day’s trading. “We are traders with a good discipline. We don’t take unnecessary risks.” But this alone doesn’t explain how this old-world firm has built up a proprietary trading capital of Rs. 550 crore, one of the biggest in India, and come to account for 5-7 percent of the open interest in the derivatives market. Not to mention the dealing room’s daily turnover of Rs. 1,500- 2,000 crore, with each trader working with a limit of Rs. 3.5 crore of capital, again among the biggest in the industry.

“They understand the market from the ground level,” says Sanjiv Shah, executive director of Benchmark Asset Management Company. “During times of extreme volatility all these years, I have heard of several brokers being in trouble. But I have never heard of such a thing about Dolat.”

Derivatives trading is just seven years old in India but Dolat’s business has been around for more than five decades in different forms. Every decade or so, Dolat has redefined its business and shifted early to emerging trends. In fact, the firm may already be calling the peak of profit potential in derivatives and moving on to newer and more rewarding opportunities. It is in this evolution that we hope to glean clues for what makes Dolat tick.

The Man on Dalal Street
Dolat’s business was literally born in the kerb around Bombay Stock Exchange (BSE) in the 1950s (“Morarji Desai was the finance minister then,” says Shailesh). Dolatrai Amritlal Shah, a matriculate and the son of a stock market dilettante, started offering options trading to investors outside the exchange building. He had to do this informally because derivatives trading was illegal those days. He had no membership to the elite club of BSE, but dealers would come out to trade with him.
“My father used to provide daily expiry of option contracts, an innovation those days,” says Pankaj Shah, Shailesh’s elder brother.

The business thrived and by 1970, Dolatrai gained enough confidence to apply for BSE membership. BSE members resisted him saying he was an outsider who operated in illegal options trading. Dolatrai met the then BSE chairman, Phiroze Jamshedji Jeejeebhoy, who used his veto to give him a card. Dolat was in business, officially. “I joined my father’s business in 1976 and we started looking for what we can do and how we can grow,” recalls Shailesh.

The equity culture in India was just beginning. Trading was largely confined to a handful of shares and a large number of other listed companies were bought and sold very infrequently. Dolat became a market maker off ering both buy and sell quotations for these stocks. Within a decade, it became the largest market maker for public sector and multinational company shares. At the peak, it was handling as many as 500 stocks.

The 1990s were a testing time for stock brokers in India and Dolat was no exception. In those days, trading was done through the open outcry system with brokers shouting out orders to each other. Dolatrai and his sons belonged to that old world, but the advent of National Stock Exchange in 1992 ushered in trading on computer screens. A few years later, paper shares were phased out in favour of digital records in the dematerialised, or “demat”, form. Many stock brokers could not make the transition and faded out.

“When electronic trading came in, we were seriously worried,” says Shailesh. Operating computers was not the forte of Dolat’s traders. It was then that the Shah brothers tried to get a foreign institution as a partner in the hope the computer savvy foreign firm would help them sail through. But no foreign brokerage wanted to tie up with Dolat. Left with no choice, the brothers decided to plunge into electronic trading anyway. They bought computers and got people to run them. This modest investment would prove to be just the first step in Dolat’s technology adoption.

Today, the firm is noted for being ahead of rivals in using technology to gain trading advantage. Fund manager Devendra Nevgi, who had done business with Dolat for more than a decade, recalls that as early as 1998, the firm imported Korean keyboards with embedded mice to enable their traders punch in orders faster than their rivals.

The DNA Shapes Up
The 1990s also deepened the stock market. Trading in many stocks picked up and the opportunities for market making gradually diminished. That meant Dolat had to undergo another transformation. It had to shift its focus from market making to another growth opportunity. The firm chose to become an arbitrageur. “Those days, the regional stock exchanges were doing very well. We started looking at the arbitrage between BSE and the other exchanges,” says Shailesh. Dolat positioned traders across exchanges.

All of them would link up on phone on a real-time basis and exploit small diff erences in the prices of the same stock in two different exchanges. This was a naturally hedged trading strategy. That is, when the stock was bought in one exchange, it was sold in another. There was no net holding to carry over or capital locked in. “We don’t say we are investors. We don’t hold stocks. Whatever we do, we hedge it. We never want to carry risk on our books,” Shailesh says.

Whether the Shah brothers planned it or not, Dolat had by this time developed a business model that cut across time, markets and asset classes. Dolat would take advantage of market inefficiencies. First, it was the low level of trading in some stocks that Dolat fixed through market making. Next, it was the gap between technology haves and have-nots that put Dolat at an advantage. Later, it was the lack of connectivity between exchanges that helped the firm engage in arbitrage.

Thus, the Shah brothers figured that the products Dolat dealt in might change, the markets might change, but the model of finding arbitrage in market anomalies would remain consistent.

“Our business is to seek risk-free returns,” says Pankaj. “We may not make 40-50 percent profit. We will make small profits, but we will not make losses.” At one point, the family even considered entering the diamond business, a source close to the brothers says. The idea was later buried because it did not fit the family’s fundamentals, the source says. The business of arbitrage involves taking small profits and a large number of positions.

It is natural that an arbitrageur will have huge short positions to match his long positions. Whenever the market falls steeply, an arbitrage trader could thus be mistaken for a short-seller. Over the years, Dolat has been investigated several times for pulling down the market through short sales.

“We were a market maker in MS Shoes,” Shailesh recalls referring to the 1996 price-rigging scandal involving the shares of the footwear company. Again in 2001, when the tech bubble burst, investigators would not fail to haul Dolat on charges of short-selling and artificially depressing the market. Typically, these cases ended in a censure without making a serious dent into Dolat’s business. Eventually, the firm managed to convey to everybody that what it was doing was arbitrage and not short-selling.

“Dolat has not been without its share of controversies in the market. But they have managed to steer clear mostly. There was this tax case which they settled. I haven’t seen anybody else signing a single cheque for Rs. 50 crore. It showed the cash liquidity of their business model,” says a source.

The New Option
By 2002, the firm was already looking for its next opportunity because regional stock exchanges had died out erasing inter-exchange arbitrage opportunity. Screen-based trading had made stock exchanges more efficient, removing some of the advantages that Dolat enjoyed. The Shah brothers took one look at the nascent derivatives market and realised it must be their next arbitrage opportunity.

The firm’s drive into this segment was driven by Pankaj. A physiotherapist by training, Pankaj is a self-taught derivatives specialist. Today, he is acknowledged as one of the smartest brains in options strategy, but those days, Pankaj would go to shops like Bookzone in Mumbai’s Fort area to buy heaps of expensive books to read up on the subject. “I prepared for four to six years before we got into derivatives,” says Pankaj.

Thanks to Pankaj’s voracious reading, Dolat quickly positioned itself in a niche in the derivatives market, especially options. In the futures segment, it does arbitrage between the spot and the forward prices of a stock or index, a fully hedged strategy that again brings small profits with each trade. Just like it did in market making or inter-exchange arbitrage, Dolat accepts these small profits but does a large number of transactions to get expected returns. In the options segment, however, Dolat’s strategy is far more specialised.

The Shah brothers, led by Pankaj oft en sitting on the trading terminal, mainly deal in the volatility of the market and not in prices or market direction. In simpler words, they don’t care at what price a stock option sells or whether the market is going to go up or down. All they bet on is whether it is going to move a little or a lot. To do this, they use option products such as straddle and strangle that deal with market volatility. As trading expanded, Dolat needed more traders. Here too, the brothers didn’t look outside for champion traders, but decided to train their own. Long-time employees — many were just matriculates and had been employed to distribute forms of initial public offerings — were roped in as traders. According to sources in the know, there are traders there who fi le tax returns for eight-figure incomes.

Exploring New Ground
 The Shahs don’t look at their business as being derivatives trading. They look at it as arbitrage: Wherever there is a market anomaly, bridge the gap and make money. They will move on from derivatives once the profits vanish. A bit of it is already happening. Th ree or four years ago, Dolat accounted for a much larger share of derivatives trading in India, but competition is cutting it down.

Shailesh does a back-of-the-envelope calculation: If each unit of volatility is traded at Rs. 4, his costs and taxes would take away about Rs. 2.75. “I am now working with a profit of one rupee twenty-five paise. I know the profits are coming down due to competition. I am ready to take this profit down to 25 paise, but I will increase my volume to five times.” Dolat has been maintaining a post-tax profit margin of 12-15 percent despite the competition. Very soon, it may not be sustainable with stock derivatives alone.

During the tour of his office, Shailesh takes us to another corner where a bunch of men in their early 20s trade in agri-commodities. The firm is taking small steps in this area and the volumes are modest as of now. But it is eyeing the arbitrage between the spot and futures markets in these commodities.

Shailesh admits this is a different game altogether. Unlike the cash settlement in the stock market, commodity trades must end in physical delivery unless squared off . So, visits to markets and warehouses are necessary.

But this is chicken feed compared to what a bunch of others are doing at another corner. Computers are being programmed to trade in the stock market on their own. “We are going into algo ading. We will start small and then, we will go big,” says Pankaj. The logic of the trading strategy would be evolved by Pankaj and Shailesh, but beyond that the computers would take over.

“Technology. That is their edge, really,” says a derivative analyst who once worked at Dolat. He says Pankaj has an uncanny ability to spot a wrong position by looking at a trader’s screen from 10 feet away.

Some former employees fondly remember working there saying the Shahs are “good people and good employers”.

Dolat suffered with everybody in the 2008 stock market meltdown but did not fire any employee. A 30 percent salary cut that came into effect in April is being withdrawn already, sources say.

Dolat shares daily profits with its traders. Over a period, the proportion paid out to the traders has gone up due to market pressures. Now, the owners shave off all their costs from the profit reported by each trader and share the balance with him. The trader gets 65 paise from every rupee of that net profit.

The Next Generation
Besides the new revenue streams, there is another transformation happening at Dolat. The third generation of Shahs is ready to take over. Pankaj’s sons, Vaibhav and Jigar, as well as Shailesh’s son, Purvag, are being inducted in. The youngsters have travelled wide, worked in marquee companies and bring modern thought to the company. Jigar, for instance, is spearheading the firm’s entry into program trading. He has set up a team to develop soft ware inhouse. Shailesh says the firm initially tried to get third-party soft ware. “The vendor said he will charge a rent of one lakh rupees per month. We said why don’t we get our own people to do it.”

Purvag focusses on the institutional broking division, set up in 1993. Mutual funds and other institutions are the clients. He wants to expand it and eventually make Dolat an investment bank. Age has also slowed down the senior Shahs. Shailesh, a keen badminton player, suffered an injury last year and underwent a knee surgery. He says he has not been in his best form in the market since then. The new generation comes with its own views on where Dolat should move from here, not always in agreement with what the elders have planned. For instance, the sons want to set up a Singapore office to trade in overseas futures of NSE 50 index. The dads want to wait till more volumes build up in Singapore.

Formula Decoded

The Shahs live by a very strict code:
On the broking side, they do business with top institutions and avoid the cumbersome retail business.
In proprietary trading, they focus on arbitrage from market gaps. If one gap gets plugged, they find out another.

They follow trading strategies that are naturally hedged in the market.

-They don’t lock capital in shares.

-They hold positions just long enough.

-They accept small profits but rely on a large scale of transactions.

-They worship the concept of stop loss.

-They are quick to cut losses.

-They invest early in technology to get an edge on the trading floor.

-They keep abreast of advanced markets like the US to spot trends.

-They share their profits with employees at the market-determined rates.

-They provide hands-on leadership.

-The bosses are the best traders in the firm.

-The derivative business isn’t really risk free. It has proved a perilous hole for much bigger traders. The inefficiencies that the brothers have constantly benefitted from could trap them one day.

-The key risks are running out of cash, over-leverage and being caught in positions with potential for unlimited losses.

So far, the Shahs have managed to remain in cash, avoid flashy expenses and rein in risk. “Even 15 seconds is too long to remain unhedged,” says Pankaj. Their research reports are also considered top-notch.

But as they move into commodities and the unknown space of algorithmic trading, these risks multiply dozens of times.

Shailesh says they may give up some profits but not the security that hedged strategies bring. “We are very simple people who trade with discipline and go home by 6.30 p.m. to be with the family.”