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| Correction by the weekend? |
| Devangshu Datta / New Delhi May 11, 2009, 00:59 IST |
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This is an unusually strong bear market rally, which has pulled indices well above respective 200 DMAs.
The market jumped, consolidated and corrected. It was still up 4 per cent at the weekend and the derivatives segment reflected continuing but tempered optimism.
Index strategies
Volumes remained good in cash and derivatives. This is almost always a positive signal. Throughout the week, there was buying support in evidence on every dip and the gains were distributed across sectors. Although there was a selloff on Friday, equities still ended higher.
Will there be a correction next week? After all, the market has risen 45 per cent since early March without a breather. This is an unusually strong bear market rally, which has pulled indices well above respective 200 day moving averages.
However, an eight-week run up also means that a correction is overdue and minimum expectations on the downside would be a slide of around 300-400 points on the Nifty.
Option premiums have risen in anticipation of probable volatility by weekend. For what its worth, the VIX is up and the last couple of sessions have seen large intra-day swings. There appears to be a difference of attitude between institutions. While Indian institutions have been sellers for three weeks, the flood of FII inflows continues. This has pushed the rupee up sharply. The strong rupee in turn, had a negative effect on the CNX IT index.
More interestingly, the high-beta Bank Nifty had a sharp reversal in direction on Friday. Although it was up more than 5 per cent, Friday saw a nosedive and the Bank Nifty breached an important support to set up a pattern of lower lows. This could be the precursor for a more general correction since banks have higher weightage and are more influential with respect to other rate-sensitive stocks. One would recommend that traders stay short on the Bank Nifty.
The Nifty itself has not performed the same pattern of lower lows, which usually signals a bearish trend reversal. But it did see a correction on Friday, which tested support at 3,575. This was preceded by several tests of resistance above 3,700.
That defines a narrow trading range of 3,575-3,725. Moves outside this zone could turn into a new intermediate trend. If the overall market emulates banks, the breakout will be downwards. In that case there could be successive tests of supports at 3,450, 3,350 and 3,150. If on the other hand, the election results lead to a positive outcome, the markets will make an upside breakout. If the Nifty closes above 3,700, it's liable to hit 3,900 before end-May.
An analysis of index option positions suggests that short term expectations are a little bearish. The put-call ratio (PCR, in terms of open interest) is at 1.1 with the June and beyond PCR at 0.9 and May at 1.25. June PCRs are definitely bearish and the overall expectations are close to overbought.
Until the market develops a clear trend, traders will have to be braced for moves in either direction across the wide range of 3,100-4,000. Since a 10 per cent swing (plus or minus) seems quite likely, naked option sales are out. Apart from standard bull spreads and bear spreads, the trader has to look at strangles and straddles since these are designed to manage big swings.
Risk-reward ratios are good and about equal in either direction. Although option premiums have risen across the entire chain, the rise has been more or less symmetrical. A close-to-money (CTM) bull spread with long 3700c (130) and short 3800c (90) costs 40 while a CTM bear spread with long 3,600p (159) and short 3,500p (119) also costs 40. Both pay a maximum of 60. Note that both 3,700c and 3,600p were hit inside the last session.
Given expectations of high volatility, wider spreads with long 3,800c (90) and short 3,900c (60) and long 3,500p (119) and short 3,400p (86) are possible. Both offer better risk-reward ratios than the CTM spreads. Combining these, we could have a long-short strangle combo with a cost of 63 and a maximum pay off of 37. A long strangle of long 3,800c and long 3,500p can be offset with a short strangle at short 4,000c (38) and short 3,300p (63). The net cost is 108 and the maximum payoff is 92. These are not great ratios and on balance, the best positions seem to be far-from-money bull or bears spreads. If you want a directional play, the downside seems a little more likely and it has better return-risk ratios.
If you wish to hedge both directions, combine a spread with the reversed future. That is, take a short Nifty futures position along with a bull spread or long futures with bear spread. Keep a tight stop-loss on the futures position if you do this.
STOCK FUTURES/ OPTIONS
The breadth of the market has been good but this also means that the overwhelming majority of stocks are moving in tandem.
In a high-volatility situation, it's safer to focus on the main market index rather than to seek stocks that have independent directional value. The correction on Friday has muddied the waters. We've already recommended a short position on the Bank Nifty above.
Major banks like ICICI Bank and Axis Bank could also naturally be ripe for shorts. Metals could also weaken after a run-up that was torpedoed on Friday, and Tata Steel and Hindalco in particular may attract bearish traders. The most promising long positions may be in sugar stocks like Bajaj Hindusthan and Balrampur Chini.
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