| Endowment effect means that people place an extra value on things they already own and would find it tough to swap it for something of equal market value. A part of 'Prospect Theory', the study gives credence to the idea that people make daft mistakes.
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| F&O open interest (OI) provides a classic analogy of the endowment theory. The Nifty futures OI was at historically high level near 50,000 contracts in January 2004. The outstanding refused to decline despite a failure of markets to rise above January high levels.
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| Three major tests of 1,750 levels and still OI levels remained unchanged. The markets OI refused to give way despite uncertainties of poll results, global situation and oil prices.
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| And it was only after markets cracked decisively in May 2004 that we saw OIs finally moving down from a high of 75,000 contracts to 45,000 contracts in the Nifty.
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| This highlighted the in-built inertia in the market psyche. The 'longs' refused to accept that the trended move was over and did not book profit in time only to book losses at 1400 levels.
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| Though one may argue that even the current level of OI is still high for the Nifty, the fact that Nifty futures are used as a proxy for market exposure and is used by a multitude of players for hedging purposes clarifies the viewpoint.
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| Moreover, with the aggregate OI declining by 50 per cent from January 2004 levels of Rs I5,000 crore to sub Rs 7,000 level, the stoic market exposure saw a decisive square off. The current OI situation is lacklustre and I don't expect a significant rise in July OI over June OI.
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| Continuing the argument further, 'shorts' play half the role in constructing market OIs. Since the 'longs' and 'shorts' can trade with different time cycles, the attachment of one can clearly be a trading strategy for the other, entering and exiting rangebound markets with fast profits.
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| For example, a short position could have served as counterparty to a long-term Tisco futures holder at Rs 400 levels for about three months. The stock is down 30 per cent from those levels and equals twice the market decline of 16 per cent since May 2004 levels.
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| I point out Tisco because the stock was one of those few counters which had an unflappable outstanding, remaining firm for months.
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| Endowment effect also leads to a weak investment strategy. If one is too stuck on 'long' directional moves, the non-directional part of derivatives market totally goes unexplored.
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| For example, a small study and one could have observed that a simple strategy of buying a straddle every month could have yielded about 15 per cent over the last 15 months and about 24 per cent in case one used an in-built stop loss of 50 per cent erosion of the straddle premium.
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| The average, maximum and minimum costs of the straddle starting January 2003 was Rs 70, Rs 140 and Rs 30 respectively. The markets gave average, maximum and minimum returns of 3 per cent, 18 per cent, -12 per cent respectively during the expiration months.
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| The same study can be extended to naked OTM calls and OTM puts in long strangles. Even if it was not a near-month strategy one could have at least looked at straddles near significant events, the 1800 levels early May being one of them.
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| The non-directional emphasis could have also been on selling volatility. Traders could have sold Nifty volatility after the May decline, selling 1580 calls and selling 1370 puts.
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| The strategy returned about Rs 65 over a period of a week. One could also have looked at covered calls in the penultimate week of May expiration, as most of the stock futures and index futures were quoting at huge discounts, implied volatilities were high and markets were stepping out of the oversold status.
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| One could have also looked at selling strangles on 'tech stocks', which incidentally had more pronounced price channels than stocks from other sectors.
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| Credit over debit spreads was also a measured risk-return strategy traders could have initiated. These strategies may not have given unlimited gains but could have avoided capital erosion.
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| Post-May expiration implied volatility (IV) was still high and one could have looked at credit spreads more aggressively than debit spreads.
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| A credit put would have made profits on Infosys while a debit call bullish strategy early May 2004 on Infosys - buying 5200 call and selling 5400 call start of the month - would have cost an upfront debit of around Rs 100.
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| Internationally, the VIX still refuses to give a sell signal and remains comfortably below the 20 per cent mark. And with NAZ bouncing back from the 1900 levels twice, the rangebound action continues even in US. Locally, this week may witness higher volumes, low market OI and futures discounts turning into premiums.
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| However, the market has some selling steam left before forming an intermediate base. And as one can see, the illustration highlights both annual and two-year Nifty vs PCR chart. The indicators are near the historical oversold level and suggest a market consensus on negativity. This has a positive interpretation.
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| Hence, there is a strong reason why markets may take good support between 1410-1450 levels. One should look at a downtick in market PCR before squaring off short positions and initiating trading buys for this week. Till then we are playing for a trading bounce in a bearish trend.
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| (The author is derivatives strategist at HDFC Securities. The views expressed here are his personal views and not those of HDFC Securities.) |
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