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| Expiry effect in overbought market |
| Devangshu Datta / New Delhi Oct 19, 2009, 00:52 IST |
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The cash market generated extraordinary volumes and saw net gains while the derivatives market displayed bullish sentiments and signs of decent carryover. There are also signs of traders bracing for settlement.
Index strategies
The Diwali period generally sees Indian traders and operators cutting down exposure. However, this isn't apparent yet. The FIIs hold around 33 per cent of all the open interest hence, by default, Indian operators hold 67 per cent. This suggests that not too many traders have taken money off the table.
On the surface, carryover sentiment seems good and this is usually linked to bullish expectations. There is significant open interest (OI) in November stock futures as well as in November index futures. The traded index futures and the majority of high-volume stock futures are, incidentally, at premiums to respective underlyings. So, that is also a sign of bullish sentiment.
The Vix is also low, at 26, which signals lack of fear. The put-call ratio is extremely bullish with October Nifty PCR at 1.7 and overall Nifty PCR at 1.64. Sentiment therefore, seems quite strong. The market is at a new 2009 high. However, this can also be interpreted as an overbought situation and there could be a short-term correction, especially if cash-market volumes ease.
One danger sign is that Nifty option carryover is not as strong as one would like. Rather, there has been a heavy build up in October Nifty options and that build up is within a narrow range. At this stage, with two weeks to go, one would normally expect about 40 per cent of Nifty option OI to be in mid-month or beyond.
Right now, it's 33 per cent and the bulk of the October option OI is focussed between 4,900 put (downside) and 5,300 call (upside). This is within one or two trending sessions of the money, given a market where the Nifty is moving an average 125 points per session (high-low range).
If those October positions are dissolved rather than carried over, there could be a sudden drop in activity. Also if the market does move beyond this range, there would be upheavals with traders caught flat-footed.
Technically, it's a difficult situation to call in terms of likely trading ranges. We can lay down support levels in the event of a short-term, or even intermediate correction, since there is recent trading history below current levels. It's reasonable to peg 4,750 as an outside limit in an October correction since primary support is at 5,000, secondary support at 4,900 and tertiary at 4,750.
On the upside, targets of 5,250-5,300 may be hit if we project targets from the current formations. But there's no recent price history and hence, no clear resistance levels to calculate. The easing off on OI above 5,300c suggests that most traders would be unprepared to handle another burst of serious bullishness.
An expiry effect is already visible with options beyond 4,900p and 5,300p being priced cheap. This makes it tempting to set up cheap long strangles. This is a Taleb-style strategy – you will normally expect to lose a little money. In the event that the market does move a lot, you gain massively.
Expiry effects also makes it cost-effective to hedge a directional index position by taking futures (with a stop loss) and hedging with a cheap option spread. Here, if the trader picks the right direction for the future, he makes unlimited returns while being insured against a misfire.
If you wish to take an unhedged index futures position, consider going with the Bank Nifty instead of the Nifty. The sector index has plenty of OI and decent carryover. It is also outperforming the Nifty with a high beta. It will probably generate better returns. The CNXIT is also doing well but one is increasing uncomfortable about the industry, given the dollar's weakness.
Close to money option spreads also have decent risk-reward ratios. A long 5,200c (56) and short 5,300c (24) costs 32 and pays a maximum of 68. A long 5,100p (65) and short 5,000p (38) costs 27 and pays a maximum of 73. Combine the two CTM spreads and the trader stands to lose a maximum of 59 and gain a maximum of 41 on an uni-directional movement. If the market does swing between 5,000-5,300, the trader will gain 82.
A long strangle such as long 5,400c (8) and 4,900p (23) costs all of 31. It breaks even at 4,868 and 5,431, with unlimited gains beyond those points. Admittedly, it is a long shot but it is quite a tempting long-shot. It can be laid off in theory, but there could be liquidity issues in selling say, the 5,500c (4) and 4,800p (14.5) though both instruments still have decent OI. A short future (with stop-loss) and a long 5,400c or a long future (with stop loss) and a 4,900p is another way to try and set up two-way positions.
STOCK FUTURES/OPTIONS
There are a significant number of big highly traded stocks sitting at new 2009 highs. In the circumstances, it is difficult to find short positions while long positions abound. Banks and real estate would be two places to seek highly liquid long futures positions.
On the short side, you would have to either look for something that's overbought or perhaps, seek weak IT or pharma stocks that might crash if the dollar slides further. SBI is quite a tempting long position, so is Cairn. Sterlite Industries and Jindal Steel are potential shorts which appear to be already in correction.
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