| Building on where we left last time, Endowment Theory as proposed by Kahneman has distinct similarities with the open interest (OI) behaviour in the derivatives market.
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| We sighted the example of Tisco and Nifty last time - how the market participants, specially the ‘long players’, found it so tough to book profits at Rs 400 levels in Tisco or at 1,750 levels for the Nifty, just to be rudely shaken out of their market slumber.
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| This inertia in OI figures leaves OI parameter less potent for short-term forecast, especially for day traders or may be traders with a week-long horizon.
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| But then, the ‘Hedonic treadmill’ as they call it makes most of the traders look for steady small profits over bigger profits in the long term. Putting simply, it is like gambling a euro to win a penny rather than risking a succession of pennies to win a euro.
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| We in India are no different than the traders in Europe. We are more hedonistic than our counterparts in Europe. There is a high probability that your next-door broker might recommend a covered-call strategy more often than a long straddle on the Nifty.
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| He finds it more convenient than a volatility spread, where it’s imperative for him to understand the position risk and implied volatility (IV) patterns of the market and the stock.
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| Investors have long engaged in ‘covered write’ strategies by selling an option against their portfolio, increasing the probability of a profit return for a reduction of the upside potential.
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| Incidentally, CBOE publishes data on BXM Write which is a covered-call index. There is enough literature on covered write where investors find gains in utility from capping payoffs, as the marginal utility of gains decreases at a higher asset price.
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| Indeed, the fact that individual investors sell options at cheaper than their actuarial value can only be explained by the utility effect.
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| For a mutual fund doing a covered write against an individual investor’s portfolio increases the probability of beating the index in the short run, but subjects him to long-term underperformance as he will give back such outperformance during large rallies.
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| With such findings available world-wide you really can’t blame your broker. Best selling ‘option strategy’ books endorse covered call strategy as one of the golden strategies, sighting the cliché that 90 per cent of all option positions lose money.
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| A majority of traders completely ignore the fact that how much money is made on an average during the remaining 10 per cent of option positions.
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| Consider that we are still rangebound between 1,550-1,440 levels with the Nifty closing flat week over week. Putting the above argument in perspective to play for the coming week is bit tricky.
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| And with market volumes playing truant after a rise of just 55 points in Nifty July (from the low of 1419 on Wednesday), circumspection sneaks in right away. Naked longs did look a little risky on Friday after the Nifty touched the 1,490 level and failed to cross it decisively.
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| The Nifty futures volumes fell by almost half to 77,000 contracts. Now one can ascribe this to market seasonality after expiration. But, with OI suffering from inertia and with Nifty July quoting at discounts, market optimism to breach the 1,500-1,525 levels this week seems low.
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| On the OI rollover front, the month over month trend is up across the board. Barring a few stocks like DRL, ONGC and ITC, most of the stocks saw a rise in month over month OI figures. How far it sustains, however, remains to be seen.
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| Debit call spreads were available at a 1:1.5 risk-reward prior to the rise that started on expiry. One can remain invested using call positive spreads. Traders can also look at initiating bleeding Nifty straddles as we are heading for the Budget week.
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| Internationally, stocks trades were mixed last week. In fact, after moving higher two times and falling on three occasions, the Dow Jones Industrial Average finished the week down 44 points.
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| Nasdaq performed a bit better than the Dow and gained 65 points, or 3.3 per cent, closing above the 2,000 mark decisively. VIX fell to its lowest levels since August 1996 earlier this week when it closed below 14 per cent.
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| While the low reading from VIX reflects the quiet trading during the past few months, the drop in the “fear gauge” is also a sign that investors are becoming bullish.
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| How far and how long is what remains to be seen, as overbought markets may remain overbought for extended time, but a step out of the ovetbought levels can really crash indices.
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| Indian volatilities have also eased a lot after May 2004. And with the put-call ratio (PCR) also giving a downtick, exhibiting similar behaviour like its counterpart in US, the market trend seems positive.
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| In the US market, call activity is increasing, leading to a decline in PCRs. For instance, on Thursday, 1.67 million puts and 2.46 million calls traded across six US options exchanges. The total PCR subsequently fell to .68 - its second lowest levels of the month.
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| A closer look at sentiment grids and one can see that many sentiment indicators like put-volume indicator (PVI) and PCR gave a downtick from significant highs on Thursday.
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| Overall, the market outlook remains positive for the week. Traders can look at initiating fresh longs only after market crosses 1500 levels decisively till then Nifty call spreads and straddles don’t put me on to the hedonic treadmill.
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| (The author is derivatives strategist with HDFC Securities. The views expressed here are his personal views and not those of HDFC Securities.) |
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