| I don't need statistics to talk about intuitive trading. Trading always has this intuitive element about it, unless otherwise one is using a trading black box model.
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| What works and what doesn't is what intuitive trading is all about. Surprisingly, however, the recent Economist Survey on Risk states how human intuition is a bad guide to handling risk and opinionates to think like a machine.
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| The survey talks about the Human follies - over optimism, fear of failure or loss, stubbornness to accept a flawed perception, counterproductive regret - which colours future perceptions. All of the points the survey makes are valid thought agents for the intuitive trader.
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| Translating the tenets further, one can look at volatility in the current market. We all seem to be awed by this high intra-day volatility but still regret that we did not buy a straight Nifty future, starting May 2003.
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| This is a clear explanation of the skew of market players towards futures trading and lackluster volumes in options.
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| Avoiding this counterproductive regret would have allowed the intuitive trader to make reasonable money playing in options.
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| There were clear trended moves in implied volatility (IV) starting April 2003. First it rose during the April-September 2003 period, then the trend was down starting September 2003-January 2004 and currently it is in the third-up leg where it has moved up from sub 20 per cent level of early January 2004 to the current 30 per cent levels.
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| The trader could have started with a reviewing both IVs and statistical volatilities (SVs) over these different time periods. SV calibrates a stock's tendency for movement, which goes a long way in determining how much an option is really worth.
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| By judging whether SV is high or low provides the strategist with important information regarding what type of strategy that can possibly be employed to generate profits in a specific market.
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| Just as SV is a measure of actual, historical price movement of a stock, IV is a measure of what option traders expect future SV will be.
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| Options are considered undervalued if current IV is less than past levels of IV or when IV is less than current SV. Options are considered overvalued or expensive when current IV is greater than past levels of IV and when IV is greater than current SV.
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| A volatile market like what we have witnessed since January 5, 2004 with undervalued options gave ample opportunities to make large gains through market movement using long straddles, long strangles, and ratio backspreads whether on Nifty or stock-specific. The only caveat was the negative time decay.
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| For markets that were non-volatile like the one during April-July 2003 with undervalued options, a calendar spread type of strategy was appropriate.
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| When the market is volatile with expensive options, using a reverse calendar spread is a better choice.
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| In non-volatile markets with overvalued options, the trader can capture positive time decay by initiating short strangles, short straddles, and ratio spread types of strategies.
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| All this counterproductive talk also highlights the herd behavior in the market, the very reason for over optimism and pessimism.
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| Volatility based forecasts are also common. The US markets, for example, look weak if we consider the CBOE volatility index, or VXO, which measures implied volatility in OEX options contracts.
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| The volatility index is above its 10-day exponential moving average. It is not a healthy condition for prices when the VXO is above its 10-day exponential moving average and the VXO is moving away from its 10-day exponential moving average (of its close).
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| Bulls should want to see the VXO drop and bears should want to see the VXO rise. Very near the close of trading on Wednesday, the 10-day exponential moving average of the VXO was 16.55.
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| The VXO is going to have to move below its 10-day to increase confidence in seeing higher stock prices for more than just a one day reaction to a headline.
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| About the Indian market, the IVs were ruling at a high of 30 per cent plus levels for week ended January 30, 2004.
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| As an option indicator, this was a sign of over caution and contrary to popular belief that panic had set in and the current week was another free fall. As expected Nifty did not falter and is above last week's close at 1,805.
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| However, how far the upside sustains is a tough call. It may be too early to speculate, but it seems that Nifty current futures open interest (OI) are cautious building OI positions going into the second week of trading.
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| The futures OI figures are ruling at 39,000 contracts and are about 15 per cent lower than the 46,000 odd contracts open on the January 15 this year.
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| In case the OI pattern breaks (which seems likely) not only will a nine-month OI unabated upward pattern break, but Nifty also might see sub-1,750 levels.
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| There are other reasons which reinforce a trading sell on Nifty. The volume indicator turned negative after two months and incidentally has witnessed the steepest fall since the uptrend started in May 2003.
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| In conclusion, the current volatility has all it takes to kill any market intuition. I wish to abstain from all directional talk and rather stay invested in volatility spreads using ratio spreads and long straddles on the Nifty this February.
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| (The author is derivatives strategist at Edelweiss Capital. The views expressed here are his personal views and not those of Edelweiss Capital.) |
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