| Prepare for big intra-day swings | |
| DERIVATIVES | | Devangshu Datta / Mumbai October 13, 2008, 0:50 IST | |
The selling in the cash market has seen a exaggerated reflection in derivatives. Although volumes have not risen, prices have swung sharply and the composition of index instruments to stock underlyings shows extreme caution.
Index strategies
Most of the selling was led by the FIIs but Indian institutions have been net sellers and heavy ones. One scary thought is that FIIs will see heavier redemptions throughout the October-December quarter because December is the annual reporting month for FIIs. Be braced for that.
The hedge ratio has been very high and the put call ratio very low through the past few sessions. The implications are interesting. The hedge ratio is the ratio of index contracts to stock contracts. A high hedge ratio implies traders are reluctant to take unhedged stock futures positions or are avoiding stock positions entirely. A rising hedge ratio is usually accompanied by falling share prices. We have seen a hedge ratio consistently over 2 and rising during the past fortnight. This is clearly bearish.
A low put-call ratio (PCR) is bearish most of the time. In India, overall PCRs (of index plus stock options) tend to be low because very few stocks have any put volumes at all (even stock call volume is low). However, the overall PCR has historically been in the range of 0.7 or higher. Right now, it is hovering at 0.4. That is extraordinarily low.
The bulk of option volume is in the Nifty itself. The Nifty PCR is very low – hovering at around 0.7 for all outstandings and at 0.6 for October itself. The classic interpretation is that the market expectation is overwhelmingly in favour of a rise and that in itself means an overbought market. The PCR has generally been a reliable signal.
Volatility has risen as well – the VIX closed at around 40 on Friday after hitting much higher levels intra-day. The VIX is much less reliable in the Indian context and it has a much shorter history. For whatever its worth the VIX is indicating further falls.
Historical volatility is extremely high at the moment and likely to remain so for the rest of the settlement. When you are making margin calculations, budget for sessions where the market moves through 150-250 points. This will occur regardless of direction.
One indicator that is not indicating bearishness is existence of premium of index futures to spot closes. The Nifty was settled at premium to the spot close. So were subsidiary indices such as the Bank Nifty and the CNXIT, although only nominally in the latter. However, technically speaking, Bank Nifty and CNXIT chart patterns seem weak.
Most of the short trading is intra-day but there has also been a build up of short futures positions. The Nifty futures' open interest (OI) has risen steadily even as the index has fallen. Once short covering comes into operation, the market could rise as a result.
Most short-covering will be focussed on the last four sessions before settlement (October 29) but intra-day action on this front may be enough to create sudden pullbacks. It would be prudent to expect sudden 200-250 point upward spikes on days when shorts are covered early and uncommitted day-traders go long. Expect at least one such session next week and cater for it if you are short.
In a market like this, it is very dangerous to keep overnight positions because the market has regularly been opening with a massive gap. This means that traders should be looking to work intra-day or need to hold plenty of excess margin. Preferably, do both. It's difficult to offer concrete advice for handling intra-day scenarios in a weekly column. All one can say is, keep very tight stops and focus on a very narrow range of instruments, preferably just the index.
If we examine November and December options, the OIs and breakevens tend to indicate that most downside expectations range from 3,040 to 3,200. The perspective for the Nifty would be a downside of around 3,050 and an upside of about 3,500 next week. Within that range, there will be lots of volatility. Even option buyers who need not worry so much about margins should probably stay intra-day in outlook.
One problem is that the market has fallen so fast, option liquidity hasn't kept up. Neither put nor call chain has liquidity below 3,300 levels. The 3,300p (198.5) is almost at the money and will breakeven below 3,100. Put premiums may see violent change because right now, a bearspread of long 3,400p (249) and short 3,300p at Friday's settlement prices would offer an arbitraged profit.
We can construct bullspreads with a long 3,400c (153.35) and a short 3,500c (111.75). This offers a maximum return of 59 on a cost of 41. Probably the bullspread is worth taking. The other possibility is an uncovered straddle at 3,300 – this costs about 405 and works only if the market swings outside 2,900-3,700. Not a great position in my opinion. Option traders will just have to wait for liquidity to develop below 3,300, ideally down to around 3,000 levels.
In practice, short futures positions (with stops) can be combined with long calls or bullspreads. For example, a short Nifty future with a stop loss at 3,350 and a long call at 3,400c would work if the market dropped.
STOCK FUTURES/ OPTIONS
In the stock market, very few long positions look attractive while there are a multitude of apparently attractive shorts. The most logical shorts are in the private banking and finance segments and in IT/ ITES where the slide could be more than the market. Reliance Capital, Kotak Bank and HDFC are possibilities, so is Wipro where you can keep a stop at Rs 275 and short with a target of Rs 240.
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