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| Use close to money spreads |
| Devangshu Datta / New Delhi Jun 22, 2009, 00:21 IST |
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An intermediate reversal could mean net losses over the next 4-6 weeks.
The market turned bearish going into settlement week. Volatility also jumped. The carryover trend was weaker than expected.
Index strategies
After 13 weeks of gains, last week saw net losses. This almost certainly means the intermediate trend has reversed. An intermediate reversal could mean net losses over the next 4-6 weeks. Other indicators also suggest bearish expectations in that timeframe. That’s awkward because the Budget is due.
The bearish indications are clear. FIIs were major sellers for the first time in three months. The ratio of advances to declines was negative. There was some volume contraction in the cash market and carryover was lower than usual going into settlement week.
The put-call ratio captures sentiment well and seems a reliable indicator. A ratio lower than 1 indicates bearishness – calls exceed puts only in overbought conditions. Through the uptrend, the Nifty's overall PCR (calculated in terms of open interest) has been above 1. Last Friday, it dropped to 0.8 overall and it was below 1 in terms of all three series (June, July and beyond).
Interpreting carryover is more hit-and-miss. Broadly, carryover is good when sentiment is buoyant. It was lower last week than in the previous three settlements. The market is full-margin in the last four sessions of a settlement. At that stage, there is contraction in current month OI and a rise in mid-month (and beyond) OI. Strong carryover patterns occur when new positions equal or exceed contracts extinguished.
Usually Nifty futures OI in the mid-month and beyond tends to be around 12-15 per cent of the total Nifty futures OI going into the last four sessions. About 33-40 per cent of Nifty options OI tends to be in mid-month and beyond. This time, about 13 per cent of Nifty futures have carried over – that is on the low side of normal. However, only 18 per cent of Nifty option OI is in mid and beyond. That is a drastic drop.
Another indicator that is, in the Indian context, even more hit-and-miss is the Vix. The implied volatility should rise when the market has bearish expectations. In practice, the VIX is flawed because it places undue weight on mid and long-term option premia and those spreads are illiquid. For what its worth, the VIX is rising.
Extrapolating further on the basis of low carryover, the bulk of option positions tend to be held by FIIs including both hedge funds as well as normal investors protecting their cash exposures. The drop in options OI could mean that a lot of FIIs are geared for exits. Perhaps they intend to sit on the fence until the contours of the Budget are apparent?
This argument is a stretch because FIIs hold around 36-37 per cent of all derivative OI. Bit if it turns out to be true, there will be a huge amount of volume generated next week as FIIs exit and there will be a sudden drop in volumes in the next settlement. Otherwise, if carryover picks up, there will be even higher volumes as new positions are opened.
Therefore either way, volumes are likely to be high and so is the intra-day volatility. The low PCRs also suggest that there is not a great deal of short covering interest. So if the bearishness that developed last week continues, settlement considerations will probably cause prices to firm up much. Unless, of course, a large number of short positions are opened in the next two or three sessions. One would expect one session of short-covering but not more than that.
However, there will be some short interest in the Bank Nifty at least. Banks have been counter-cyclical through this settlement and it was one of the few sectors that gained last week. This trend may continue. IT could also remain a hedge against a falling market since the connection between FII selling and rupee weakness is favourable for the sector.
Technically. the likeliest scenario seems to be movement between 4,100-4,500 with some chance of a sharp drop till the 3,900 level, if FIIs do sell another Rs 3,000-odd crore. Daily volatility is likely to be in 120-150 point high-low ranges. Close-to-money option positions in either direction are very likely to be hit. There is no sense in exploring July option spreads yet. Due to the low OI, premiums are much too high.
A bullspread with long 4,400c (46) and short 4,500c (20.5) costs 25.5 and pays a maximum of 74.5. A bearspread with long 4,300p (63) and short 4,300p (32) costs 31 and pays a maximum of 69. Both are decent risk-reward ratios – the bearspread is much closer to the money and better for that reason.
A long-short strangle combination would work only if the market moves outside the target range of 4,100-4,500. To get a decent risk-reward ratio, you need a long 4,500c and long 4,200p offset by short 4,000p and short 4,700c. A long Nifty future with a stop at 4,250 combined to a long 4,300p- short 4,200p bearspread is a more efficient way to take exposure against volatility. It is nearer the money.
STOCK FUTURES/ OPTIONS
Across the stock futures universe, we can see a recurrent pattern of declining tops and bottoms. This strengthens the feeling that the intermediate trend has reversed. Real estate counters have been hit hard and present several attractive shorts.
Keep tight stops though because there will be short-covering at some stage. Metals saw a recovery on Friday that makes the sector trend difficult to read. Capital goods, engineering and construction and commodity plays also present many bearish pricelines. J P Associates is among these. Keep a stop at Rs 205 and short with a target of about Rs 180.
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