Book profits on long positions on or before Budget

A good or bad Budget either way will give a chance to re-invest

Investors extrapolate likely future trends from past data. These estimates have an inbuilt error factor and varied timeframes. So, although the market leads the real economy, there is no hard and fast rule about the lead-time. The stock market may lead the real economy by six months, by a year, or a few weeks. In addition, liquidity counts. If there is spare money, it lands in the stock market.

February tends to see a focus on the Budget, which means lead time shortens to just about a month. Short-term inflows occur in February in the hope of a good Budget. This creates a “buy on rumour, sell on news” situation. If there's a good Budget, the short-term money exits with profits. Otherwise, it exits at a loss. Of course, if it's a good Budget, long-term money flows in.

We may have the pre-conditions for a large pre-Budget rally. January points in that direction. The stock market is up over 10 per cent, the government of India sounds cautiously optimistic. Externally, there are hopes of containing the Euro Crisis. Liquidity has improved because FIIs have been net buyers.

On the policy front, the UPA may embark on long delayed reforms if the Congress improves standings in assembly elections. However, Pranab babu won't have two entirely different documents waiting on election results though he may have contingency provisions.

All these guesstimates could also go wrong. Elections may yield unhelpful results for the UPA. The scams that have destroyed credibility may have an impact if more ministers are indicted. Eurozone negotiations may totally collapse. The tension with Iran may leave India scrambling for alternative energy sources (India imports about 12 per cent of its crude from Iran).

But all the negative outcomes except for Iran would take more than a month to fructify. Iran is the only situation that could blow up in the next three weeks. Negotiations centred on Greek debt may fizzle out but Greece won't default immediately even then. Scams will meander through the justice system taking their own sweet time.

Over the next three months or so, I think there are just too many potentially negative situations to cater for. Finances are reeling with massive and growing deficits. Corporates are facing continuing pressure due to high interest rates. There will be some Eurozone unpleasantness, for sure. Crude prices will stay high due to volatile geopolitics.

Strictly in value terms too, a market trading at a current PE of 19 doesn't seem justifiable from the point of view of earnings growth. Earnings Per Share (EPS) growth in the past four quarters has been barely 10 per cent. We'd need to see a doubling in the rate to justify PE 19. Such an acceleration isn't likely until Q3, 2012-13, even if all goes well.

So February is a narrow bull market window. Prices seem likely to go up but unlikely to be sustainable. One way to play this sort of situation is to hedge your bets. Go long in February and hedge with long Nifty puts. Let's see how this could work. The Feb 2012, 5000 Nifty put last traded at a premium of around Rs 24. If the market drops 200 points, this would double in value. At a leverage of 10:1, you can take a long futures position in the Feb Nifty at about 5350.

Suppose you hedge each long Feb future with a long put. On the upside, breakeven occurs at about 5375. On the downside, the option premium rises if the Nifty falls, offering protection. If the market rises beyond say, 5450, liquidate puts. If it drops till say 5200, cut losses by exiting futures and hold the puts to recover some losses.

This is a simple derivatives traders' strategy. You can vary the ratio of puts to futures for a bigger hedge. Or, you write calls above say, 5500c to generate cash to fund the position. Similar ideas work for positions that can be benchmarked to the Nifty. For example, a specific stock can be benchmarked via its correlation and sensitivity to the Nifty. So can units of an index ETF.

If things are panning out fine, you can carryover positions into the March settlement. February settlement occurs on Feb 23 so the early part of the March settlement period would be bullish given a pre-Budget rally.

Either way, I'd want to book profits on any long positions on or before Budget Day. If the Budget is great, there will always be a chance to get back into the market. If the Budget doesn't live up to expectations, or some other unpleasant event occurs, the market will collapse from higher levels.