Short-term trend looks weak

Expectations seemed too high going into the Budget and there has been a sharp correction in the last few sessions. Retail traders and domestic operators seem to have exited, there has been some foreign institutional investor (FII) selling and domestic institutions continue to be cautious.

As a result, the market has hit its lowest point in five weeks. The Nifty is testing support at 7,450 - this is a pullback of five per cent in three sessions. Small-caps and midcaps have lost more ground due to the switch in retail sentiment.

The long-term trend would still be reckoned up but the intermediate trend is down. The short-term trend looks weak, given poor advance-decline ratios and a fall on high volumes. There could be relief rallies from this point.

One rule of thumb could help guide traders about potentially serious change in sentiment. The market was at 7,200 levels before election results on May 16. A fall below that would mean sentiment had got seriously worse. On the upside, the all-time of 7,808 was hit just before the Budget and the market would have to beat that to confirm a bullish trend.

The monsoon failure could be an inflationary factor while fighting in Iraq remains a potential threat to global crude oil supplies. But there was good news on the macroeconomic front. The May Index of Industrial Production was quite positive, beating expectations. Inflation in June was lower across both the consumer price index and wholesale price index.

That lower inflation may help trigger a rally in Bank Nifty which has lost a lot of ground. But monsoon does mean fears on food inflation. The information technology (IT) index could play its part as a defensive hedge if there is heavy FII selling and, hence, a strong dollar. In other sectors, one would have to wait for the Budget to be fully discounted.

The Nifty's put-call ratio reads as very overbought. The July PCR and three-month PCR are at 0.7, a bearish signal and it is confirmed by the breakdown in the price trends. Option premia have eased slightly, indicating the market may see volatility easing. But the option chains indicate many traders are still braced for big moves. There is ample open interest (OI) up to the July 8,500c though the call OI peaks at 8,000c. In the puts, there is OI down to 6,500p but the peak is at 7,000p, with a big bulge at 7,300p. There's quite a lot of time for the settlement (July 31) so traders could seek spreads at some distance from money. The index is at 7,454 with 30 points premium on the future. A close-to-money bullspread of long 7,500c (80) and short 7,600c (43) is acceptable with a cost of 37 and maximum payoff of 63. A close to money bearspread of long 7,400p (61) and short 7,300p (33) is acceptable with cost of 28 and payoff of 72. The trader can move one step away in either direction and the risk:reward ratios become really attractive. A long 7,300p and short 7,200p (16) costs 17 with a maximum payoff 83. A long 7,600c and short (20) costs 23 with a maximum payoff of 77. These positions are zero-delta and the risk:reward is better for bearspreads. A combination of long-short strangles with long 7,300p, long 7,600c, short 7,200p and short 7,700p costs 39 with break-evens at 7,239 and 7,661.