Spot Prices Could Drop Further

Most technical tools work best when prices are definitely trending. Unfortunately stocks often bounce randomly up and down inside a range instead.

It is difficult to make money during range-trading. It is also difficult to develop technical tools that give reliable signals during these times. And, reliable advance warning of a breakout in either direction doesn't really exist either.

However, Fibonacci calculations can help. It is sometimes possible to use those number series to pinpoint a time period when new trends might develop. But Fibonaccis often don't give conclusive answers.

Another possibility is observation of the derivatives market. If F&Os suggest a certain trading pattern, at least you know market expectations. In India, one has to adjust for the systems of settlement, margin and carryover.

The spot market seems to be heading towards the bottom of a range and may in fact have made a breakout into a downtrend this week. Can we make judgements as to the future pattern from watching F&Os?

Settlement on the last Thursday always leads to a rise in trading volumes during that last week. There is also always a rise in open interest in the next month's F&Os. However, premiums (cost of carry) may move in either direction and they are an useful indication of market mood. So are Put-Call ratios. The P-C ratio is an useful indicator of overbought or oversold conditions.

Trading volumes were high during the Budget week, which naturally coincides with the settlement, and have since dropped. This is the usual trading pattern, and no conclusions can be drawn from this. Open interest has risen quite a lot however - this is interesting.

Even if we make allowances for the fact that there is always a rise in open interest in the first week of a new settlement, the rise appears significant.

Most trades are usually short-term with speculators trying to profit from the momentary fluctuations in premiums. Even if volumes rise, open interest doesn't necessarily do so. Given higher OI, let's assume that more people are looking to hold until close to expiry.

The P-C ratio has shown a pronounced rise in the last five days. This suggests that the market is getting more bearish in its outlook. The P-C ratio has now hit the 0.6 mark - that is, there are around six open Puts per 10 open Calls.

This seems quite high but P-C ratios have often topped the 0.7 mark before the market has seen a short-term rise. So we could suspect a further drop.

The premium situation is also interesting. While futures have declined, they have declined less than spot prices. The cost of carry has actually increased in futures. In Put options, the premiums have also risen. Either the Put buyers are wrong or the futures buyers are over-optimistic.

What can we make from all this? The fact that spot prices have hit the bottom of a range while P-C ratios could still travel up indicates that spot prices could drop further. In that case, Puts are worth buying and March futures are worth selling. The OI buildup suggests traders' expectations of further falls until the end of March.