Strategies to play a potential downtrend

Globalisation offers access to external funding. Capital flows towards excess returns and boosts growth in the capital-scarce developing economies. In its wake, other resources are shared—technology, highly skilled professionals, exposure to best practices, etc.

But capital flows depend on a multitude of variables, most of which are beyond control. If money flows out with great momentum at the wrong moment, horrible things may happen. The Asian Flu of 1997 saw apparently healthy, export-oriented economies like Thailand and Indonesia going through currency collapse as their forex reserves disappeared in a few days.

The most scary variables centre on the PRC-US trade and currency equations. China derives a very substantial chunk of its GDP from exports to the US. The PRC (People’s Republic of China) ploughs the dollars back into US treasury bills to help maintain favourable exchange rates. If the PRC rebalances its forex reserves and exchange rates change (the yuan is a pegged currency), there is turmoil.

Of course, the PRC also tracks its own domestic rates. It is currently going through high inflation. So, there is speculation about a rise in rates. That will impact domestic consumption after some lag. It will also affect forex rates. A slowdown in the PRC means a negative impact on global GDP. In specific raw materials, and intermediates, like metals, coal, auto ancillaries, etc, China is, the largest importer — re-exporting after value-additions.

Until the PRC situation stabilises, portfolio flows will be jerky. Many FIIs will flee to “safe”, hard currency assets. There is no telling how long this uncertainty could last. It should take the stock markets down somewhat further than we've already seen. Fibonacci retracement calculations suggest successively lower levels of Nifty 5,975; 5,700 and 5,500 are possible in the case of sustained corrections. The first level has already been hit several times in the past month.

One way of playing a potential downtrend is a relatively cheap and deep December bearspread such as long December 5,800-put (Rs83) and short December 5,600-put (Rs59). This costs Rs24, and creates a position that makes a theoretical maximum of Rs76. If the market does fall, even if it doesn't go all the way to 5,600, the spread will appreciate in value.

The cost of such a position can be lowered further to a net Rs15 by taking the opposed short November 5,800-put (Rs16) and long November 5,800-put (Rs7). The reversed bullspread could lose if the Nifty does slide below 5,800 by November 25. But those losses will be compensated for by corresponding appreciation in the December position.

There will also be a lot of action in the currency markets. One fairly low-risk method of exploiting this is to play the USDINR equation. The dollar is likely to appreciate versus the rupee due to portfolio outflows from India, if nothing else. If you keep a stop-loss at Rs45.15, going long on the December USDINR futures (last price Rs45.67) could be a good punt.

The author is a technical and equity analyst