Where is the Nifty headed - 4,500 or 6,000?

The Q1, 2012-13 results were quite poor. When that is coupled with a negative IIP trend and the prospects of a poor monsoon, as well as falling exports, the macro-economic signals seem bad. However, the market has stubbornly refused to react downwards.

Broadly, there are two factors keeping stock prices afloat. One is the hope that finally, the situation has deteriorated to the point where reforms may be forced on a reluctant government. The other is excess liquidity flowing into Indian equity from foreign institutional investor (FII) operations. On a comparative basis, India remains a marginally more attractive destination than most large global economies.

This is not a stable situation. If the bulls are correct, we will have to see concrete policy action pretty soon. If reform does start being implemented, the inflows will accelerate, pushing equity prices up. Otherwise, the money will start pulling out again and the market will crash.

When one says “pretty soon”, it is difficult to define a time period. I would personally suspect that the smart money will perhaps, wait till the Q2 corporate results. By mid-October, if not earlier, if there are no signs of a pick-up either in the business cycle, or in policy action, money will start pulling out. Alternatively, if there is a pick up, there will be more money coming in.

Either way, we have what technical analysts call a trading range. We could see a 10-15 per cent swing in either direction from here by the end of the year. This implies that by December 2012-January 2013, the Nifty might be at either 4,500 or 6,000. My personal bias is bearish, but I wouldn’t pretend to know either the mindsets of politicians or FIIs.

This is a difficult situation for a fundamental long-term investor. You cannot commit large amounts to equity without the serious risk of capital loss if a downtrend starts. Nor can you walk away from the market because it could be on the verge of a serious upmove.

How can a trader exploit this situation? The best shot that I can think of is to look for a series of very wide strangles in the Nifty options market. The trader can take a long 4,500p and a long 6,000c position in the December 2012 series. Or he can buy the same options in the August series and rollover into September, October, November, December, etc.

A combination long strangle position of December 4,500p (29) and December 6,000c (49) costs 78. You can reasonably expect to double return (actually 3 times is likely) if either option is struck. It may cost less to take these positions in August (total cost of about 22) and rollover into September, etc.