Market likely to continue making gains till May 16

Take a look at prices on May 15 and assume a five per cent move in either direction by May 29. Then, strangle with long puts and calls

"In the short run, the stock market is like a voting machine and in the long run, like a weighing machine." Benjamin Graham, an investment legend, once said this. Incidentally, nobody has ever defined "long" and "short" in a hard-and-fast way.

Stock prices react continuously to the news and the ebb and flow of sentiment. Theorists hope those fluctuations even out in the long run, with the irrational downturns cancelled by the irrational uptrends to leave prices that, more or less, reflect fair fundamental values.

It is very difficult to say if this is just wishful thinking or true. In the very long run, it is true stock prices seem to reflect fundamental variables such as earnings growth, return on capital, operating margins, etc. But a given stock, or an entire market, can be undervalued or over-valued for years.

There have been many studies of the potential impact of a news event on stock prices. The conclusions are inconclusive - markets respond in many different ways to similar events. There seems a slight bias in favour of positive news. Markets move up more for a positive event than they lose ground for a negative one.

It is also very difficult, if not impossible, to control for possibilities like news leakage (benefiting insiders), for high cash liquidity, for "background sentiment" (is the good news coming in a bull market or a bear market?) and a host of other factors.

One tentative conclusion researchers draw is that the positive bias is due to good news leaking more than bad news. It could also be due to the fact that shorting a stock is usually much more difficult than going long.

What does one do about news-based events like quarterly results, central bank policy reviews, Budget announcements, elections, disasters and other events? It is "bottom-up", company-specific moves in terms of trading quarterly results. Sometimes, a smart investor can extrapolate from results in one company to guess correctly about trends in a peer company with the same characteristics.

In case of disasters, the impact can be blanket-negative with even businesses unaffected by the event also beaten down due to poor sentiment. This often gives investors a chance to pick companies at low valuations. There is an obvious difference between a poor monsoon and an earthquake.

Budgets and central bank reviews tend to trigger responses based on a combination of guesses and possible information leakages. Big investors and traders crunch various risk-reward equations and make guesses about the likely policy direction, based on what they know of the officials in charge.

Election results are unknowns. In the era of electronic voting, there is very little or no scope for hold-ups in information and a process of continuous updation of results. So there is little chance of insider trading. It boils down to placing bets prior to the counting and hoping one has judged both the poll results and prevailing sentiment correctly.

There are three possibilities from a trader's perspective when it comes to the general elections. The results are due on May 16. Until then, the market is likely to continue making gains. After May 16, there will be a surge or a crash or there will be range-trading.

The surge is likely if the BJP-NDA has a smooth verdict and a stable majority. The crash will occur if the BJP does badly, confounding all those who are following the opinion polls. The range-trading will occur if it seems the NDA can put together a government but it's not cast iron. In this case, there will be a delayed breakout, with the direction depending on the ability of the BJP to put a government together.

This is the classic sort of situation for an option trader. Look at long call positions through April and early May. On Thursday, May 15, take a look at prices and assume there could be a five per cent move in either direction by settlement (May 29). At that stage, strangle with long puts and calls. This could fetch you great returns, regardless of who wins.