The great trader, George Soros, often referred to the theory of reflexivity when it came to trading. Reflexivity was a concept he had borrowed from the late philosopher, Karl Popper. Reflexivity assumes that trading trends can strengthen in a self-referential way via feedback loops, somewhat like weather patterns. As a result, once a trend is in force, it is likely to overshoot rational limits.
In less fancy language, when a price trend develops and momentum traders pile into the trend, that leads to a strengthening of the trend. The trend may for example, have been justified because a stock was under-priced. However, it is likely to push prices past fair valuation to overpriced levels because of the momentum factor. Or, vice versa, an overpriced asset might develop a short trend, which takes it to a point of under-valuation.
However, trends don't develop all that often. The past couple of months have seen the markets marking time rather than displaying any major trends. This situation is not surprising since almost every class of market participant is sitting on the fence and waiting for a resolution of the political situation. A trend can only develop if there is either an excess of cash chasing shares or an excess of shares being offered for sale. Neither situation prevails at the moment.
This situation is likely to prevail until the election results are announced and at that stage, a trend is very likely to develop. Any trend that does develop after a five-month period of fence sitting is liable to be very strong.
This could lead to a very strange situation. The market is reasonably valued at the moment at a current PE of 17-18. It is on the low side of the long-term average valuation but then earnings growth has been quite poor in the past two years. A strong post-election trend could take the market zooming to over-valued levels or alternatively push it down to a level of serious under-valuation.
What the trader sees in this scenario is a likely sudden spike in volatility with no strong directional bias yet. (As elections get closer, opinion polls, etc, could give a stronger directional bias.) In the circumstances, using options to create deep Nifty strangles in the June 2014 or even December 2014 settlement periods is very tempting. For example, the trader might look to buy both calls and puts with strikes at about 600 points (roughly 10 per cent) from the current Nifty levels.
The trader will, however, have to make a difficult decision in terms of when to start taking such positions. Normally, one would expect option premia to fall as the settlement approaches closer. However, this is an unusual situation in that everybody could be expecting a jump in volatility as and when election results are out and it's quite possible that option premia will actually rise.