The risks of leveraging

Mild fear has replaced nascent greed in the markets. The Sensex has dropped nearly 600 points, or almost 9 per cent, in seven trading days.

On Wednesday, the sell-off led to leveraged positions being unwound hastily, and operators resorted to selling in the cash market to fund their losses and margin calls in the futures markets.

Traders sold off stocks on which they were making money to fund losses on other scrips. This had a cascading effect on all stocks. Mid-cap stocks were badly hit, because even a bit of selling is enough to send these illiquid scrips plunging.

In December, there had been plenty of reasons for optimism. The flood of dollars into emerging markets was expected to continue, with the dollar testing new lows.

That assessment was jolted in the first week of January, thanks to the minutes of a US Federal Open Market Committee meeting which showed that the Fed was concerned that its rate increases of 25 basis points each were not doing enough to contain inflation.

At the same time, the one-way fall in the dollar's value was arrested and the US currency started appreciating. The upshot: a rise in bond yields, a reduced appetite for risk, and sell-offs in emerging markets, gold and metals.

Hedge funds, which operate the "carry trade"""borrowing at low US interest rates to fund their bets""dumped assets. Global funds recorded their second largest outflows, after the meltdown last May.

Indian equities have been among the hardest hit.

This week, however, most other markets have stabilised, the dollar has stopped appreciating, and metals have recovered, but the Indian market continues to fall.

The reasons for this second wave of selling lie in conditions internal to the Indian market. Plainly, the initial selling, by FIIs or hedge funds, served as the trigger for capitulation by others.

Speculators had built up large positions all through December, on the assumption that larger allocations by foreign investors to India would lead to further buying by FIIs in January.

This fond belief evaporated after FIIs started selling instead of buying in January. To be sure, they didn't sell large amounts, but even the absence of fresh buying was enough to trigger a rush for the exit doors.

And once the margin calls started coming in, over-leveraged traders had no option but to sell in the cash market. Stop-loss orders added to the selling.

While the market had run up too far too fast, and most investors believed that a correction would be healthy, nobody anticipated such a plunge in such a short time.

The short-term reality is that open positions continue to be high, so it's possible that the unwinding of futures positions may still have some way to go.

The positive news is that valuations have become more attractive. On the evidence so far, third quarter corporate results are unlikely to disappoint.

And the dollar appreciation may be just a blip. In short, the "fundamentals" continue to be sound, and there is no reason for panic.