Caution in the air

SMARTSHARE

After Bush played Santa last week, it was the turn of Saint Bernanke to play Kris Kringle. This concerted efforts by five central banks of the world can help needy banks since it comes with a shroud of secrecy as no bank worth its salt would be willing to be seen borrowing from the Fed.

But back home, the derivatives data is becoming a concern and some of the key ratios are getting into an area of discomfort. The last time derivatives statistics were blamed for triggering a fall in the market was in May 2006. Those numbers are now almost there.

The main concern is that the ratio of Stock Futures OI to total Futures OI has risen to the levels that are no more in the comfort zone. The ratio had reached 79 per cent in May and is currently pegged at the same level now. The second concern is that the percentage of Total Futures (Stock + Indices) to Total OI has risen to 81 per cent, which was 82 per cent in May.

And the third concern is that the percentage of Nifty OI to Total OI has fallen to 31. It was 30 per cent in May 2006. Taken together, these ratios all point towards one development "" the high proportion of Stock Futures. Now what's wrong with that? We will come to this later.

An increase in Open Interest, accompanied by a price rise, is considered bullish by markets. The current total OI at Rs 11,792 crore is more than double that of May 2006. Nothing wrong with that except that this high open interest starts becoming a millstone when prices tumble.

Positions taken in derivatives are leveraged positions. That means you are allowed to take positions worth several times your margin. It works to your advantage when prices go in the direction you intended them to go. But your margin can get wiped out if prices move in the opposite direction. No wonder Warren Buffet calls them weapons of mass destruction.

Long positions in futures can be hedged by buying puts. But there should be a ready-seller and at your price. Unfortunately, stock options account for just 5 per cent of the total stock related OI. Barring a handful of stocks, options are not liquid. For instance, in the November series not a single option, either a Put or Call, was traded at the HDFC counter, a leading bank and a Sensex constituent. To expect liquidity from lesser mortals would be asking for too much.

So when Futures start tumbling, traders have no option but to sell their futures. This brings selling pressure and markets tumble further, which has a cascading effect. Nifty, on the other hand, has options which are liquid. So if the markets start tumbling, they can always buy Puts.

The markets are on a relatively stronger footing if the proportion of the Nifty Futures to total Futures OI is higher. But in India, as Stock Futures are more popular, the proportion of Stock Futures to Total Futures tends to be higher. Currently it is at 79 per cent (it is known to go down to 65-68 per cent) and we are at the higher end of the range.

While our mid-caps are doing fine, the movements of large caps is an issue. The top five stocks in the derivatives, in terms of open interest, had added 25 per cent open interest in the first 10 sessions of the November series. Whereas in December, the top five stocks have added just 14 per cent in the OI. This indicates that the stocks, which occupy a lot of the market OI, are not really moving.

Essentially, I see reluctance on the part of the big elephants (read bulls) to move. That usually happens when a tiger (read bear) is crouching somewhere in the vicinity.