Banning of PN stock-lending increases possibility of short-covering which means disproportionately large bounces in this low-volume market.
The past two weeks, prices have fallen so fast, option traders have trouble due to the lack of quotes at the south end of option chains. Although last week started on a bright note, it ended very weak.
Index strategies
Since breaking the 3,800 support, the Nifty has fallen 750 points inside 10 sessions. This incorporates one strong pullback and several sessions of sideways trading. Volatility has risen sharply with intra-day movements of 200-250 points. The VIX at 46 says implied volatility is also very high.
The FIIs continue to hold around 35-40 per cent of all derivative outstandings while being consistent sellers in cash. But despite the volatility and this consistent firangi trading pattern, the derivatives market hasn’t seen high volumes. Instead it has seen a narrowing trend. Trading is concentrated on the Nifty. The downtrend has been pretty much spread across all industries but stocks with high leverage and high FII holdings have lost more ground.
Settlement is two weeks away and though margins have been hiked, we’ve seen short-covering doesn’t come in a major way until full margin is imposed in the last four sessions. But the banning of stock-lending through PNs does increase the possibility of short-covering and any short-covering could cause disproportionately large bounces in this low-volume market. The cash market momentum signals are heavily oversold but in situations when the trends (long, short and intermediate) are in phase (all bearish at the same moment), equities can be oversold and continue down.
Derivative market signals are also bearish. Index derivatives are at discounts or very small premiums to underlyings. The Vix is travelling higher. The Nifty put-call ratio (in terms of open interest) stands at 0.55 for October and at about 0.7 for all Nifty option OI. The PCR is very low and bearish and hedge ratios are very high. All these are signs of a continuing downtrend at least until fairly close to the settlement.
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Carryover trends are moderate with only 33 per cent of index OI in November and beyond. A very high proportion of daily volume has been day-trading. This is understandable. The market is swinging at high velocity and often opening with gaps of 2 per cent up or down.
So margin considerations dissuade traders from overnight positions. In index futures derivatives, there is a possible calendar arbitrage with the October Nifty settled at 3,071 while the November Nifty was settled at 3,097. Go long in October and short November would be the prescription. The difference should narrow to about 8-10 points by the end of next week.
There has been a peculiar problem in the option chain. As mentioned above, the downtrend has been so rapid that put liquidity has not caught up. This problem remains. The lowest available liquid put is the October 3050p which is barely 20-25 points from the money. Bearspreads cannot be created. Nor can strangles at a reasonable distance from the money. This has contributed to the exaggeratedly low PCR because winning puts have been cashed out.
On Monday, there’s likely to be an upheaval in the put chain with premiums changing sharply and quotes becoming available in the 3,000p and 2,900p contracts unless the market opens very high.
But until put option liquidity develops below current prices, the trader will have to find innovative means of trading downtrends. One possibility is of course, the simple short future. The problem with this is margin - the market may open high and destroy an overnight short futures position. A short Nifty futures trader will need to maintain tight stop losses of not more than about 50 points from the position.
Other possible ways to exploit a downtrend include the following:
Sell calls to create reversed bearspreads
Buy in-the-money puts and hope that the market continues to move down, leading to a higher premium.
Both carry risks.
The reversed bearspread would lose a lot on any uptrend.
Winning puts are expensive and difficult to layoff.
What are the downside expectations? A look at the December 2008 put option chain suggests that a significant amount of money expects breakevens in the 2,800-range. Last week, that was around 3,050. What are the upside expectations? The market could lift till around 3,450-3,500 on some short-covering and it will probably test those levels at least once more in the settlement.
A bullspread with long 3,200c (97.9) and a short 3,300c (64) costs a total of 34 and pays a maximum of 66. An in-the-money bearspread of long 3,200p (224.85) and a short 3,100p (171.05) costs 54 and pays a maximum of 46. This will obviously change since it offers an arbitrage profit. A reversed bearspread such as long 3,500c (26) and short 3,600c (16.45) pays an initial 11.5 and could cost a maximum of 88.5. It is however, reasonably far from the money and not that risky.
The bullspreads are likely to be hit at least once and they have decent risk- reward ratios. The reversed bearspread is unlikely to be hit but it has a very adverse risk-reward ratio.
| STOCK FUTURES/ OPTIONS There are very few stocks that seem outright bullish. Indian Oil is possible long futures position – keep a stop at Rs 395. DLF (Rs 293) and Infosys (Rs 1,200) also look to have hit reasonable support and may bounce on short-covering. Keep stops at Rs 285 and Rs 1,250 respectively. On the short side, there’s a plethora of potential choices. NTPC would be a good pick. Keep a stop at Rs156. |