The next down move will come about as India goes into campaign mode.
There has been a spurt in derivatives volumes after the market made a down move. Rising volumes have not been backed by a rising Vix, implying at first glance, that the market will settle down and become less volatile.
Index strategies
The Vix methodology as applied to Indian markets has been vilified by many, including yours truly. The flaw is that it was transplanted wholesale from a much deeper market. Chicago's methodology gives weight to medium and long-term index option premiums assuming basic liquidity across all time-frames.
This is not true in India. It results in computational absurdity in the last eight days of every settlement when highly liquid near-term index options are replaced by illiquid long-term options.
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The spreads on long-term options resemble a sumo wrestler's girth and hence, the VIX is distorted. However, one expects genuine interest committed to the April and May series due to elections. Indeed, open interest in the April and May series' has reached around 35 per cent of all index option open interest.
That is a little higher than normal and it appears to have narrowed April spreads. In turn, that has led to a down-move for the VIX (which uses March and April at this point of settlement). Hence, the apparent paradox of the VIX easing down because traders are nervous about a future event.
It's a point to be borne in mind: if traders are actually taking views on a future event, the initial effect in an illiquid market may be the opposite of the expected–the implied volatility eases.
In other respects, this seems a standard breakout. Volumes have expanded with the breakout and the initial target projections (2,550) have been achieved. Then, there's been a technical reaction, which should result in a pullback to near the breakout point (2,800).
That reaction is likely to be weaker than the initial down move because the major and intermediate trends are down. Projecting a little further ahead, the move after the reaction should be down again. In terms of time, the next down move will come about as India goes into campaign mode.
There is a lot of historic data from the 1990s onward about general elections and their short-term linkages with stock markets. Markets hate uncertainty and elections are chancy affairs. There is always uncertainty during the month-long phase of polling itself. That means volatility.
Given the high chance of a coalition, there is also likely to be uncertainty during the post-election phase while alliances are thrashed out and horses traded. Finally, specific industrial groups are seen to have linkages with specific political groups and the market discounts accordingly.
Net-net, elections are always accompanied by volatility and usually accentuate any bearishness that may exist. This is short-term– the market's initial reactions are often wrong. But common sense backed by statistical evidence suggests that the electoral process will trigger one or two months of higher volatility and very likely, lower prices as well.
Coupled to that, we already have the rupee entering a new realm of lows. This is partly triggered by FII sell-outs but it could end up creating a feedback loop where more sales happen because a rupee downtrend is established. The currency risk adds a further element of volatility. It also makes the CNXIT an attractive hedge.
Based on historical stats, it's very likely that option premiums will not reflect that situation and therefore, be somewhat underpriced, during the next three months. This is the sort of situation where option traders want to be long rather than sellers. It is also the sort of situation where far-from-money situations could offer massive payoffs.
In the context of the next week or so, the market could move up. It has an upside till 2,800-2,850. However, in the context of the next month or so, a move down till the 2,250 levels seems very likely.
There is a logical case for any option trader who is taking directional views to be consistently seeking far-from-money positions with a bearish bias until such time as the next government is installed.
Any technical reaction has to be driven by the Bank Nifty because that is a large component of the Nifty and it has seen inordinately large losses. There is a case for a short-term position in long Bank Nifty futures, which settled at about 3,450 on Friday. Stop loss at about 3,350 and go long with a target of 3,650.
In the options market, a bullspread with a long 2,700c (39.5) and a short 2,800c (15) costs about 24 and offers a maximum return of 76. A bearspread with long 2,600p (78) and short 2,500p (45) costs 33 and pays a maximum of 67. A wider bearspread of long 2,500p and short 2,400p (25) costs 20 and pays a maximum of 80.
These have good risk-reward ratios and so does a long-short strangle composed of long 2,500p and long 2,700c offset by short 2,400p and short 2,800c. That costs a maximum of 57 and offers a one-way maximum return of 43. But both sides of the position could be hit before settlement.
| STOCK FUTURES/ OPTIONS There are a couple of long stock positions that look quite interesting. TCS appears to be well-placed to ride rupee weakness. Keep a stop at Rs 475 and go long with a potential target in the range of Rs 510-Rs 515. ICICI Bank is another possible long position, it could run till around the Rs 285-Rs 290 levels. Keep a stop at Rs 265. If you want a short position, Reliance Capital looks quite tempting. Keep a stop at Rs 300. |