Derivatives volumes remained high in a truncated week when net gains were registered. There was a clear trend of carryover into April and May with a lot of March index positions extinguished.
Index strategies
Corporates have suffered rating downgrades and India’s sovereign outlook has deteriorated from “stable” to “negative”. FIIs have cut back on India exposure due to wariness about the rising fiscal deficit. In turn, that has led to rapid rupee depreciation.
The rupee firmed last week as FIIs did a little buying for a change. In a thin cash market, that was enough to lift prices. The short-term bullishness could continue with healthy short-term signals such as premiums in index futures versus respective underlyings and also, bullish put-call ratios in index options.
However, this bullishness may be temporary and the trading focus is shifting to the election months of April-May. About 16.5 lakh March Nifty futures were extinguished on last Friday and 11 lakh new April futures positions opened. Similarly, a lot of April calls were settled and new May calls opened.
Right now, about 13 per cent of index futures Open Interest (OI) is in April-May and around 44 per cent of index option OI is also in April and beyond. That is unusually high and the early carryover, if it can be termed that, is obviously triggered by elections.
The technical perspective gels with historical statistics of market behaviour in proximity to elections. Technically, the current phase should lead to recovery till around the 2,800 mark followed by another downtrend starting late next week or early in settlement week.
By then, India will be on the cusp of elections and those are usually marked by high-volatility, bearish trading. Almost certainly, the 2,500-2,600 support levels will be tested and broken. The 2,250 support that held in October 2008 will probably be tested and there is a good chance that it will be broken, if there is a messy coalition. There could also be a quick bounce if political stability seems achievable. But, weak macro-economic conditions make a genuine trend reversal unlikely.
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In the short run of the next 4-5 sessions, long positions in both the CNXIT and the BankNifty appear tempting for the bullish trader. Both indices are liable to outperform the Nifty. The IT industry has received some boost from the weak rupee. The BankNifty has benefited both from short-covering and also from the market’s favourable reception of gradual cuts in commercial lending rates. However, there are clear caps on the upsides. The CNXIT and BankNifty are liable to peak out at about 2,300 and 3,750, respectively. Anybody going long will also have to maintain disciplined stops because there are no easy hedges for either index.
The historical data pertaining to an election scenario also suggests implied volatility as measured by option premia is likely to understate historical volatility. The rule of thumb for traders should be to buy options in such a situation.
There is a strong case for emulating Nassim Taleb in the April-May settlements. Taleb made a fortune in the 1987 crash by buying cheap out-of-money puts. It is a strategy that usually loses small sums of money and only gains in very exceptional circumstances.
Consider what happened in May 2004. Fears of a hung Parliament triggered a 23 per cent fall in five sessions. In election months, there has usually been a swing of about 15 per cent. An option taken about 10 per cent away from money generally costs between 0.3 per cent and 0.5 per cent. In a market that swings 15 per cent in a single settlement, such a position offers a payoff of 1,000 per cent or more. The risk-reward equation suggests that it would be worth keeping such positions.
Unfortunately implementing such a strategy right now is not cost-effective. The Taleb-imitators will have to wait until April kicks in. In the meantime, we need to look at conventional spreads with the timeframe of two weeks. Here, the trader must consider possible moves between 2,400-2,900 with the market more likely to remain inside the range of 2,500-2,800.
A long 2,700c (72) and a short 2,800c (28) costs a net 44 and pays a maximum 56. A long 2,600p (26) and a short 2,500p (13) costs 13 and pays a maximum of 87. The massive discrepancy between the bearspread and the bullspread is due to the fact that the Nifty closed at 2,695. A wider bullspread of long 2,800c and short 2,900c (7.5) costs 20.5 and pays a maximum of 79.5. But, this position is unlikely to be fully realised although it would gain on any upwards move even if it isn’t struck at all.
A strangle-set that combines long 2,800c and long 2,600p with short 2,900c and short 2,500p costs a net 34 and pays a maximum of 66 for a one-sided movement. The upside is unlikely to be fully realised in any event. On balance, the option trader should take the March 2,500-2,600 bearspread and wait until April before trying to do a Taleb.
| STOCK FUTURES/ OPTIONS There is a problem for the stock futures trader. Most stocks are in short-term uptrends that are liable to hit resistance fairly soon. |