The market was ripe for a reversal

MARKET INSIGHT/ When the odds are in favour, it makes sense to bet against the trend

Suppose you were offered 6:5 on a coin toss? That is, every winning call fetched Rs 1.20, while Rs 1 was shelled out on a losing toss. It's a great offer since an unbiased coin has a 50 per cent chance of landing in your favour. Occasionally, the derivatives markets offer equally good deals. It's one of the most useful warning signs of a correction.

There are always several warning signs before a market correction. For example, look at the situation for about a month or so before the December 8 crash. Trading narrowed with volumes concentrated in highly liquid stocks. There was an absence of volatility - the intra-day high-low ranges narrowed - even though stocks were at record highs.

Most interestingly, the payoff:cost ratios of standard option spreads went haywire as near-money premiums became asymmetric. Option spreads offers nearly exact payoff-to-loss calculations. The Nifty option chain consists of liquid contracts at 50-point intervals around the prevailing spot and near-term futures prices (these are usually within 10-20 points of each other).

By and large, bull (bear) spreads consisting of a long near-the-money call (put) coupled to a further from money call (put) offer mildly favourable payoffs. Over a 50-point range, the minimum available in practice, the maximum payoff usually consists of between 28-30 on a cost of 20-22. Usually bull and bear spreads offer roughly similar payoffs.

Now, a 50-point range is equivalent to a movement of around 1.25-1.3 per cent at current prices. The Nifty swings almost 2 per cent in a typical session. (Mean daily swing 1.99 per cent; Median daily swing 1.62 per cent since January 2004). A spread can be held until the end of the monthly settlement. The chance of a 1-2 per cent swing in either direction is as close to 50 per cent as makes no difference.

In the lead-up to December 8, this relatively even ratio of payout to cost changed. Call premiums spurted close-to-money and, hence, the payoffs for bull spreads narrowed to below par. By December 1, the Nifty was trading at 3997 in the spot market. A close to money bullspread with a long 4000 call (premium 98.15) versus a short 4050c (68.8) cost about 30. The maximum payoff was 20.

In contrast, a bearspread with long 4000p (93) and short 3950p (75.5) cost about 18 and the maximum payoff was 32. Even much earlier, by November 10, when the spot Nifty was at 3835, a bullspread with long 3850c (60.45) and short 3900c (35.6) cost 25 and paid a maximum of 25. A bearspread with long 3800p (51.5) and short 3750p (36.8) cost about 15 and paid a maximum of 35.

While the overall trend was unquestionably up during November, and early December, the odds were skewed in favour of option bearspreads owing to the asymmetric premium-pricing. In fact, bear spreads fetched positive returns in the November settlement (October 26- Nov 30) on the basis of a few single-session blips though the Nifty gained 7.5 per cent over this period.

Some four weeks before the price correction, the odds already favoured bear spreads. And in the December settlement, bear spreads continued to offer significantly better payoffs than calls. Until the market broke. At this point, the payoff ratios reversed!

On December 8, when the Nifty closed at 3962, a long 3950p (76.65) versus short 3900p (54.55) offered a payoff of roughly 28 on a cost of 22. By December 21 when the Nifty was down to 3834, the long 3850p (78.2) versus short 3800p (50.2) offered a maximum return of 22 on a cost of 28. Has the wheel turned full circle since bullspreads now offer better odds?

The cautious trader would argue that over the past three years, the Nifty has delivered long periods of continuously climbing prices when bear spreads would have lost money. That is entirely true. But there have been few periods when the risk : return equation for close-to-money option spreads have been skewed enough to suggest that betting with the trend does not make sense. One of those occurred in April-May 2006 before the mid-year crash.

When the odds are sufficiently in favour, it makes sense to bet against the trend. Nassim Nicholas Taleb has made a fortune on low-strike rate / high reward trading. He buys cheap out-of-money positions and loses small sums very often. His rare wins are sufficiently rewarding to keep him ahead of the game.

You may not care for a low strike-rate strategy. You may not even play the options market. But when the odds are out of whack, you do receive a signal that tells you the market is ripe for reversal.