Traders focus on stock futures

The rally has gone up over 2,000 points and even a mild correction could mean a 400-500 point drop from the peak.

The derivatives market continued to generate high volumes and premiums remained high as well. The focus on stock futures significantly increased.

Index strategies
Throughout the bull-run of the past three months, the hedge ratio (volume of index instruments to all instruments) has been consistently higher than normal. However, last week saw expanding stock futures volumes.

Historically, India generates high stock futures volumes and tends to have low hedge ratios. This can be explained in several ways. All contracts are cash-settled and the lack of an efficient shorting mechanism in the cash segment makes stock futures tempting. Stock futures are instruments that are favoured by individual traders who are optimistic enough to believe that movements will always be in their favour and hence, try to benefit from the leverage.

India's derivatives market features two-and-a-half classes of players. One-and-a-half are the FIIs, who can be divided into hedge funds and long-term investors who hold hedges against equity portfolios. Hedge funds may not bother with cash exposures. FIIs collectively tend to hold 35-40 per cent of outstanding open interest. It was about 36.5 per cent of OI last week, down from over 42 per cent.

The rest of the derivatives volume is generated by traders, who consist of operators with reasonably deep pockets and individuals, who hold a couple of contracts each. Many don't bother to hedge at all. Very few bother to calculate the complexities of arriving at the appropriate index hedge position. They see no point in "wasting" margin.

The falling hedge ratio suggests that individual traders are increasingly making their presence felt. This could also mean that the rally is into its last stretch of overheating followed by collapse. Since intermediate trends rarely last as long as 12 weeks, this is a reasonable prognosis.

However, credible chart projections also suggest the market will top out in the 4,750-4,800 range and that could occur with traders piling long positions on. Either way, stay braced for at least one 150-200 point session next week.

In the cash market, domestic institutions have turned sellers with a vengeance. Last week, DIs sold over Rs 1,500 crore (net) while FIIs bought around Rs 1,400 crore. The market went up because individuals and operators were net long. So FII attitude remains a key to the rally since they alone can balance further DI sales. If FIIs turn net sellers, the intermediate trend would switch.

A switch in the intermediate trend would mean a fairly deep correction. The rally has gone up over 2,000 points and even a mild correction could mean a 400-500 point drop from the peak in a down trend spread over a month or more. A Fibonacci first-stage retraction would mean around 700-points knocked off. There are strong supports at 4,450, 4,300, 4,100 and 3,900.

The subsidiary indices showed interesting trends last week, running counter to their historical behaviour. The CNX IT went up by over 4.5 per cent although the rupee strengthened. The Bank Nifty went down marginally without triggering a fall in the Nifty despite the large weightage of the sector. I suspect that both CNXIT and Bank Nifty could revert to normal patterns next week. If the rupee stays strong, the IT sector will see profit-booking while the Bank Nifty would strengthen if the market does move up.

In the Nifty options segment, OI increased in both puts and calls. The overall put-call ratio (PCR) is at 1.1 (in terms of OI) and its at 1.25 in June and 0.86 in July and beyond. The near-term PCR is still bullish but the overall PCR and the mid-long PCRs suggest market expectations of a fall in the time frames of either late June or early July.

An option trader should try to stay braced for moves between 4,100-5,000 in the context of the settlement and for moves between 4,300-4,800 in the context of next week. Any trader focussed on Nifty futures should at the least, have stops at 4,450 if long and at 4,650 if short.

A bullspread close to money like a long 4,600c (153) and short 4,700c (109) has a cost of 44 and a maximum payoff of 56. This is not bad at all with the spot close at 4,589 and the June futures settled at 4,582. A bearspread of long 4,500p (119) and short 4,400p (85) costs 34 and pays a maximum of 66, which is also quite decent.

A long-strangle of long 4,400p and long 4,700c costs 194 and it can be offset with a strangle of short 4,200p (42) and short 4900c (50) reducing the net cost to 102. This position would have breakevens at 4,802, 4,298 with a maximum return of 98 on a one-sided movement.

Another method of working possible two-way movements is to hold a 4,400-4,500 put-based bearspread and take a long June Nifty futures with a stop at 4,550. The potential maximum loss on this is about 70-90 ( about 35-55 on the future and 34 on the bearspread). It delivers positive returns outside 4,465 on the downside and about 4,625 on the upside.

STOCK FUTURES/OPTIONS

The big volume stock futures contracts include Suzlon, J P Hydro, Reliance Industries, Unitech, DLF, Unitech, Reliance Capital, HDIL, RNRL, Tata Steel, etc. MRPL also shot up on news that it had tied up crude at a discount from Cairn and it may now be worth making a short due to over-exuberance. However, the most interesting priceline seems to be that of J P Hydro which has moved from Rs 55 to around Rs 95 in the past fortnight and is still seeing volume expansion. Go long and keep a trailing stoploss at Rs 90.