The hedge ratio at over 2 is exceedingly high.
The week saw moderate volumes and a strong focus on index instruments as traders seemed afraid to make large commitments on either side of the fence. Prices continued to drop as the selling pressure from FIIs continued.
Index strategies
Technicians often talk about the “hedge ratio”(HR), which can be loosely defined as the number of index instrument positions (say short Nifty futures) required to hedge a stock position (say long Reliance futures) against an adverse movement.
However, the HR can also be seen as just the number of index contracts outstanding versus the number of non-index contracts outstanding. In a bull market, the HR tends to be low. In a bear market it tends to rise. The implications are that stock futures and options dwindle in liquidity as traders focus on the key market direction.
Right now, the HR is over 2, which is exceedingly high and suggests a very bearish outlook. Index instruments make up 70 per cent of all open interest.
This bearish sentiment is backed by several other signals. The FIIs continue to hold exposures in the range of 37 per cent of all open interest (OI) but their index exposures are around 65 per cent of all their positions and 43 per cent of their exposures are in index options. It seems that we can expect more selling in the cash market from hedge funds and FIIs reeling under redemption pressures.
There are also the put-call ratios (PCRs) for both the overall market as well as for Nifty options alone. PCRs also suggest an overbought market. In the October settlement, the Nifty PCR is around 0.75 and it's around 0.95 across all Nifty options. In stock options, the PCR is about 0.25, which is also quite low. The PCR tends to be a fairly reliable short-term signal.
Less reliably, the VIX is at 35, and edging higher, which should also suggest bearishness. Index futures settled at small premiums to spot on Friday. The Bank Nifty is interestingly poised with around four lakh in OI. The banking index swung through a huge range to close down 0.6 per cent in a week when it was down 10 per cent at one stage. It could stabilise next week at somewhat higher levels.
The CNXIT has continued to lose ground on weakness in the US economy but at some stage the weak rupee should act as a counter balance. Mid-October, the second half guidance from Infosys will probably offer some sense of direction. Since everybody is bearish, a contrarian could be cautiously bullish on the basis that much of the bad news has been discounted.
However, while the Bank Nifty and CNXIT will draw their share of attention, the main focus of the next week will remain the Nifty. That presents an interesting problem. In technical terms, the support at 3,800 has just about held since the market has not closed below that level. However, it has swung as low as 3,715 on intra-day basis.
If it does close below 3,800, there's a good chance that the market will dip to 3,500. The key to this will be FII attitude. In the first three quarters of the calendar year, they have pulled out $9 billion equivalent. If Q4 is worse in terms of redemptions, and it promises to be, the market could see Nifty at 3,500.
A look at the highly liquid December 2008 options series offers some answers in terms of consensus expectations. The most highly traded puts are the Dec 2008 3,600p (premium 170) and 3,900p (293). Breakevens on those contracts are between 3,430 and 3,610. Conversely the most highly-traded calls are Dec 2008 4,000c, 4,500c, 4,600c and 5,000c.
The breakevens on these contracts range from 4,200 to 5,018. An options trader will see these breakevens as likely support and resistance levels. Indeed, chart analysis suggests that 3,600 and 4,200 would be pretty powerful support and resistance respectively. There are no quotes for the October 3,600p, which reinforces a feeling that if this level is broken, there could be panic.
The best case scenario for next week would be the Nifty range-trading between 3,700-4,150 - a breakout beyond 4,150 seems exceedingly unlikely unless there is a radical change in attitude. The worst case scenario would see it settle into a range of 3,500-3,800. My personal view is that there will certainly be a drop below 3,800, probably below 3,700, and a recovery till around 4,000, as well.
A bullspread of long 3,900c (133.6) and short 4,100c (63.95) costs 70 and it pays a maximum of 130. A bearspread of long 3,800p (148.85) and short 3,650p (90.85) costs 58 and pays 92. The bullspread has better risk-reward ratios.
The bearspread is somewhat more likely to work and closer to the money (October Nifty settled at 3,839). Strangles like long 3,700p and long 4,000c cannot be laid off due to lack of liquidity below 3,650 in the put chain. This makes them too expensive to be worth deploying.
| STOCK FUTURES/ OPTIONS The entire F&O scenario is dotted with attractive looking shorts. Many stocks have made downside break outs to 52-week lows. There are far fewer attractive looking long positions. One consideration is liquidity. As the hedge ratio has increased, liquidity in stock futures has decreased. Going outside the top 20 (in terms of trading volume) would be dangerous. |
Among long positions, BPCL, Dr Reddy’s, HCL Tech, Hero Honda, Ranbaxy are potentially lucrative.
On the other hand, Hind Oil, Hind Zinc, Parasvnath, Punj Lloyd. Reliance Industries, Rel Infra, RPL, Sail, Sobha, Sterlite, Tata Motors and United Phosphorus all seemed to be headed lower and offer lucrative shorts. In Rel Infra, the downside target is around Rs 700. Keep a stop at Rs 760 and short.
