Brace for extreme volatility

This could be an extremely volatile week for Indian equities in particular and global financial markets in general. It started well, with the Nifty rising on the back of good Index of Industrial Production numbers. Both Consumer Price Index and Wholesale Price Index support calls for interest rate cuts at the Reserve Bank of India's (RBI's) next policy meeting (September 29). That is actually in the October settlement.

RBI meets only after the US Federal Open Markets Committee policy meeting this week. If FOMC decides on a dollar rate rise, there will be turmoil across financial markets. Otherwise, there could be some sort of a relief rally. Consensus expectation is that the Fed will not hike. To cap it, there will be additional tension in India's markets, given the exchange holiday on Thursday. This means additional volatility on Wednesday (September 16) and Friday (September 18).

Although, markets did rally through the tail end of last week, the long-term trend looks bearish. The Nifty and Sensex are both below their respective 200-Day Moving Average (200-DMA). A bearish chart pattern of lower lows continues to be in force.

  To break this, the Nifty must stay above 7,540, the latest 52-week low, which was hit on September 8. It should ideally climb past the 200-DMA, which is at 8,220 (Exponential) and 8,410 (Simple). Volatility expectations are high. So, are option premiums. The global scenario is volatile. China continues to look weak. The FOMC could perhaps, change sentiment if it doesn't raise dollar rates.

Foreign institutional investors (FIIs) sold heavily through the first fortnight of September. However, Domestic institutions have been strong net buyers. The rupee remains under pressure. The intermediate trend seems negative and so does the short-term trend.

The previous bull market lasted 40-months. There is a Fibonacci retracement level at Nifty 7,400, which would be a 37 per cent correction of the previous bull run from 4,531 (December 2011) to a high of 9,119 (March 2015). The next Fibonacci retracement levels of 6,800-7,000 could also be important. That's where the market was before the Bharatiya Janata Party came to power in May 2014.

The rupee has slid below 66.30 versus the dollar, though it has recovered from below 66.80. If the Fed raises policy rates, a further drop is likely. The forex market is liable to stay very volatile with every Emerging Market currency seeking lower lows versus the dollar. Information technology and pharmaceutical stocks are potential hedges.

The Bank Nifty is, as always, high-beta versus Nifty. It almost hit 16,000 and it has pulled back near 17,000. A long strangle of long 16500p (229) and long 17,500c (159) costs 388 (about 1.1 per cent), with the index at 16,910. This would gain handsomely if September remains volatile. Two trending sessions would be enough to strike one end of this strangle.

The Nifty's put-call ratios are at neutral levels of 1.01 for the three-month and 1.04 for the one-month series. The call chain for September has peaks at 8,000c, 8,200c and 8,500c. The September put chain has open interest (OI) peak at 7,800p, 7,500p and very high OI at every strike down to 7,200p. Premiums are high but spreads are reasonable. The trader can move some distance away from spot.

The Nifty traded at 7,872 on Monday. A bullspread of long September 8,000c (77), short 8,100c (45) costs 32 and pays 68 and it's struck 130 points from spot. A bearspread of long September 7,700p (83), short 7,600p (61) costs 22 and pays a maximum of 78 and this is 170 points from spot. These spreads could be combined but the risk:reward ratio is adverse. A long strangle in the Bank Nifty will give better returns if the trader is looking at two-way volatility.