F&O underdogs

If there has been one indicator that we all like to quote, it's the affable put-call ratio (PCR). However, the top notch PCR rarely gets quoted these days at CNBC and the dailies.

It's got transcended to the underdog status. Some broad reasons are that the PCR did not exhibit much movement and remained broadly stagnant for most of the market rise that started in May 2003.

And as analysts would like to interpret it, the indicator failed to give any new trading signals and was continually in the 'sell' mode for more than six months ruling below 0.3, which as a 'static interpretation' is low and a trading sell.

Reading F&O indicators in such markets have always been tricky. PCR is an easy one in theory, but in practice things become a little complicated.

It is an easy matter to say that when the ratio gets too high, you should buy the market. Conversely, if the ratio gets too low, you should take bearish positions.

Quantifying too high and too low is where things get tricky. Past experience has shown that 'static interpretation' of the PCR is an incorrect approach, for investors and traders change their investing patterns. Rather a 'dynamic approach' is best.

A 'dynamic approach' means that one looks for peaks and valleys at whatever absolute levels they may occur and not just at a static level (0.14 as low and 0.75 a high) - in the PCR to indicate buy and sell points.

This is a very important concept because if you use static interpretations, you will most certainly be deluded into making an inappropriate trade.

A blind static approach would have meant that you would have been 'short' for most of this rally that started in May 2003 as the PCR was below the 0.3 mark for most of the period.

This approach would have been clearly wrong in the current market trend as we would always been a contrary seller based on PCR.

No one would be that stubborn, of course to stay short for months while the market moved up by more than 100 per cent. On a short term basis looking at the local minimum or a local maximum is a better approach.

As one can see, Nifty PCR remained in the 0.55-0.75 range from April-October 2003 and only recently moved up decisively above the 0.70 mark. And though the marketwide PCR has given better trading signals than the Nifty PCR, the signals are quite useful from Nifty PCR, too.

This underdog gave seven good trading signals in the last 10 months. Incidentally all of them were correct signals. One should learn to ignore the noise (arbitrage, covered writes and spreads - distort but not counteract it altogether).

Sector index options' PCRs worldwide are less liquid and, hence, traders expect the signals to be less accurate - and they are but they are still quite useful most of the time.

According to a recent study, the following indices were responding best to PCR ratio signals and proved to be a good trading vehicle for the respective sectors: NDX - Nasdaq, MSH - Morgan Stanley High Tech, XNG - Natural Gas, BKX - Banking, XAU - Gold and Silver, HKO - Hong Kong, JPN - Japan, XOI - Oil and Gas, OSX - Oil and Service, DRG - Pharmaceuticals, RUT - Russell, SOX - Semiconductor, TXX - Tech Stocks and UTY - Utilities.

About the markets in the coming week: After falling 8.5 per cent from the Nifty close on January 19 in three trading days, markets bounced back and closed the week down by just 2.8 per cent.

This though does classify as a dip leaves many traders perspiring with shock wondering what hit them. About other signals we had seen a classic IV bottom on January 5, 2003, before the markets made an intermediate top happened on January 6. The possibility of breaching the intermediate top in the coming days or weeks seems unlikely to me.

Then we have the open interest (OI) which fell by about Rs 40 billion in value terms in the last five trading days closing the week with around Rs 100 billion.

We also saw Nifty futures volumes becoming the top traded F&O segment with more than 200,000 contracts traded in a day. This was a down day and hence is negative on the face of it.

In conclusion, down volumes are still higher than up volumes. We crossed the highest trading volumes at Rs 190 billion also on a negative day.

And with volumes nearing the half a million contracts mark, the days ahead will need more such skill in reinterpreting the F&O underdogs to make money. I am negative on most of the index heavyweights barring SBI.

OI has been in an uptrend since the start of this rally. This is a typical situation whenever the equity markets gain momentum to the upside. There is a large pickup in participation and an increase in open interest.

A perilous market situation occurs, however, when there is a persistent pattern of several days in which the open interest rises, but the market is unable to close at a new high for the move.

Something like what we are seeing today. The Nifty closed near year end levels on Friday despite an increase of about 31 per cent in the number of OI outstanding contracts.

The trading volumes also increased by about 16 per cent during that period without any support from the rise in the level of Index.

Whenever such a situation occurs at the same time - viz. increasing OI and volumes without any further rise in price - there is a consensus that the market has become overloaded with bulls and the public's buying is being met with selling by hedgers, who are determined to establish their short positions.

As a trader if you sell short in this environment, then stay short until a substantial liquidation of the open interest has taken place.

(The author is derivatives strategist at Edelweiss Capital.)