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| Derivative indicators seem to have worked more often than not
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| The derivatives market can be a window to mass psychology. The cash and derivatives markets, when studied together, can give us an indication on the broad direction of the markets.
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| Intraday buying and selling in the derivatives market can provide an insight on whether investors are predominantly bullish or bearish.
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| In mature markets like the US, cash market investors follow and track several derivative indicators to get a fix on the future direction of the cash market.
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| In India, however, the link between the cash and derivatives markets is not as strong for several reasons. The Smart Investor takes a look at various derivatives market indicators, what they stand for and whether their predictive power works in the Indian context.
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| In the futures market, analysts essentially look at the movement in premiums and discounts of futures contracts relative to the cash market.
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| In options, there are essentially four major indicators that market players look at: put-call ratio (PCR), put volume indicator (PVI), open interest (OI) and implied volatility (IV).
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| Futures premium and discount: In the futures market, one can look at trends in cost-of-carry (CoC). The relationship between futures prices and spot prices can be summarised in terms of CoC.
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| This measures the holding cost plus the interest that is paid to finance the asset less the income earned on the asset.
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| A high CoC implies bullishness in the market, though what is high for one stock may not be so for another. Any decrease in CoC will, therefore, indicate a decrease in bullishness (which is not necessarily an increase in bearishness).
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| PCR: PCR is the most basic derivative indicator available to investors. It is also the most widely tracked ratio worldwide to gauge the market sentiment.
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| PCR is simply the total number of puts traded in a day divided by the total number of calls. When PCR is high (a higher proportion of puts being traded than calls), it indicates that the market is bearish and vice versa.
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| It is used as a contrarian indicator in the sense that when PCR reaches extreme highs, we can expect a bounceback in the market. On the other hand, if PCR reaches extreme lows, there is a lot of bullishness in the market and a correction can be expected.
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| "PCR is one indicator the market has begun looking at. It works especially when there are extreme values," says a derivative strategist with a foreign research house.
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| A look at the PCR and Nifty movements over the past two years indicates that extreme levels of PCR are when the ratio touches highs of over one and lows of 0.25. Every time the PCR crossed one, it has been followed up by a rise in the Nifty.
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| On the other hand, when the PCR fell below 0.25, the Nifty peaked and the downtrend began accompanied by a rise in PCR. However, in between these values (0.25 and one), PCR does not provide a concrete view on the market direction.
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| Analysts feel that PCR does not seem to work in the case of individual stocks, while it has more often than not worked in the case of the market and the index. Also, PCR should not be viewed in isolation in our markets, feel market analysts.
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| PVI: PVI is another indicator which measures sentiment. It measures excessive pessimism by tracking put volumes. PVI is also viewed like the PCR. We calculate PVI by dividing a particular day's put volumes by the 10-day moving average of put volumes.
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| The PVI is a contrary indicator because when negative sentiment reaches extremes, it is usually a sign that the market will rally. High readings signify extreme pessimism and fear, sometimes outright panic, and indicate bottoms very often.
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| Low readings of this indicator result from the anticipation of lower prices ahead and are, therefore, considered bearish. Very high readings of the PVI often coincide with market bottoms.
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| Since puts make money when stock prices fall, the idea is to gauge relative levels of bearish sentiment or negativity in the market by tracking levels of put activity.
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| In the last two years, the panic level has been defined by a PVI of more than 1.15. On the other hand, PVI lows (markets tops) are usually around 0.7 levels. Unlike PCR, PVI seems to work better in the case of individual stocks than for the index.
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| OI: Of the four indicators, OI is watched most closely. OI coupled with market movement and volumes can give us a fair indication of where the market is headed.
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| What is important here is the change in OI and not standalone figures. Say, for example, we see a sudden rise in OI of deep-out-of-the-money calls.
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| This will indicate some expectations of a rise in that counter. But not all the time can we see action that can be deciphered so easily just by looking at OI figures. In becomes necessary to combine different indicators to get a better view.
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| The OI Vs Nifty chart clearly shows that a rise in OI often coincides with a rise in the market and vice-versa. Also, the Nifty volumes chart indicates that whenever volumes peaked they were accompanied by a market top or a bottom.
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| IV: IV can also provide some insights into market perceptions. But this measure is not helpful as an independent indicator. Volatility simply means the range in which the stock price is expected to move in a year. It is taken as a standard deviation of returns for a specified period.
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| For instance, if the volatility of a stock is 25 per cent, it essentially means that the stock price is expected to move 25 per cent up or down. The price of an option is a function of time to expiry, volatility, stock price and its strike price.
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| The Black-Schools model then gives us the price of the option when we put the above-mentioned parameters. We derive IV by using the current price of the option.
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| What does IV indicate? Consider a situation where IV of calls shoot up along with a rise in the market price, OI and volumes; such a situation would clearly indicate bullishness.
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| Similarly, several permutations and combinations can be applied to take a view on the cash market.
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| What are the indicators suggesting now?
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Right now, PCR does not indicate any definite trend. "The current PCR does not indicate anything. Sentiment indicators work best at extremes. When PCR touched levels as high as last month
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