Fluid situations call for a close watch on stock market prices and premiums. Positions may have to be switched at a moment's notice.
Enron took insurance to cover political risk on the Dabhol project where politics was definitely the biggest issue, though there were many other problems. However, while it is possible to price political risk in a given project, it is impossible to price political risk across an entire economy.
Thanks to 2G, we’re guaranteed some political turmoil. There seems a good chance the UPA government will survive, based on current Lok Sabha numbers. It would be over-reacting to liquidate long-term portfolios since we expect a bounce.
However, rather than passively ignoring the situation, a rational response is to seek profits on the short side since there is a very high probability of falling stockmarket indices. The fundamental impact on the telecom sector will be more long-term and difficult to evaluate since it depends on how this is dealt with.
In the low-probability scenario where the government falls, there will be a big crash. But rather than second-guessing political developments, a financial investor or trader can extrapolate from market behaviour in prior scams and be prepared for various political eventualities. The market nosedives during periods of instability and it bounces back quickly once stability does return.
Valuations are currently stretched at Nifty 5900, with the Nifty PE at 23.5. That makes it less likely that value investors will offer instant support and implies a substantial downside. Index options are ideal instruments in this situation, both to hedge existing portfolios and to make money.
The downside is probably not fully priced into far-from-money, long-term premiums although put premiums have risen in the past two session. Option pricing is a controversial topic. Everybody agrees on the important variables like time till expiry, interest rates, price of the underlying, volatility of the underlying, strike price and so on. Unfortunately, those variables can be massaged many different ways.
Every option pricing method has flaws. This is not just a theoretical problem. Huge sums are staked on the basis of option pricing models, and every corporate that offers ESOPs or carries major derivative positions has to price them notionally on the balance sheet.
Despite the blind spots in modelling, options are by far, the most convenient hedging instruments. In theory, options can deliver returns regardless of the underlying's directional movements. There are multiple ways to exploit a correction using option combinations.
The simplest way to exploit a correction is to buy deep out-of-the-money puts. Another method is to hedge with directional bias. A short Nifty Futures ( November or December) coupled with long calls (cheap due to the fall) would make profits if the market fell further, while limiting losses if it doesn’t.
A third way is to create out-of-money bearspreads, by buying higher-strike put option in December settlement (expiry December 30) and selling lower-strike December put. This is cheaper than naked puts and gives ample time for a slide.
A fourth, more risky method is to exploit the impending November settlement (expiry Nov 25) by selling out-of-money calls. If the options expire worthless, the seller takes the premium. But a bounce in the next four sessions could cause big losses.
A fifth way to exploit a potential fall is to short some other asset that has a high Beta relationship with the Nifty. The Bank Nifty for instance, generally outperforms the Nifty both in a correction as well as on the next bounce. So the trader could sell BankNifty futures short and perhaps hedge that position with long Nifty calls.
Once the possibilities on the short side are covered, the next logical step for a trader is to think about playing the bounce that could occur once the political situation stabilises. This may be best achieved by buying very cheap, out-of-money calls in either December or January. The longer the time to expiry, the better the chance that a bullish perspective will pay off.
In terms of strategy, this trading attitude is easily understood. First, short the market as it’s affected by political shenanigans and then, ride the subsequent bounce as the politics straightens out. If we’re right about the directional bias and the way the politics will pan out, this will work. It’s sensible to hedge in order to limit damage in case we’re wrong about the politics.
However, in this sort of fluid situation, prices and premiums change very rapidly. The devil is in the details. A trader needs to monitor prices and premiums closely and to be prepared to switch positions at a moment’s notice. This is why trading on politics may yield quick money but it is definitely not easy money.
