The tsunami has already caused huge loss of life and frighteningly, things could get worse if the nuclear problem escalates. One sincerely hopes Japan can stabilise quickly. But even amidst this tragedy, distasteful as it may seem, it is sensible to consider financial implications unemotionally.
Global markets have see-sawed with a downwards bias. Disaster recovery will cost huge sums, even if the nuclear situation does stabilise quickly. If it gets worse, the costs will increase exponentially. The nuclear power industry has received a body blow, with long-term implications for global energy.
In the short term, markets could bounce big on a relief rally if the nuclear situation is contained. Or more likely, global markets will drop massively as the disaster is fully discounted. In the long term, or even the intermediate, the outcomes cannot be good.
As a rich country, Japan generally has huge funds surplus to requirements and the yen interest rate was near-zero. The yen has fuelled a lot of overseas trade and investment, including both portfolio investment and long-term foreign direct investment. This source of funding will be cut-off and yen interest rates may jump. Contraction of Japanese industrial production and overall GDP may also reduce commodity demand (metals, gas, crude).
The tsunami may temporarily reduce the demand for oil, but the crude supply situation remains tense due to the Arab crisis. In the long term, if the nuclear power industry loses ground, the energy sector will see realignment. A look at crude oil prices suggests that they will march upwards in the timeframe of the next 3-12 months.
Crystal-gazing as to the exact dimensions is difficult. But the outlook is pessimistic and the markets will probably realign downwards. However, such a drop may occur after some sort of temporary, but sharp relief rally.
Where does the trader go? In the Indian markets, the best strategy may be to take Taleb-type index option positions. Take a wide long Nifty strangle in either the March or April series. Assume a 10 per cent swing occurs inside the April settlement, perhaps inside March. A big swing will mean that either Nifty calls or the puts that are now 10 per cent from money will jump in value.
With the Nifty at 5,450, the March 6,000 call and March 5,000 put are priced respectively at 2 and 19, showing downside bias in expectations. Close to money premiums are 5,400p (96) and 5,500c (97). If the market moves 10 per cent in March, the put/calls that come into the money will hit similar premiums. Hence, potential returns could be over 500 per cent for the put and much more (4,800 per cent) for the call. The April 5,000p (60) and April 6,000c (16) are much more expensive but you get an extra four weeks. Again, if either option is struck, there's a big net profit.
A nimble-footed trader could sell the March strangle and buy the April strangle, with a net cost of 55 and potentially unlimited return beyond 5,000-6,000. If this range is broken in March, the gains in the April positions will over-compensate for losses in March. Frankly, the upside breakout is unlikely but the calls are quite cheap and in such volatile situations, it pays to have both possibilities covered.
The author is a technical and equity analyst
