Hope is a dangerous thing, as investors found on the eventful Budget day. If the finance minister was guilty of presenting an insipid Budget that was low on the details that the market wanted, investors too were perhaps guilty of expecting too much, too soon.
But it would be foolhardy to blame the melt down in the market on the budget as there were telltale signs from the options data on the eve of the Budget. Option premiums ruled high as the market seemed braced for a bout of post-Budget volatility. There was also a dwindling of open interest that suggested caution on the part of traders.
These were some indication that regular market participants anticipated a continued correction. First, there was a distinct loss of trading volume. Second, substantial cut-back in open interest. Third, the put-call ratio for August and September options was bearish (0.8). Fourth, global markets were showing sustained weakness while India continued to hold high. Hedge ratios (HR) had been high ? another sign that the market consensus was negative.
Hedge ratios can be loosely defined as the number of index instrument positions (say short Nifty futures) required to hedge a stock position (say long Reliance futures) against an adverse movement. However, the HR can also be seen as just the number of index contracts outstanding versus the number of non-index contracts outstanding. In a bull market, the HR tends to be low. In a bear market it tends to rise. The implications are that stock futures and options dwindle in liquidity as traders focus on the key market direction.
These ominous signs then unfolded on the B-day with benchmark indices correcting nearly 7% and marked the beginning of a corrective phase which continues till the time of writing . A particularly interesting trend is seen unfolding at these levels on the Nifty ? participation (number of contracts traded) in the index options space has seen a steady rise while open interest in index futures contract is dwindling.
If we were to compare today with the market data at the time when the election results were announced, a sharp contrast is seen. An average of 1.340 million contracts were traded between July 1 and 9 (Budget was announced on the 6th) as against 1.114 million contracts traded between May 12 and May 20 (Election results announced on May 16).
It is pretty well documented that a lot of participants who were short on the Nifty on the eve of the election result got massacared the following day on account of Nifty hitting upper circuit. Coming back to the present time, participation has reduced in the naked futures which has unlimited profit/loss possibility, while positions taken in the index options which thereby limits the possibility of a loss, have increased.
Traders, having burnt their fingers earlier, have matured. This not only increases the market depth but also invites participation from a much larger audience, thereby making various option parameters namely, volatility, India volatility index, smart money ratio etc far more potent and accurate.
(The writer is a derivatives analyst)