The great Indian juggernaut continues its one way move unabated surmounting one peak after another. During the course of this week, benchmark indices hit its 52-week highs, drawing both praise and criticism from believers of two different schools of thought. On one side are the optimists who attribute this meteoric rise to anything from a stable government, easing liquidity, reduction of risk aversion or simply better sentiments.
On the other side are the pessimists who still believe this rally to be a bear market rally given that not much has changed on the macro front especially the fiscal deficit, lack of credit flow to the end users and better corporate performance still being couple of quarters away.
Given their valid and logical arguments, I, certainly am neither authority nor an expert to declare winners amongst them. But I?m tempted to follow the optimist?s camp for which I present my own argument.
A lot has been written and spoken about the root causes of the unprecedented global crises which we were witness too in the not so distant past. If I were to pick one I?d pick?leveraging as the key. Let me explain why.
Any investor or trader looking to take a position on a stock, would for instance, buy a future contract worth Rs 2 lakh by paying a margin of say Rs 50,000 or 25% of the contract value, apart from the daily mark-to-market margin. If the futures contract rate rises by 25%, he pockets a gain of 100% of the margin payment. However, if the bets go wrong, the loss would also be equally large, which would have a domino effect across the street given the herd mentality. This is what happened when the stock market crashed during January 2008.
Options unfortunately were considered tools for the sophisticated investor more so due to the lack of understanding of the same, although it limits the extent of loss suffered by the trader. The graph of options turnover as a percentage of the total turnover in the derivatives market couple of months prior to Jan 08, highlights my point. As inferred from the graph, options turnover ranged between 10-11% on an average.
Coming back to the present day, it is very interesting to see if options still continue to be a mirage beyond the realms of a common trader.
Voila?an average of 40%.
This increased activity in options limits the possibility of a sharp downside as the amount of leverage in the market reduces significantly.
This suggests that participants have a cautious outlook and the euphoria of the bull run is largely tamed. Hence the probability of a crash like the one in Jan 08 is nullified to a large extent. Given that India has been one of the best performing emerging markets and incremental flows getting stronger, it is poised to reach greater heights with traders getting smarter and me?an optimist.