Monday, January 12, 2009
 Apna Money
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Spotting the trend

F&O data can be used to gauge the market undertone. However, do not rely on one indicator, rather look at them in relation to each other

A lot of information is disseminated on stock and index derivatives by stock exchanges daily. A good amount of information is also available on the websites of stock exchanges. For instance, the National Stock Exchange (NSE) regularly provides information on trading in the futures and options (F&O) segment including quotes or prices, number of contracts traded, open interest, top contracts by volume and value, put-call ratio and so on. This information is made available through various channels including bhav copy and daily market activity report. Apart from these reports, investors can scan business newspapers for a quick glance at the F&O trend. Business newspapers also provide ratios and commentary on the F&O segment.

Generally, trends in the F&O market are not studied by investors in detail or not much importance is accorded to the F&O data. However, F&O numbers can reveal broader trends in the cash market that can be used while transacting in equities. Investors can look at various parameters and ratios to gauge the mood of the market and determine in the investment strategy. F&O numbers give a hint about the short-term market movement. A note of caution: investors should use the F&O trends as one of the tools in the decision-making process and not completely rely on them for investment calls.

This is because the F&O market is still not sufficiently liquid. Liquidity is necessary for better price discovery. Liquidity or trading is concentrated in the Nifty index and in 20 to 25 stocks in the F&O segment. A few stocks go without trading for many days.

Among index futures, the Nifty futures account for over 90% of trading. Around 250 stocks are traded regularly in the futures segment. The top 10 contracts contribute to over 35% of the total traded volume in individual stocks in the futures segment. The Nifty options comprise around 98% of trading in options. Of the 265 stocks eligible for the derivatives trading, less than 100 stocks are traded regularly in the options segment. The top 10 stocks account for over one-third of trading in the options market. Stock futures are more liquid than stock options. Thus, investors have to ensure that the stocks they are examining in the F&O segment have good volume to decipher the trend in the cash market.

Premium or discount to the cash market: First, inspect if the stocks or indices are trading at a premium or discount in the derivatives market compared with their underlying to predict whether the market mood is bullish, bearish or indecisive. Suppose stock futures or index futures are trading at a premium compared with the underlying stock or index. This points to a bullish trend in the cash market. But a stock or an index trading at a discount in the futures market indicates a bearish market.

Investors can also look at the quantum of premium or discount to understand the magnitude of the bullishness or bearishness. If a particular index is trading continuously at a premium, it would indicate buoyant market sentiments. However, if the premium turns negative (discount) to the underlying stock or index, it would mean the stock or the market is weakening or likely to weaken in future. Of late, select real-estate and banking stocks have started trading at a discount in the futures market compared with the cash market. This indicates bearishness. This can be attributed to the overall negative sentiments towards the real-estate industry on account of tight liquidity situation, slowing down of the economy, and falling real-estate prices.

Put-call ratio: This ratio is also known as the put-call volume ratio. It is widely used to understand the sentiments prevailing in the cash market. The put-call ratio is calculated by dividing the daily or weekly traded volume of put options by the daily or weekly traded volume of call options. This ratio is not only easy to calculate but also simple to interpret. Higher the number of call options traded higher are the chances of the market turning bullish in future. If put options are more popular, bears could dominate the market.

An increasing ratio over a period of time means investors are putting more money in put options, implying the broad market outlook is bearish. Thus, the market can be expected to move south or witness a sell-off. This could also be the case of investors trying to hedge their portfolios. On the other hand, a declining put-call ratio indicates investors are showing more interest in buying call options and the market is likely to move up in the near future.

Interestingly, extreme values point to a trend reversal in the coming days. This can also be termed as a contrarian indicator. An increase in the ratio to unjustifiably high levels is considered a buying opportunity as traders start covering their short positions. On the contrary, too many call options or a low put-call volume ratio signifies the market has reached an overbought level and a correction is likely. In short, a very high put-call ratio indicates the bear phase is likely to end, while a very low ratio means bulls could lose the grip over the market and a market correction is likely.

Put-call open-interest ratio: The put-call open-interest ratio is also one of the key indicators of possible futures movement in the spot market. The put-call open-interest ratio is calculated by dividing the total open interest of put options by the total open interest of call options. For instance, if the open interest for put options is nine and the same figure for the call options is 10, the put-call open-interest ratio would be 0.90. A put-call open-interest ratio of more than one means put options have a higher open interest compared with the call options and, thus, the future price trend is likely to be bearish. A low put-call open-interest ratio means bullish sentiments are likely to continue in future. Investors can monitor periodical changes in the put-call open-interest ratio to gauge future market outlook.

Cost of carry: The concept of cost of carry attempts to explain the relationship between the cash market price (underlying) and its price in the futures market. It means expenses incurred while a position is being held, interest on securities bought on margin and storage cost less income earned on the asset. Suppose Reliance Industries is trading at Rs 1150 in the cash market. Assuming the investor can borrow money at an interest rate of 15%, the fair value of the one-month futures contract should be Rs 1164.46. The formula is as follows.

Cost of carry = Price of the underlying in the cash market * e (2.71828) ^ (Cost of financing * Time till expiration in years)

Cost of carry can be negative or positive. If the cost of carry is substantially positive or negative, it offers arbitrage opportunities for traders. If the cost of carry is positive, traders can sell futures and buy the underlying in the cash market to effect arbitrage. If the cost of carry is negative, traders can buy futures and sell the underlying to make riskless profit. The cost of carry ensures that the futures price stay in tune with the spot price.

Now what does the cost of carry indicate about the future? Generally, negative cost of carry indicates bearish sentiments, while positive cost of carry points to a bullish market undertone. At the same time, a very high negative cost of carry signifies building up of huge short positions on the counter. Any subsequent profit booking could lead to an downturn in the stock. Though a higher positive cost of carry indicates bullish undertone, it could also lead to trend reversal once profit booking sets in. Investors can find the cost of carry for stocks eligible for derivatives trading on the NSE website.

Daily volatility: Investors love a bullish market and perceive it safe as well. On the contrary, a bearish market is considered risky. Therefore, increase in daily volatility is considered bearish, while lower or moderate volatility is taken as a sign of a bullish market. Daily volatility represents volatility of the future contracts on a particular underlying stock or index. These figures are available on the NSE website.

Rollover: The near-month F&O contract expires on the last Thursday of the month. At the time of expiry or close to expiry, investors will find news articles discussing rollover. Rollover is applicable to future contracts and not options. If an investor is holding a position in futures, he will close his position in the near month or in the current month and take a fresh position in the next-month contract. Rollover helps investors to carry his position for a longer period of time. Suppose an investor is long on, say, 10 contracts of Nifty futures in December. To roll over, he will have to sell these 10 contracts and simultaneously buy 10 contracts with expiry in January 2009. There is an indirect cost attached to it. If the Nifty futures expiring in December 2009 are trading at 2,650, the investor will find the Nifty futures with expiry in January 2009 trading at a slight premium: above 2,650. Suppose, the Nifty futures expiring in January 2009 are trading at 2,660, he will have to bear the difference:10. Further, the investor will have to bear transaction-related expenses such as brokerage.

The percentage of outstanding positions rolled over to the next month is used to gauge market sentiments. A higher percentage of rollover symbolises bullish undertone, while a lower rollover indicates bearishness. It is difficult to comment on the market mood by just looking at the rollover figures. Investors have to use other numbers to deduce the right conclusion. Every buy side has a sell side to it. As a rule of thumb, if the market is in a bull phase, a high percentage of rollover could mean the market would remain firm or move up in the near future. In an extremely bearish market, a high rollover could spell trouble as it could denote that the bears are convinced the market would fall in the future.

Open interest and change in open interest: Open interest in the F&O market along with price movement and traded volume is also used by traders to predict future trends. Open interest is basically the total number contracts — futures or options — that remain open at the end of the day. It can also be defined as the number of contracts that are still to be closed or to be delivered at the end of the day. It can be also termed as the number of 'buy' contracts that are still open. For instance, the open interest in Reliance Industries 1,300 with January 2009 expiry call option is, say, 100. It means these many contracts still need to be closed.

Many investors get confused with open interest and volume of trade and assume that both are same. However, volume of trade and open interest are different. Suppose, an investor buys 100 contracts of Reliance Industries 1,300 call. Volume for the day will be 100. If he sells 50 contracts next day to another investor Mr B, the volume will be 50, but open interest will remain the same at 100 as these many contracts are still open: 50 positions are open with the investor and another 50 with Mr B. Now suppose Mr C bought 25 contracts from Mr D on the third day, volume will be 25 and open interest will be 125: 100 existing plus 25 new contracts. Open interest goes up as and when new positions are created.

Analysing open interest on a standalone basis could be misleading. Here, investors need to use information about open interest in conjunction with two other bits of information: price and traded volume.

Volatility index: Volatility is the prime factor that reflects risk. Volatility Index (VI) is a measure of the market’s expectation of volatility over the near term. Volatility is defined as the rate and magnitude of changes in prices. VI measures the amount by which an underlying index is expected to fluctuate in the near term. VI is based on the order book of the underlying index options and is calculated as annualised volatility denoted in percentage. In the domestic market, the India VIX developed by the NSE is a volatility index based on the Nifty 50 index option prices. From the best bid-ask prices of Nifty 50 options contracts, a volatility figure is calculated, indicating the expected market volatility over the next 30 calendar days.

VI indicates expected stock market volatility over a specified time period. An investor can get a sense of market volatility by simply looking at one number: VI. A rising VI means increase in volatility and vice a versa. As the volatility index is calculated on a real-time basis and is continuously disseminated throughout the trading session, it can aid ‘buy’ or ‘sell’ decisions.

The F&O segment throws up a lot of information that certainly helps to understand the future market outlook. However, the data need to be used with caution and in conjunction with other F&O indicators to attain better accuracy

Different scenarios in the F&O segment to determine the future of a stock or an index in the cash market
Price Volume Open Interest Market Outlook
Scenario I Increasing Increasing Increasing Bullish
Scenario II Increasing Declining Declining Bearish
Scenario III Declining Increasing Increasing Bearish
Scenario IV Declining Declining Declining Bullish

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