Hold on to shorts for bigger gains

‘Sell on rise’ was our call last week and we did get a decent rise in the first couple of days in a truncated week. After quite some time, we had initiated short positions on markets around 5385 Nifty futures. More than one reason compelled us to do so.

First and foremost, sticking to derivatives data, one very interesting and important observation is that Nifty index futures open interest, in terms of the number of units, has gone down to multi-year non-expiry day low.

If we compare last week’s open interest with expiry-day open interest, then it is comparable to two lows formed in December 2010 and July 2011. Implied volatility during these two months’ expiry was very low. This is what we are facing today — very low open interest and very low implied volatility.

So what? After such data, markets have taken a plunge and both times the fall has been in double digits, percentage-wise. So are we saying that same may happen again? Maybe yes, maybe not. But a correction looks quite possible. As of now, we are banking on  the support zone around 5000-5050.

Do not go long but cover short positions, then, if data don’t point to further negativity.

It’s visible to all that liquidity is drying up at the FIIs’ end and feelers from the US Fed that there may not be any quantitative easing soon is doing no good to expectation of increased fund flows into equity.

And more than what the Fed has to say, it’s our observation on US bond yields and its correlation with equities which is making us feel a bit skeptical on liquidity. At the fag end of December 2011, we became bullish on markets. One of the reasons we cited then was that markets are at lower levels and so are bond yields which were near the bottom of the 1.75-2.10% range.

Now, if we compare it with the current scenario, then it becomes clear that bond yields have already surpassed the higher end of the above band and are around 2.23%. Equity markets are also at their recent highs.

It’s known to all that one may not see a rise in interest rates in the US, so one should not expect further significant rise in yields. So, at this juncture, a fund may see a better risk-reward ratio in debt compared to equity.

This week, we anticipate that there would be a rise in open interest and a rise in implied volatility. A majority of times, this kind of thing would happen when markets correct. Short positions formed last week should not be covered in hurry and buying near 5200, the so-called support, is also a strict no-no.

The writer is head - equity derivatives, Angel Broking