Lack of fresh shorts signalling stability

Nifty had yet another volatile week as the damage continued throughout the last week.

Nifty futures did see some confidence building up by turning into nearly 15 basis points premium early on, but the same proved short-lived as the futures traded around parity with the underlying index.

Participation in the Nifty futures has risen this week as well. Major falls were associated with rise in open interest (OI) and fall in basis (premium/discount). Nifty futures OI rose nearly 10% last week, indicating further penetration of pessimistic shorts.

Stock futures, on the other hand, continue to remain light with less than 1.9 billion shares in OI, which is due to just over 2% addition in aggregate OI last week.

The pessimism continued in stock futures as well, as the proportion of stocks trading into discount went up to almost 40% midweek and still after the respite last session, over 20% stocks trade in discount. 

The only silver lining is that we had reduction in OI in nearly 50% of the stocks available in F&O week over week. After aggressive additions in sectors such as infrastructure and financials, the net additions slowed down last week.

In Options, Nifty February series saw a slight drop in implied volatility towards the end of the week. This indicates that the risk factor priced into options is lowering, anticipating at least stability in the underlying index for the time being.

The Open Interest Put Call Ratio (OIPCR) tapered off from almost neutral to 0.8, which is due to aggressive call writing at every breakdown level in the index coupled with exits by Puts through the fall.

We are trading with the Nifty OIPCR at the lower end of the recent range, which generally persists when the pessimism is overdone.

As we still trade with relatively higher implied volatility, the choppiness may still very well continue. We do have some indicators which are signalling stability like lack of fresh shorts or even exits in stock-specific OI.

However, it is not prudent to exit shorts completely. Hence, amid volatility we feel the best strategy is to go long on volatility by buying either side options.

One can buy Call of one step higher strike than current price at the same time one can buy Put of one step lower strike than the current price.

The reason behind this is that one gets best out of the same if we see a reversal and a sharp pullback. On the other hand, if we do not sustain these levels then the follow-through selling may create a favourable pay-off as well.

However, one should keep in mind that options are wasting assets. If the choppiness reduces going forward, the strategy may turn unfavourable.

Hence, one should keep a five to seven session time stop loss to the strategy and should exit if the volatility does not kick in during next few sessions.                                

The writer is manager-derivatives at Motilal Oswal Securities Ltd