Implied vols stay high hinting trader churn

Expanded F&O, high cost of funds spawn big swings

MUMBAI: Are you angry with your stop-loss?

If you are a day trader in these volatile markets, you must be.

With prices swinging so wildly, stop-losses often become spot losses.

Take for example the Reliance Energy share, which was trading at Rs 1957 in the morning.

Suppose you bought an REL share for Rs 1,950 with a stop-loss of Rs 1925 on Thursday afternoon. The stock plunged to Rs 1,905 in a violent jerk in late trade, triggering a stop-loss. But in a matter of minutes, it shot past Rs 2,005.

Yes, with a Rs 1,925 stop-loss, your loss was limited at Rs 25, but you missed the Rs 100 upside move immediately afterwards.

It’s time to be aware of an animal called implied volatility (IV).

Marketwide IV in the December series futures touched an all-time high of 72% two days ago. On Thursday, it stood at 68%.

In simple terms, IV is the rate at which shares are rising or falling.

Professional traders consider it to be a notional cost. In other words, it shows them the notional rate at which they can lose or make money.

IV is calculated using the Nobel Prize-winning Black-Scholes options pricing formula, also called as the Value At Risk model.

This can be measured in monthly terms or on an annualised basis.

What such high IVs does is push up the cost for traders/operators.

For example, suppose a trader borrows funds at 15%. He then has to contend with a Nifty cost of carry of 3% and then the 72% IV. This would tantamount to a whopping 90% cost of funds.

“Higher IVs mean stock prices will move slowly. Operators will not buy and hold because of the high cost of funds. They will look to churn to get more bang for the buck. So they might repeat the same trade again and again. This, in turn, increases market volatility and a vicious cycle is created,” said Vijay Bhambwani, CEO, BSPLIndia.com, an investment advisory.

In the last 2-3 months, marketwide IV of 60% plus has become a regular feature. “The activity in midcaps in the futures segment has shot up of late. A number of new stocks have also been added to the F&O segment. These factors could be driving up the IVs,” says Manoj Abraham, derivatives analyst at Brics Securities. Utpal Choudhury, senior derivatives analyst, IDBI Capital, says IVs rise when there is a doubt on the direction of the market. “This exaggerates speculation, which lifts IVs”

The last time high IVs were witnessed was before the big crash of May 2006. It stood at 47% immediately before the crash.

Does this mean another crash is imminent? Unlikely, says Bhambwani.

“The index levels then were 12000. Now we are 55% higher and the IVs are amplified to that extent since swings are larger. What this can mean is a range-bound move in the markets and option premiums rising. It will push up the futures prices also,” Bhambwani said.

The Sensex has been highly volatile within the band of 18300-20000 in the last 6 weeks due to investor concerns surrounding high valuations. But Swiss bank UBS has raised its end-2008 target for the Sensex from 19,000 to 22,600.

“While a global economic slowdown and credit market dislocation could adversely affect Asian markets, the domestically-driven Indian market is relatively insulated,” noted Manishi Raychaudhuri, head of UBS India Equity Research, said in a report on Thursday.

Raychaudhuri sees a continuation of a strong investment cycle in infrastructure and industrial capex and the peaking of banks’ lending and deposit rates.

But he concedes that the RBI may not signal a peak in the cycle in the near term. He said continued positive surprises in earnings and stable earnings growth will be the key themes driving the market in 2008.