Stay Safe, Don’t Play

JUST IMAGINE, during one of your regular morning walks, you suddenly see a tiger prowling in front of you. You would be scared, isn't it? Now imagine, instead of one, you see two tigers prowling in front of you. Would you be twice as scared as you were when you encountered one tiger? Yes? No? Maybe?
    It's a no-brainer that the stock market is nothing, but a reflection of the cumulative greed and fear of all market participants put together. While about a year ago, it was all about greed, we all know what rules the roost today — it's fear, fear of nothing less than death. While financial journalism overly abuses superlatives, nothing can be 'too much' to describe the fear that exists in the market today.
    But how does one measure this all-important fear? For, fear is nothing but a measure of the expected volatility, and volatility is one of the most important factors that influence the price of an option contract. This is where a volatility index comes in handy. And while the Indian version has, once again, failed miserably in its job and is quoting over 20% below its all-time highs, the Chicago Board Options Exchange Volatility Index (CBOE VIX), above everything else, reflects that's there is nothing else but blood that's flowing on the Street today.
    Last Thursday, the VIX hit a life-time high of 81.17% (at the time of this edition going to press, it was trading around 72%) — that's over 60% higher than its all-time highs until the beginning of the current month and over 400% above its August-end closing levels. The VIX at 81.17% essentially means that S&P 500 option contracts expect, with a 68.2% confidence (the first standard deviation), a humongous 81.17% move in the S&P 500 over the next year.
    To put it simply, S&P 500 contracts expect to see the S&P 500 either below 200 or above 1600 in October '09. The corresponding figures in the more closely tracked Dow Jones Industrial Average are sub-1700 or above-15300, i.e. Black Monday, 1987 lows or new life-time highs! While you may think that this is as panicky it can get, and is an apt reflection of the fear in the market, in reality, even such a preposterously high VIX doesn't properly reflect the fear on the Street. For, today, the fear among investors is not four times of what it was at the end of August, but maybe a few hundred times. This is because, while you can hope of somehow escaping the clutches of one tiger, if you see four of them prowling in front of you, you just resign yourself to death and that resignation is impossible to measure.
THE CARNAGE:"When you pick bottoms, you get nothing but s*** in your hands" — this popular market saying has come back to haunt all investors, that too, with a cruelty that was unimaginable. More importantly, it has meant that all traditional forms of analysis and conventional indicators have become absolutely useless. Let's take the example of the put-call ratio (PCR). At close on Friday, the PCR of Nifty option contracts expiring in October hit 0.55. This means that there exist almost two call options for each put option — a clear indication that in order to protect their portfolios, investors are writing calls as if there is no tomorrow and put writers have gone into extinction. A near-month PCR of 0.55 is probably the lowest ever and is marginally lower than the PCR of 0.56, with which the Nifty had bottomed out on June 14, '06 after the correction of May-June '06. Since all conventional forms of analysis cease to work once we enter unchartered territories, analysing the current PCR if of no use.
    If the PCR has become useless, then analysing the build-up at various strike prices has become even more redundant. For, at close on Friday, there didn't exist a single in-the-money call option or out-of-the-money put option (the 3050 strike price opened late on Friday and has hardly got any build-up worth discussing). So, even if you are looking to just hedge your long positions, you are now out of options. As for ETIG's smart money ratio (SMR), it's simply shooting out of sight. However, even this time round, it has proved its superiority over the VIX, which is basically trying to tell us that the panic now is much less than that in July.
FRESH TRADE: In many ways, last Thursday hinted at a classical bottom formation in the Nifty. Firstly, you had a panic bottom in place because of absolute capitulation (this had occurred on the previous Friday, October 10), then the dead cat bounce took place (last Monday and Tuesday), followed by the drift down to retest the panic bottom (on Wednesday and Thursday). Finally, we had the sucker punch — the fall below the previous low (this happened between 11 am and 1 pm on Thursday) and ultimately, the upward march.
    The other reason why the bottom seemed to have been formed on Thursday is that the sucker punch seemed to have worked, as even a 5% inthe-money call like the 3100 call and the 3200 call had seen massive build-ups on Thursday. However, all such hopes were dashed after 12 noon on Friday, as the Nifty collapsed to a fresh low, losing over 5% in the last two hours of trade.
    Notwithstanding this, the Nifty is unbelievably oversold and Dow technicals suggest that it may have already hit a bottom. So, the trading call for the second successive week remains the same — just stay out of this madness. For, short positions can get caught in mind-numbing dead cat bounces, which are sure to come almost anytime and just because the Nifty is oversold doesn't mean it can't become further oversold. At the same time, the VIX seems to have created some short of a double top and may just taper off, but even in this case, don't get lured by the huge implied volatilities and go for any short-volatility strategy. For, that is worse than standing in the way of a Mumbai local!
    shakti.patra@timesgroup.com