Wednesday, September 22, 2010
Trends in the F&O 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 liquidity or trading is concentrated in the Nifty index and in 20-25 stocks in the F&O segment. Liquidity is necessary for better price discovery. 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. In the option section 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. So now let's move to F 'n' O Indicators.
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/discount to the spot market.
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.
But care must be taken when considering the dividend on stocks.
Future price will be in discount if there is a dividend EX date announced in that particular month. Then the Future price is equal to Cash price minus dividend amount. That means future price is lesser than cash price which does not mean that stock is bearish.
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.
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.
The daily Put/Call ratio can be found out by clicking the link and then accessing the data for current month of the year.
Investors prefers 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. India VIX represent the daily volatility on overall market on the NSE.
The daily India VIX data can be found out by clicking on the link.
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. The investor will find the Nifty futures with expiry in next month at a slight premium. he will have to bear the difference. 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.
Don't get confused with open interest and volume of trade. Volume of trade and open interest are different. Volume is total no of transacted contract for the day and open interest is total number of contract (buy) that still needs to be closed by going opposite transaction.