Signals from F&O

Here is a low-down on what the various derivative indicators tell about the future course of the market.

It's just over seven years since the NSE launched its derivatives segment. Although there was initial hesitation about these exotic instruments, Indian traders have taken to them like a duck to water.

Nowadays, derivatives generate huge volumes that dwarf the cash markets. In fact, the NSE is among the world's premier exchanges in terms of F&O activity and Indian stock futures are among the most liquid, high-volume instruments in the world.

Derivatives offer high leverage and good hedging possibilities so traders naturally gravitate to these instruments. Their concerted actions generate a rich lode of data, which can be mined to provide hints about market sentiment.

Some specific signals generated by the F&O market can be understood even by non-traders or long-term investors and these can help them identify major market peaks and bottoms.

You don't need to trade the F&O market to track its signals. Since contracts expire on given dates, you know that the position in a specific contract reflects expectations that will hold until that date.

Technical analysis of cash positions revolves around price and volume data. In the F&O market, much additional data is available and we can also get a sense of the prevailing conditions by comparing F&O prices with the underlying spot prices.

Typically one considers the following data series when making an analysis of the F&O market with an eye to possible peaks and troughs. A brief general explanation of these signals follows before we get to specifics in the Indian market:

1) Divergence between futures and spot prices and the related cost of carry (CoC): The futures price of a spot contract is related to the CoC. Given neutral expectations, the CoC will be positive and close to the discount interest rate. A wide differential between CoC and the discount rate will trigger arbitrage.

In practice, CoC can be either positive or negative or even zero. A positive CoC implies bullish expectations while a negative CoC reflects bearishness. Caveat: Close to settlement, CoC may go negative.

2) Open interest in various contracts (OI): The end-of-day OI is a key signal. In a bullish market, OI tends to be high. It is a danger signal when OI is high and spot volumes are not. The implication of lower spot volumes is that the market is not that bullish, whereas high OI suggests some disconnect between spot and future expectations.

But in the Indian context, there has been an explosion of interest in the F&O segment that has led to a natural expansion in OI diluting the value of the signal. Close to a settlement, high OI suggests that there will be high carry-over and it's a bullish signal.

3) Put call ratio (PCR): The number of puts traded to number of calls traded is an important index of future expectations. If the PCR is low – that is, calls outnumber puts and the PCR is well below 1, the chances are that the market is overbought and looking to decline.

If the PCR is high, that is puts outnumber calls and the PCR is over 1, the expectations are more bullish. Some traders prefer to use a PCR modified to reflect only end-of-day OI. Others simply divide the number of puts traded by the number of puts. Both are valid methods of calculating PCR. Any PCR calculation assumes that the options market is efficient and liquid. That is not necessarily the case in India.

4) Implied volatility and historical volatility: You can look at spot prices and calculate historical volatility (HV). There are many ways to do this. Again by examining option premiums, we can derive implied volatility (IV) from the F&O market.

In a bearish market, IV tends to be higher than HV and vice-versa. The famous VIX index of Chicago tells us that IV tends to be markedly lower than HV close to market tops and IV spikes up once the market slides. At a market bottom, IV tends to fall as prices rise.

Now let's look at some of these signals with specific reference to the Indian markets

1) Futures – Spot divergence: Normally there is a marginal differential between futures price and spot Nifty price. The CoC is slightly positive until the end of settlement when it goes negative close to the last session. Normally the percent difference between the spot and near-term futures is less than 0.5 per cent.

The behaviour is different in a market crash such as May 2004. As the bearishness intensified, the near-term future was settled with a difference of more than 1 per cent on several occasions. There were several sessions (May 17-20, 2004) when the difference was over 2 percent. Again in May-June 2006, when the market crashed, the differential rose sharply.

Note that the differential dropped back to normal levels as the market bottomed. In February 2007 as well, there was a similar pattern of a rising differential in favour of spot prices. In all these bearish phases, the CoC turned negative and stayed negative. The OI dropped as well.

These seem to be consistent signals during a serious market downturn. The CoC will go negative – that is, the spot will trade at significant premium. At the bottom, the CoC will start to correct and the differential will ease off.

2) OI: As mentioned above, OI tends to be up during a bullish phase and down during a bearish phase. In key market downturns, the OI plunges. There may be a scenario where there is a lot of daily volume but much less OI.

However the market has been generally bullish through the past several years and the NSE has trebled the available underlying during that period. So OI has in general, gone up. We cannot use a historical yardstick of OI. You can at best use something like a 10-day moving average of OI to judge if it's dropping by unusual amounts. This will give a high number of false signals

The period January 2006-June 2006 provides an interesting example of how OI is affected by market movements. We've charted the Month-on-Month Nifty gains (percentage) versus the total no of contracts (F&O across stocks and indices) open. There's a sharp drop across the April-June period when the market lost ground.

3) PCR: Methodology in calculation can obviously make a difference to PCR levels. In the Indian context, stock option volume is very limited and there are very few puts. Stock option PCR tends to range between 0.15-0.3 if we're considering all traded contracts. It is nearer the lower end of this range if we only consider end-of-day OI. This is a function of illiquidity and frankly, it's impossible to make any judgment based on overall stock PCRs in the Indian market.

The overall market PCR is heavily skewed by the fact that the Nifty generates close to 90 per cent of all put volumes. The data is more easily available in terms of all traded contracts rather than in terms of OI. So, we'll use the methodology of all traded contracts.

The F&O market has gained so much depth in the past three years, previous data is probably useless in trading terms. Since January 2004, the average market PCR has been about 0.65, with a standard deviation of 0.21.

Since January 2006, it's up to 0.8 with a standard deviation of 0.15. This is a sign of a more mature and liquid market. In bearish phases, it has plunged. The chart depicting the Nifty's movement since January 2006 versus the daily market PCR shows a positive correlation. If PCR is high, the market tends to be high.

4) HV and IV: The theoretically correct way to calculate HV and IV are both very complicated. You can use a thumb-rule calculation instead which will give similar results. Take the daily high-low range as a percent of the future's settled price. Take say, a 20-day moving average of this in order to get a smoother value.

This is your proxy for HV. As of June 6, 2007 the HV was 1.18 per cent under this method. There are 15 sessions to expiry so we can expect a maximum swing of about 17-18 per cent in either direction.

Now take the nearest to money call option and nearest to money put option premiums and calculate the breakevens to derive a range. That is, with Nifty at 4384, the 4400c (premium 65) and 4350p (75) are worth considering. A strangle breaks even outside 4100-4665.

The implied volatility is about 13 per cent. With 15 sessions to expiry, the IV is lower than the HV so, the market is not exhibiting bearish signals. If you run a similar calculation during a bearish phase, the IV will generally be higher than the HV. There may also be asymmetrical pricing in that puts and calls at the same distance from the money will be priced differently.

Conclusion: The above just scratches the surface of the research possible with F&O data. Obviously specific indicator levels will change along with market conditions. As stock options become more liquid for instance, and more traders start using sophisticated models, the market's PCR will change. However we hope that this study introduces you to the world of derivatives analysis.