The Hindu Business Line : FIIs could be holding on to July short positions

Much has been written about the role of FIIs in perpetrating market crashes. It is probably for this reason that the daily action of the FIIs is of such great interest to market participants.

FIIs in cash

There have been five major corrections, exceeding 10 per cent, since the bull market commenced in 2003.

The FIIs have been net sellers in four of these falls.

The only occasion when market correction was accompanied by positive FII cash inflow was during the correction in March this year.

The massive DLF and ICICI Bank public issues are responsible for this anomaly.

The recent correction in July-August recorded the second largest exodus of FII funds in the cash segment.

The highest outflow was witnessed in May 2006.

The ferocity with which the funds were withdrawn in the recent fall is surprising when the magnitude of the fall is taken into consideration.

The 2006 correction shaved off 30 per cent from the market’s peak, while the recent fall was less intense, causing the Sensex to lose just 13 per cent.

The outflows recorded during the corrections range between 1.5 per cent and five per cent of the total FII inflows recorded up to the date of the commencement of the correction.

Again, the deepest cut was in May 2006, when the FIIs pulled out almost five per cent of the funds that they had infused until then.

FIIs in derivatives

The FII action in the derivatives section follows a defined pattern.

They invariably sell in large quantities in index and stock futures in the first few days of the correction.

This could be due to portfolio hedging or caused by short positions being initiated in anticipation of a sharp fall in the market.

Once the recovery begins, they are forced to cover their short positions, thus making the recovery steeper and faster than it would have been in the absence of these short positions.

This trend was more distinct in October 2005, when many hedge funds holding naked short positions were caught on the wrong foot due to the sudden about-turn that the market took.

In May 2006, FIIs were net sellers in the derivatives segment in the second week, but covered their shorts half-way through the correction, thus thwarting a ‘V’ shape recovery akin to October 2005.

FIIs acted similarly in the recent correction too.

They were net sellers of over $1.6 billion in Nifty futures on July 26 and July 27.

But large-scale short covering has not been witnessed so far, leading to the assumption that FIIs could be holding on to some of the short positions initiated in July.