In life, as in stock markets, interpreting signals right spells the difference between success and failure.
Investing in stocks, traditionally, had two main approaches — fundamental and technical. However, as with anything in the world that evolves, markets too have developed significantly. Over the years, newer approaches have come to the fore — such as combining technical with fundamentals to time buying and selling decisions, combining quants with fundamentals to better capture broader market trends, or even combining all the three, in some instances.
While at times it may end up as a case of too many cooks spoiling the broth, done wisely, capturing signals from different sources can help you play your cards right and optimise your capital returns. Given the unpredictability of markets at any point in time, whatever the supportive data points in favour of one direction as per your approach (fundamentals or technical), giving due weightage to certain signals from different market data points can go a long way in improvising risk management as well.
Given the huge volumes in the Indian derivatives segment, whose turnover is about 250 times that of the cash market in November, there is a trove of data from the wisdom of the crowd in that segment. Here is a lowdown on signals that you can pick from a few important metrics in the derivatives segment. Although it can be difficult to predict long-term trends out of it, constant monitoring of these will tell us the market sentiment, which can aid us in making better investment decisions.
India VIX is a volatility index based on the options price of the Nifty 50 index. This is also called the fear index as, in general, volatility goes up when the market falls. To calculate, the bid and ask quotes of out-of-the-money near and mid-month Nifty options are considered. For instance, currently, the VIX is calculated using bid and ask prices of December and January expiry (monthly contracts) options. The methodology was taken from CBOE’s VIX calculations where S&P 500 options are used.
Volatility determined here is implied volatility and not historical volatility. While historical volatility is calculated based on the past data, implied volatility is estimated based on the prevailing option price and this is believed to give us a picture of the future. It shows the expected volatility over the next 30 calendar days.
When the India VIX goes up, it indicates that the participants are anticipating a large move and vice versa. It is important to note that volatility per se shows the magnitude of the expected move but not the direction. However, we still attribute increasing VIX to bearishness and decreasing VIX to bullishness. This is because, historically, the bear trend has been sharp whereas the bull trends are usually slow and steady.
In the past, India VIX has largely stayed within a range except for extraordinary circumstances like the 2008 collapse and Covid crash. Mostly, it has bottomed out between 10 and 12 and on the other hand it has topped out between 25 and 30. So, here’s the signal for the investors. When the VIX rises to the upper band, a bottom is probably around the corner; when it falls to the lower band, the volatility might start increasing and we might see the Nifty 50 topping out, resulting in a correction.
For example, India VIX touched the 25-30 band in February this year and the markets formed a intermittent bottom in March. After cooling from there to 17-18, India VIX again topped out between 25-30 before the Nifty bottoming out in June. After the Nifty reversed higher, the VIX dropped and is now at around one-year low.
Put Call Ratio
Put Call Ratio (PCR) of options is another derivatives indicator that can aid participants in gauging the market sentiment. The ratio is arrived at by dividing the total Open Interest (OI) of put options by the total OI of call options. Importantly, they should be of the same expiry. Open Interests are nothing but the outstanding contracts that are yet to be settled. Alternatively, PCR can also be calculated by taking the volume i.e., dividing the volume of put options by the volume of call options.
While OI is the number of contracts that are unsettled at a point in time, volume refers to the number of contracts traded during a particular period.
When the ratio is above 1, it means there is higher activity in put options and when the ratio is less than 1, call options are more active. While there is no definite way to see the ratio and gauge the sentiment, in general, one can take the sellers’ side — the reason being that selling options requires higher margins and entails theoretically unlimited losses as well. Usually institutional and professional traders are the ones who write options. They are considered to be informed traders, and hence one can say that when there is a huge put option selling, the market is likely to form a base, if not a rally.
Similarly, when PCR is less than 1, it denotes more call writing than put selling. This indicates that the big money is not expecting the market to rise much. It could either consolidate or decline.
That said, it is always better to look at PCR in conjunction with other factors. For instance, when the VIX is falling and simultaneously PCR is increasing — this can be taken as a bullish signal. Or when the market is at a key resistance and PCR starts to fall, it means call sellers are becoming aggressive and the market could fall or stay sideways.
Extremes can be an indication of reversal. For example, although PCR at 0.3 means substantially higher call writing vs put writing, which generally means bearish inclination, too much of call selling means the market or that particular security might see a bounce. A minor rally can trigger short covering, reversing the trend sharply. Hence one needs to assess the signal differently when they are at extreme levels.
Like index level PCR, stock level PCR data can be easily calculated from the data available on the exchanges. PCR counts the calls and puts contracts in all the strikes. One can also look at much more detail, which brings us to the option chain where we can specifically see at what price, referred to as strike price, participants are interested in.
Option chain, also called option matrix, lists all the calls and puts options available to trade on a particular security. The most useful feature of option chains is that one can identify how many open interests are outstanding in each strike price of the underlying. Through this, we can infer what price levels are drawing the interest of the participants.
For example, assume that Stock A is trading at ₹95, and the 100-strike call option has a significant number of outstanding open interest. This could be a hint that option sellers are not expecting the stock to rally above ₹100 during that expiry. On the other hand, a breakout of ₹100 can result in a sharp rally as well.
And generally, out-of-the-money call option strikes with high outstanding open interest are considered to be resistance levels whereas out-of-the-money put option strikes with high outstanding open interest are seen as support levels.
On regular tracking we might sometimes see certain strikes witnessing unusual and sudden spurt in both volume and open interest. This can be an indication of an impending wild price movement.
Option chain also provides us with information like bid and ask price of each contract, the implied volatility, last traded price, change in option price, total outstanding open interest, change in open interest on that day and volume.
While the above indicators are based on options, we can also get a sense of the market with the help of futures contracts.
Based on the difference between the spot price i.e., the price of an underlying and its futures price we can assess the market sentiment. Usually, the futures curve will be upward sloping i.e., the premium to the spot price will be higher as we go farther. The condition is also called contango. This is a bullish indication as the market is expecting the spot price of the asset to increase over time. But note that the futures and the spot price converge as we head towards the expiry.
Positive expectations aside, the futures trading at a premium is also attributed to the carrying cost. This is specifically true to commodities.
That said, there are times where the futures price of an asset is at a discount to spot price. Here, the futures are said to be in normal backwardation or simply referred to as backwardation. Such conditions can exist because the market expects the price of the asset to drop as we go forward.
An asset, especially commodities, can also be in backwardation if the current demand is huge or there is a supply crunch or a combination of both, driving the prices higher temporarily. For instance, the crude oil market has been in backwardation since early 2021. Earlier the discount at which the farther contracts were trading was not much. However, in early 2022, triggered by the Ukraine conflict, the spread i.e., the difference between the price of contracts of different maturity shot up. That is, the condition of backwardation strengthened and ever since, the price has been on a fall. Though, it has now turned to contango.
Another metric based on futures contracts that one can use to evaluate the market mood is the rollover and rollover per cent, used in common parlance. Rollover is defined as the process of liquidating a contract that is set to expire and opening a similar trade in the next expiry. Simply put, it is carrying over a position from one expiry to the next.
What is important to note here is the reason as a participant will rollover the contracts only if he/she believes the existing trend will continue. Otherwise, the trader would have let the contract expire — and stayed out of the market. While rollover can be considered in absolute terms i.e., the number of contracts, rollover percentage is commonly used. Below is the formula
Rollover percentage = (Total number of mid and far open interest/Total outstanding open interest)*100
So, when the market is moving in a direction, either up or down, and there is a healthy rollover, one might normally expect the current momentum to sustain.
For example, on November 24, 2022, the outstanding open interest of November, December and January futures stood at 27, 112 and 10 lakh contracts, respectively. Here, December is the mid-month and January is the far month. Therefore, rollover percentage stood at nearly 82 per cent — sum of 112 and 10 divided by the sum of 27,112 and 10.
However, when there is a fall in rollover percentage, we might be heading for a reversal in the existing trend. If not a reversal, we might at least see a corrective price action.
The rollover percentage per se may not give you the current sentiment. It should be seen with the prevailing trend and in general, it is compared with the average of the last three months.
Between the expiry of October and November contracts, the Nifty 50 appreciated by around 4.2 per cent. Rollover percentage, at 82 per cent, was a little higher than the three-month average of 79 per cent. Here, the indication is bullish i.e., the participants are expecting the rally to extend in December.
How to interpret F&O metrics
India VIX stood at 13.48 at the close of last week. Note that on Friday it marked a low of 11.91, thereby entering the 10-12 band that we discussed. While this does not confirm a bearish reversal, it is of course sending a signal of caution that we might be nearing a market top. If you are very bullish on the markets, you may want to factor this and manage your risks accordingly.
The PCR of weekly options i.e., December 15 expiry also shows a bearish bias as it stands at 0.52 and that means call writing is nearly twice the amount of put writing in terms of number of contracts across the strike prices. However, the PCR of December 29 series (monthly expiry) stands at 1.25, indicating more put writing than calls, which is a positive signal. Therefore, the Nifty 50 index might fall this week and witness a recovery from next week onwards.
Looking at the option chain, the December 15 and 29 expiries show that 18300- and 18000-strike put options have seen a good amount of writing i.e., these strikes have the highest outstanding open interest among out-of-the-money options. So, if the index falls, it can find support at 18,300 and 18,000. Coincidentally, the price action of Nifty 50 shows that 18,300 is a good support. On the other hand, the 18600-strike call option (December 15 series) has the highest outstanding OI and therefore, the price level of 18,600 is expected to be a strong barrier.
And remember that, the rollover to December futures, at 82 per cent, was higher than the three-month average of 79 per cent and the futures curve of Nifty 50 is upward sloping, meaning the farther contracts are at a premium. These are bullish clues.
Therefore, consolidating the above, we might see the Nifty 50 index decline to 18,300 and possibly to 18,000. Thereafter, it could resume the rally. That said, the above data need to be continuously monitored for any change in sentiment. Things in markets can change quickly, but looking at these metrics we can gauge where things stand as of now and accordingly manage our investment/trading decisions and, more importantly, risk management.