Stock Futures Basics

Advantages of Stock Futures

1. Leverage
2. Lower Transaction Costs
3. Hedging/Shorting

Market Participants

1. Cash volumes are mainly generated by Long Only funds, DII and Retail participants. The volume in retail is fairly stable over time, compared with futures volume.

2. In Stock Futures, major participants are retail speculators and hedge funds – looking for high leverage.

3. Index Futures are mainly used for hedging purposes by institutional players – long only funds.

OI Information
Stock Futures OI largely are a function of speculative activities in the market. In periods of heavy bullishness (2007-end), there was huge OI build-up in the stock futures (and not much in Index Futures). However, that corrected after the crash, and came back to normal levels. Index Futures OI do not fluctuate too much as hedging requirements do not wildly fluctuate.
 
Important Indicators

1. Basis: Sign of pressure from longs or shorts
2. Open Interest: Amount of interest in the underlying
3. Price Change: Direction of the momentum in the underlying

Have to see these indicators together to make sense of the activities of the market participants – for example, when basis is strong, and OI is rising, a price rise indicates long side speculative activities.
 
Index Arbitrage
Nifty futures usually trade at a discount to the fair value (as it is used as a hedging instrument by the long only guys), and as a result, arbitrageurs put up positions in Long Nifty Futures and Short Stock (or SSF).
A large chunk of this position is sticky, in line with the fact that a large chunk of short Nifty (hedge) is also sticky. However, not all arbitrage players have access to the full 50 stocks at all times, and hence they usually have to short a few SSF also in the stock basket. Hence, some of the stock futures also trade at a discount due to this factor (mostly those whose inventory is not readily available). Most of the under-owned stocks trade at discounts (only Nifty stocks).
 
Futures Rolls
At expiry, investors have the following options:

1. Unwind
2. Expire
3. Rollover
4. Convert to Spot (buy/sell spot in VWAP)

Considerations during the expiry

1. Basis: If the futures have been trading in premium over the month, then there would pressure from the long side – rolls also might happen at a premium (the premium in near month would move to next month close to expiry)
2. Market Trend: A rising market would imply futures in premium – and hence rolls also might happen at a premium
3. OI with Price Action: A rising OI with price increase would also mean more and more pressure on the long side, and higher roll premiums.
4. Historical Rollover Ratio: The proportion of futures positions getting rolled every expiry also gives a good indication of the remaining interest in the counter.

Exit Point

Why do all the trading literature concentrate so much on entering a trade? The successful exit strategy is as important as entry. And that would many a times make the difference between a profitable trade and an unprofitable one.

More on this later, when I finish some of the Technical Analysis books that I have got.

Market View: October 23

Nifty Movements: Nifty lost some of its gains this week, and ended the week a shade below the mark of 5000. However, the market was quite strong, and despite the bad news from the RIL front, managed to close flat on today. Think the market would continue to hold over the short term, and may end the year at a high. Usually, markets do have a tendency of rallying close to the year ends, and if that happens, we may be in for another 10-15% up move from here.
 
Stocks: Telecom stocks have been very weak recently, and they continued to be under-performers. Real Estate also faced sell-off for a couple of days. However, the big under-performer has been RIL – marred in controversy and court battle, and then the Hardy pullout. IT companies surprisingly have held out well in spite of a stronger outlook on INR, though going forward we may see some weakness there. Another sector to watch out for could be the metals, with bad news expected from China.
 

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Next Week Views: The main risk remains the Chinese markets, and if the news coming out of there about the overheated economy and inflation concerns indeed is true, then we may see weak markets. However, there is not much bad news coming out of West at the moment, and if the results continue to surprise, the markets may even accommodate modest bad news from China.
I think we are standing at some sort of an inflection point – there are people who believe markets would reach new highs, and there are people who believe we are in the middle of a ‘W’. And the rational from both the sides seems to make sense. May be, this is the way markets are designed to be – capturing all the present information, and standing well in balance. I haven’t seen a bull-run from a trading floor before, so am not sure how they appear. Were there equal number of skeptics way back in the bull markets of 2003-2007 as well?

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Food for Thought: How do you think the consumption patterns would change in the next 10 years? What would be the next generation consume more, and what they would consume less? I think all the things traditional would be consumed less and less (in value terms adjusted for inflation). And people would consume more and more technology. Just like there has been a great shift in ‘Telecom’ consumption over the last decade, I think people would consume some technology a lot more than what they are consuming now. If I have to put a bet on different industries, this is how I would think:

1. IT wouldn’t remain an industry servicing large brick-mortar corporation. As more and more things start happening online, more and more IT services would be consumed by all organizations. And I would think there would be a drastic shift in the IT-related expenditure for all firms.
2. Telecom would continue its march, and might develop into the biggest industry. Most of the telecom companies would offer all sort of communication services – Television, Media, Broadband, and Telecommunications (they have already started). I think the opportunity here is huge, and we have just hit the tip of the ice-berg. The usage for the communications would increase greatly, and if somehow they manage to replace the credit cards as payment options, then it would be unprecedented. And I see nothing that a credit card offers which a mobile phone can’t do better.
3. Media/Entertainment: This is another industry which I would think would grow. Currently media is not being priced correctly, and most of time people make bundled payments (when paying for all the channels). With selective view-based pricing, and more and more cities coming under the multiplex chain, media revenues make take a quantum leap sometime in the next few years (with multiplexes opening just in the metros, the revenues from movies leapt from 10-20 Cr average to 50-60 Cr average).

Rally Monkey: Still Playing At a Market Near You

Nothing describes the current markets better than the Rally Monkey music. This one has to be played out loud in the office during the market hours (you will need to turn ON the sound on this page).

Disclaimer: The webpage actually has nothing to do with the markets, but all the investors indeed dance to similar tunes :)

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The markets have been correcting for the past few sessions, and daggers are out on the sustainability of the rally. A growing number of people believe that the markets have run up too high, and are long overdue for a correction. Well, I’m not completely bearish even now, and think there are still a couple of legs to the rally. I might be wrong here, and might have to eat my words pretty soon (for October isn’t over yet), but I would still stick to the long view.

Oil is back at $80 levels, Gold is trading at record highs, EUR has gone back to 1.50 levels and Equities are almost at their early or mid-2007 valuations. But China is still 50% down from its peak. The country best placed to avert the crisis, inspite of all the steroid-led growth stories, hasn’t seen too much of a recovery. And even though it makes sense (as China’s growth is led by export to US), I don’t think US would remain with 10% unemployment numbers for a long time. And hence, there is a strong case of rise in Chinese stocks, adding another leg to the global rally.

The underlying rational for all my bullish thoughts is the assumption that US isn’t going to have a lost decade. Japan’s case was different – Yen wasn’t the world’s reserve currency. Here, US is the master of the world – and any holes in its economy would be plugged by Qatar or Singapore or anyone else. There is a strong queue waiting to bailout US, for its the safest asset in the world. And as US comes out of the crisis, the whole world would follow, sooner or later.

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Food for thought: I got an answer to my long puzzling puzzle of why markets tend to go up more often that not. Money Supply growth is quite large compared with the World population growth, and hence, with each passing day, world is getting richer and richer. And there are only two avenues to use this money – consumption or investment. Inflation measures the rise in consumption demand, and rising markets measure the rise in investment demand. And since the marginal propensity to consume goes down as income increases, the rise in investment demand increases more than the inflation. And hence, the world markets are in perpetual bull runs.

Market View – October 5

Oktoberfest has started in Germany, but the Oktobercrash is nowhere in sight. And with each passing day, I’m getting more and more pessimistic about the possibility of it (rather than sounding optimistic, I have tried to use a double negative here).

1. To start with, I don’t see too many companies posting very bad results. Most of the times before the crash happens, the results are really bad (like in 2008) – which though not the final trigger, but atleast contribute to the weak markets. This time around, with the lower expectations, results won’t be ‘exceptionally’ bad for most of the companies. Hence, one of the crucial requirements of a crash is missing.

2. Another factor which shoots down a possibility of a big crash is the fact that rarely have the markets crashed in two consecutive Octobers. Historically, we have had crashes separated by a decade or so (atleast in near history, with 1987 crash, followed by 1997 Asian crisis, and 2007 credit crisis). So, it might be too much to expect a crash in 2009. I would rather put my money on a 2017 crash here :).

3. Last year, there was a great uncertainty in the markets – job markets as well as asset markets. No one seemed to have any clue as to how many banks would go under, or who’s next, or whether one would be left with any jobs at the end of the year or not. There was panic everywhere, and people had put on hold all their investment plans – manifested in the falling property prices, no IPOs, decelerating loan growth, etc. Somehow, this time around, that fear is missing. Property prices have risen by 20-40% in Mumbai, people are no more ‘too’ concerned about their job prospects, and all the asset classes are booming. Somehow, the fear factor seems to be gone.

4. Relentless FII buying in India is in fact making me believe that we may be in for a big rally soon (even from these levels). FIIs have bought stocks worth USD 12-13 Billion this year, and this is inspite of the initial selling in the months of Jan and Feb. To put figure into perspective, in 2007, FII had bought stocks worth USD 17 billion, and in 2008, they sold worth USD 13 Billion. So, the buying this year is almost on a record scale, and won’t be surprised if the locals start jumping in anytime now. Post-diwali, I think there would be a queue of people trying to get into the markets, and that might take it another 10-20% from here.

So, I would stick with my year end estimate of 20,000 on the Sensex. This might sound ridiculous, but then, 2009 as a year has been exactly that.

The Chase for Alpha

Much has been written and publicized by the investment managers about their ability to generate Alpha – above market returns. Most of the Mutual Funds offer documents and advertisements talk about how the fund has consistently beaten the market over the past years. And surprisingly, using very carefully chosen time frame as well as parameters, most of them have data also to substantiate their claims.

So, does it mean that these managers actually beat the market? Well, very unlikely – and if one adds the entry load (1-2% for most schemes), management fees (~2% annually), and exit loads (0-1%), there is very very miniscule chance that an investor would be better off by investing in a fund as against directly in the market index. Assuming an average all-expenses of 3% for a fund, you need the manager to beat the market by more than 3% to be actually able to generate alpha to his end clients. Add to it the fact that alpha is strictly a zero-sum game, and for every manager who beats the market, there would be another one who has been beaten by the market.

I’m strictly against use of Mutual Funds, atleast by people who can understand the basic nuances of stock market, and have the resources/skills to invest directly in the market. Most of the time we are afraid of losing money in the market – a fact compounded by frauds like Satyam, and we always run the fear that we may be caught on the wrong foot. However, the reality is that the same is true for a professional fund manager as well, and in fact I would like to think that they would have a larger tendency to take risks. And most of the fund managers in reality were caught napping during the Satyam fiasco.
So where does this leave an average retail investor? There are two choices for generating the market returns - (a) Using Index Futures, and (b) Using ETFs. I tend to prefer the latter over the former as futures are by their very nature a short term betting instrument, and if one plans to have an investment horizon of atleast an year, then futures would entail rolling the contract at every expiry – a costly as well as cumbersome exercise. ETFs are nothing but essentially a basket of all the stocks in an index, and have a small ticket size (currently INR 500 for Nifty BeES). Much goes behind the scenes with regard to how they are structured, and how they are able to track the Index. However, for a small investor, it would be sufficient to understand that they would tend to trade very close to the actual index value, and the management fees are much lower (0.50% or so) for these funds. So, if one just wants to have a plain exposure to the market, ETFs present a much better option compared with the mutual funds.

Why there is no word called ‘Bear-sh*t

To start with, let me put the disclaimer first:

I have a very strong belief that most of the asset classes in the world always trade at a premium over their fundamental value – defining fundamental value as what people would earn if they indeed keep the asset till perpetuity. I have a term for it as well – the ADR phenomenon. It goes like this – any ADR can anytime be converted into the underlying stock, and hence the value of an ADR will seldom fall below whatever an investor can earn by buying the ADR and then immediately converting that into stock. So, ADRs most of the time trade at a premium to the intrinsic price of the underlying share. The price of the stock here is the ‘Opportunity Value’ of the ADR – which could be derived any time the investor wants to. The same rational goes for the stocks or any other asset class – they always trade at a premium over what people can earn by holding them to perpetuity (their “Opportunity Value’). Only in times of deep recessions and market crashes do they trade below their values. So, more than 80%-90% of the times there is a bubble in the market.

Now building on my belief about the perpetual asset bubble in the world, any rational person would most of the time expect the market to correct (looking deeper into the terminology here – market falls are called ‘correction’, while the rise in markets are given terms like ‘bubbles’, ‘frenzy’, and ‘euphoria’). So, there is an inherent bias in the market where more people always believe that markets should fall. Whether they expect the fall to happen immediately or later is where the opinion differs, but they are all united in their belief that they are over-valued. There seems to be slight sophistication in thinking ‘Bearish’ – anyone who thinks markets would keep on rising is termed a naive retail speculator, whereas anyone who can substantiate a market fall is an ‘Economist’ or a ‘Trader’. So much are the professionals in the field biased against the bulls that they have named the ultimate description of crap as ‘Bull-sh*t’.

So, little wonder that all the ‘E’s and ‘T’s of the world are united in terming the latest rally as overdone, and are predicting another crash to happen ‘any moment’. No one likes a rising market – anyone can make money there. The dumbest of people end up making the most mullah in a bull market – as they don’t have the slightest of fear about a market fall. If one was born in US in the last 1970s, and discovered their senses in mid-1980s, then he/she saw was an ever rising market. How on earth would someone explain him/her that markets could fall as well. They were living in a ‘fool’s paradise’. NNT also warned against the bull markets, and bought deep OTM options – in the full knowledge that markets one day would fall big, and he would make a killing. He did make it, but that came after years of painfully watching the market move up, and seeing all his options expiring worthless (he did get all his money back, but that was from the sale of his books, rather than from the markets). No one ever loses everything in the market – either you make money, or you learn.

In the end, everyone is right about it – but seems that if you do not think about it too much, you are right on more occasions than the rational thinkers. You might lose everything you made in just one bad year, but then, its the same with the other side as well. So next time an expert warns you against a crash, just tell him that you would rather lose money in a couple of crashes, than being worried about it for all your life. And for all the ‘bears’ in the world, there is one simple answer - ‘Ignorance is Bliss’.

Market View - August 13

This is getting really interesting with the whole world now divided almost equally between the Bull and the Bear camps. Past two years we have seen people all over having similar views. 2007 was the year of the bulls, whereas 2008 was the peak of bearishness. This year has been a mixed bag for both the camps, and people have often changed their places.

The fight quarter truly belonged to the bears, and they kept sitting tight over the market. It was a classic range bound market between January and March, and Index almost finished flat at the close of the quarter. The second quarter belonged to the bulls with market seeing returns of 15% and 28% in April and May respectively. The bears were left too stunned and circuited to do anything about it.

As we moved into the 3rd quarter, the bulls have done well with momentum with them. However, lately they seems to be running out of the 'good news' fuel at their end. The markets are more than 75% up from their low, and still 33% away from their peak. However, the peak of 2007 was a result of exeberance where the word 'RISK' completely disappeared from the world. Whatever progress we have made over the past years, whereas it may be debated that we are out of depression zone, but certainly we are far far away from the exuberance period as well.

So, I'm turning a little cautious on the markets, and think that over the medium term, 4800 could well turn out to be the pivotal point for the markets. If they are able to cross it by the end of September, I would believe that we would end the year on a high. Else, we may be pulled into the deeper holes of recession once again. This rally is no doubt driven by liquidity, and one needs this ponzy scheme to keep feeding itself till the time the global economy recovers. However, if this thing falls flat, and the train is stopped too soon, we may be back to square one. The markets would need to keep going up to sustain the bull run - much like the space rockets. The printing press all over the world have injected fuel into the markets to move out of the recession zone, however, if the markets are stuck into a zone for even a month, and public confidence gets lower, we could all be into a big mess once again. 

Are IPOs Underpriced?

In my B-School, I wanted to do a term paper on the Under-pricing of the IPOs. Sadly, the concerned professor had already been approached by many other students, and he rejected my application. And when I joined my job, the markets crashed within a short span, and IPOs almost dried up.

Now 2009 promises to be a good year for the IPOs, and I would expect at least 5 big offering to hit the market over the next few months. And I would really like to test the theory of under-pricing by actually subscribing to them. 

The first issue to hit the market is NHPC, and it has already opened. The price band is INR 30-36, and I would expect it to be over-subscribed by as much as 10 times at the least. Lets see how it performs!

Have we entered the Bull Market?

It initially started with disbelief, and people were laughing at any levels above 3000 for Nifty. Everyone though there was free money to be made by writing Calls, and people wrote OTM and even ATM calls in size. People blindly sold 3000C and 3100C, in the belief that we wouldn’t be seeing these levels in the whole of 2009. Once that was crossed, 3500-3600 become the TOP for the market, and people continued to write calls to cover for the losses they made on 3000-3100 Calls. Had it not been for the Knock-Out punch delivered by the election results, people might have foolishly continued to write calls even up to 4500 levels.

Now markets are flirting with 4500-4600 upper limits, and have been trading into a range between 4100 and 4500 for some time. I’m slowly turning quite bullish on the markets. While I will agree that valuations have turned quite costly, and rationally one should be selling the stocks at these levels. However, markets tend to move with a ‘herd mentality’, and there are legs to every rally/correction. This is due to the fact there are different classes of investors who invest at different points of a move. And where we are standing today, we still haven’t seen too much participation from ‘Long Only’ and ‘Private Equity’ guys. These guys are sitting with huge chunk of cash, and even though some of it has been deployed, the majority is still ‘all cash’. And the longer the market sustains at these levels, the more probable is this money flowing into the equities.

My overall sense of the market is that we won’t be seeing any more ‘crash’ in the market going forward. There would be issues on the loan books of the commercial banks, as well as concerns over the credit card defaults. However, I think these won’t escalate into very big problems, and would result into a couple of billions of charges and write-downs. Other potential triggers could be some Sovereign defaults, but again I think we won’t be seeing any major nations defaulting. Overall, I think we don’t have too many downside triggers for now (I repeat FOR NOW).

On the upside, the buying pressure from local Mutual Funds could pick up in the coming days. I think they would soon be launching new schemes, and public would come back to the markets after staying away for some time. Equity allocation has been close to a low in recent times, and I expect more and more people moving their debt funds into equities. Another upside shock could be the results – the results would surprise on the upside for most of the corporates.

On the volatility front, I have now changed my view. I now believe that we will have a low volatility period from July to September. Markets would trade in the range, and might slowly move up from here. Volatility might continue to drift down, and we may enter the sub-30 phase soon. That would also mean VIX entering a sub-20 phase, and when that happens, the funds would start flowing back into the markets.

On currencies, I think INR would appreciate from these levels, and we may touch 45 levels by the end of this year. I would be a seller of USD at any level close to 49 (currently).