The Nifty index on the National Stock Exchange has reached a two-year high and valuations seem rich at around 23 times past earnings. Could a correction be around the corner?
India’s option writers, who are among the savviest traders on the street, are united in their belief that a correction is nowhere in sight. At least that’s what current option prices indicate. The India VIX index is at an all-time low. The index is a measure of the implied volatility based on traded prices of Nifty options. The lower the prices of options, the lower the implied volatility.
Interestingly, with every rise in the markets these days, the cost of buying protection against a fall in the markets has fallen. The fact that put option writers are willing to sell at increasingly low prices indicates a growing confidence that the markets won’t fall from current levels. Note that this isn’t a vote of confidence for India’s growth story or valuations relative to the rest of the world. This is purely based on the belief that the current liquidity-driven rally will continue to find support from strong foreign institutional investor flows, thanks to high liquidity in developed markets and due to a weakening dollar, which enables a carry trade.
Also Read Drowning worries in a sea of liquidity
The most traded Nifty put option contract on Tuesday was one with a strike price of 5,300 and expiring at the end of this month. This contract is available for a price of Rs52.10. Each Nifty contract has a multiplier of 50, so the total cost of buying this Nifty put option would be Rs2,605. The buyer would break even when the Nifty falls to 5,247.9 (5,300 less 52.1). That’s a drop of just 2.2% from the Nifty’s current levels of 5,364.5.
If the index corrects by 5% from current levels, the net gain for the option buyer would be Rs7,600, or nearly three times the cost of buying the option. The option writer’s payoff is exactly the opposite. Still, put options worth at least Rs14,000 crore in notional value were written on Tuesday, indicating that the level of confidence in the market is rather high.
Graphic: Ahmed Raza Khan / Mint
The earlier example involved a contract that expires by end-April. What if one expects the market to drop in the next three months or perhaps the next one year? While long-dated options aren’t very liquid, there are a few contracts with decent volumes which one can use to bet on a market fall.
The Nifty 5,200 put expiring in June will turn profitable if the market falls by 5.2% from current levels. The Nifty 5,000 put expiring in December this year will turn profitable if the market falls by 10.8% from current levels. And the Nifty 5,000 put expiring in June next year will turn profitable if the market falls by 12.6% from current levels.
Of course, the initial investment will be higher (Rs5,600, Rs10,600 and Rs15,500, respectively), but the longer time till expiry increases the chances of the trade becoming profitable. With option premiums being at record lows, this could be the chance to take a cheap contrarian bet.