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Volatility set to scale new highs

Dear Reader,

Last week I suggested that bulls maybe boxed into a corner as statistical ßeta (pure price volatility) hit crescendo levels. These are not market moves that an average retail trader is geared to handle. I believe volatility is about to get more extreme before it stabilises. Last week we saw oil markets log volatility levels that were the highest in three decades. It is for a reason that oil and gas markets are called the “widow makers.” Oil markets are likely to keep global financial markets on tenterhooks.

I have also expressed my concerns about interest rate sensitive stocks as the cost of funds is rising. I drew you attention to the Indian 10-year bond yields which ended the week at 7.13% - the highest since May 2024. Bond markets are clearly indicating that the era of cheap and easily available money supply are over atleast for now. That means financial asset prices are done with exuberance and are now in procyclical phase. Procyclicality is said to occur when asset prices are in sync with the economic realities. The economic outlook is downwards right now. Compare that with the Covid-19 lockdown phase when markets were zooming inspite of manufacturing activity was near standstill. That was a phase of counter cyclicality – when asset prices were defying gravity and economic realities. Now a mean reversion is underway.

Whenever markets move from counter cyclicality to procyclicality, volatility is often extreme. Which means the challenge level for retail traders is about to get even higher. Don’t be surprised if these are the highest volatility levels seen in financial market history. Which brings us to the best trading strategy in these times – capital preservation via tail risk (Hacienda) hedges. I have been suggesting this stand operating procedure since 2024 and swear by it. Leave no open trade unhedged.

In the commodity segment industrial metals may remain firm as supply disruptions are rampant and transportation costs keep escalating. That may cushion declines in metal mining company stocks. Public sector undertakings (PSUs), particularly banks will see heightened participation as emotional and financial capital involvement is extremely high in this sector. The banking sector commands a weightage of 38% in the Nifty-50 and is therefore a swing sector for the markets. 

     

Rear View Mirror

Let us assess what happened last week so we can guesstimate what to expect in the coming week.

The fall was led yet again by the banking and financial stocks as fears of higher inflation and easy money supply spooked markets. This pressure is likely to continue this week. Bullion saw safe haven buying as did oil. Gas prices softened as profit taking was seen on advances.

The US dollar index (DXY) was unchanged and the INR strengthened against the US dollar as RBI curbs on banks’ dollar positions brought in a relief rally in the Rupee at the fag end of the trading week.

Indian 10-year bond yields suggest a higher interest rate regime maybe around the corner. That may soften banking and financial stocks, and due to their weightage, the broader markets. The NSE gained 0.26% in market capitalisation and that suggests the broader market remained optmistic.

Market wide position limits eased routinely after expiry and US markets saw headline indices rise uniformly. That provided tail winds to our markets.

Retail Risk Appetite – I use a simple yet highly accurate yardstick for measuring the conviction levels of retail traders – where are they deploying money. I measure what percentage of the turnover was contributed by the lower and higher risk instruments.

If they trade more of futures which require sizable capital, their risk appetite is higher. Within the futures space, index futures are less volatile compared to stock futures. A higher footprint in stock futures shows higher aggression levels. Ditto for stock and index options. 

Last week this is what their footprint looked like (the numbers are average of all trading days of the week) –

The high volatility and capital intensive futures segment saw increased turnover partially due to the rollover of the monthly derivatives series.

In the relatively lower risk options segment turnover contribution rose in the stock options segment. Overall risk appetite remained robust.

Matryoshka Analysis

Let us peel layer after layer of statistical data to arrive at the core message of the markets.

The first chart I share is the NSE advance decline ratio. After the price itself, this indicator is the fastest (leading) indicator of which way winds are blowing. This simple yet accurate indicator computes the ratio of number of the rising stocks compared to falling stocks. As long as gaining stocks outnumber the losers, bulls are dominant. This metric is a gauge of the risk appetite of one marshmallow traders. These are pure intraday traders.

The Nifty-50 clocked smaller losses on a week-on-week basis thanks to the late buying on Thursday. The advance decline ratio however jumped to 3.13 (prior week 1.57). That indicates there were 313 gaining stocks for every 100 losing stocks. This ratio is an outlier and unlikely to sustain for long. As long as the ratio remains 1.0 with rising prices bulls remain in charge but the buying momentum of 3.13 may cool off significantly.

A tutorial video on the Marshmallow theory in trading is here

The second chart I share is the market wide position limits (MWPL). This measures the amount of exposure utilized by traders in the derivatives (f&o) space as a component of the total exposure allowed by the regulator. This metric is a gauge of the risk appetite of two marshmallow traders. These are deep pocketed, high conviction traders who roll over their trades to the next session/s.

The MWPL fell routinely post expiry. However this low level is a multi-month low. That tells me swing traders cut their exposure significantly last week. This is an undeniable sign of caution.

A dedicated tutorial video on how to interpret MWPL data in more ways than one is available here

The third chart I share is my in-house indicator ‘impetus.’ It measures the force in any price move. Last week impetus readings for both indices rose with fall in prices. That indicates the fall was on higher momentum and may extend this week too.

The final chart I share is my in-house indicator ‘LWTD.’ It computes lift, weight, thrust and drag encountered by any security. These are four forces that any powered aircraft faces during flight so applying it to traded securities helps a trader estimate prevalent sentiments.

Even as the Nifty logged smaller losses the LWTD reading fell from 0.01 in the prior week to -0.08 last week. That tells us the probability of aggressive fresh buying is low. Though short covering can always get triggered, it can at best cushion declines temporarily. It takes big ticket fresh buying to boost markets.

A tutorial video on interpreting the LWTD indicator is here

Nifty’s Verdict

Last week I warned you the steep decline of the price below it 25 week moving average (proxy for six month average holding on cost of a retail investor) indicated some mean reversion. That was evident as the Nifty attempted to rally unsuccessfully. The wide gap between the average and the price has been bridged partially which means a pullback rally may be seen but higher levels can attract fresh selling by trapped bulls.

For even a slight possibility of a pull back rally the Nifty must trade sustainably above the weekly of 22,940 and close above it sustainably. However the resistance level of 24,400 remains overhead and trapped bulls are likely to attempt a quick exit at those levels.

On the flip side a continuous close below the weekly low of 22,180 opens the doors to further declines.

Higher levels can encounter selling pressure
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Your Call to Action – sustained trade above the 24,400 level indicates the possibility of a fresh rally. Only if this level is overcome confidently can a new bullish phase begin. A sustained trade below the 22,180 level can trigger fresh weakness.

Last week I estimated ranges between 54,200 – 50,350 and 23,600 – 22,050 on the Bank Nifty and Nifty respectively.  Bank Nifty breached the specified support level mildly yet again.

This week I estimate ranges between 53,550 – 49,550 and 23,500 – 21,900 on the Bank Nifty and Nifty respectively.

Trade light with strict stop losses. Avoid trading counters with spreads wider than 8 ticks.

Have a profitable week.

Vijay L Bhambwani

Vijay trades markets as a prop trader since 1986 and is the CEO of www.Bsplindia.com. a proprietary trading firm. He tweets at @vijaybhambwani. Edited by Michael Correya. Produced by Shad Hasnain.