VIX is the most prominent barometer of risk that is available in the market. Many banks tried to bring in their versions of risk barometer with much fanfare but failed to impress the market. VIX is still the most preferred indicator whether it is VIX of S&P 500 or of Indian Nifty.On Thursday Nifty VIX registered 16.4 which is the lowest since September 6th, 2010 the day it closed at 15.2.
VIX of S&P 500 too registered the lowest reading of 15.4 since March 27th, 2012 on last Thursday though on Friday it gained some and closed at 16.3. Nifty VIX and S&P 500 VIX as shown in the chart below are tantalizing close, volatility parity! Since its inception Nifty VIX has been at discount thrice and all these instances occurred during high volatility regime. The reasoning is that the US economy is so precarious that any gloomy news leads to surge in insurance premium and overshoot that of India’s.Hence unless we see any larger crisis the spread between Nifty VIX and S&P 500 VIX should widen going forward.
Nifty VIX is currently close to its historical low and hence the chance of VIX reverting to its mean is high. The low VIX reading turned out to be a prescient for the strong rally in the month of September 2010 and the rally was fuelled by strong buying by FIIs. In July 2012 we can’t ignore the dejavu of low readings by VIX and money flow from FIIs but the factor that undermines these sentiment boosters is the weak volume. Despite strong FII inflows in the month of July the volume has been steady decline.
Appraising Nifty
Arriving at the fair value of any index is a tedious affair as compared to that of equity and hence some proxies or some thumb rules are used to ascertain whether the index is priced fairly or not. We have used Return on Equity (ROE) and earnings yield which is the inverse of Price Earning Ratio to gauge how Nifty is placed. Instead of using plain ROE and earnings yield for our analysis we have used difference between ROE and its average and difference between earnings yield and its average, respectively. The rally is sustainable when ROE is above its average and earnings yield is below its average but currently ROE is well below the average and earnings yield is close to the average and hence the market might remain subdued.
Option Analysis
As on Friday close call of strike 5300 has more than 10.0 million open interest closely followed by 5400 call with 9.6 million and large number of open interests are also seen on put of 5000 strike (7.7mn) followed by 6.0mn of 5100 put and 5.5mn of 5200 put. Heavy concentration of calls at strikes 5300 and 5400 at the start of a expiry week hints that Nifty might gain from 5200 but atslightest negative triggers the market can drop sharply aided by strong buildup of calls.
The chart which looks at the open interest of put and call of strikes 5200 and 5300 shows that the open interest of call 5300 has been building up strongly while that of put of strike 5300 has been getting wound up taking the OI put call ratio to 0.28x, a level which can work either way.
In an expiry week the theta decay will accelerate and hence trading in option is more risky.With this caution we suggest buying a put option. As mentioned in our earlier article the Nifty spend last week filling the gap though the work is still in progress. Currently with low volatility the option premiums are cheap and hence shorting option is not a viable option and coupled with the fact that shorting gamma in an expiry week can wipe out any make shorting a strict no.
As mentioned above fundamentally there is no need for Nifty to rally and secondly strong accumulation of call options can work in favor of bears, and technically Nifty looks weak and hence we suggest buying put option. The put option is priced at an implied volatility of 12.6 which shows that option is trading cheap.