Rising OTC options deals point to a correction on Dalal Street

19 Jun 2009, ET Bureau

MUMBAI: Are stocks headed for a sharp correction? The consensus among most institutional investors seems to be ‘yes’. At least, the kind of equity options strategies that are in demand in the unofficial over-the-counter (OTC) market, where savvy investors such as hedge funds and investment banks strike deals over the telephone, reflects this sentiment.

People familiar with deals in the OTC market said there’s an increased demand to buy relatively risk-free options strategies such as risk reversals or equity collars. But such strategies are not finding too many takers, suggesting that most of these influential traders are not ready to risk-betting that the market will not fall sharply over the coming weeks.

“There are certain indications that dips could be rapid, which is why there is a demand for risk reversals...Nobody is really interested in naked bets,” said an official at Antique Stock Broking. A risk reversal involves simultaneous purchase and sale of out-of-the money (OTM) ‘call’ and ‘put’ options to create a near zero-cost trading structure. In this trading strategy, an investor is selling ‘calls’ and buying ‘puts’ to create synthetic short futures, which use options to mimic the certain characterestics of futures contracts.

This is how a risk reversal works. In a hypothetical situation, if the Nifty is at 4,400 and an investor expects the index to fall sharply, he would sell 4,600 or 4,700 call options for a premium of Rs 100. By selling this call option, the investor is bearish on the index. He then uses this premium to fund buying 4,000 or 4,100 put options, ideally, at Rs 100.

So, the investor benefits, if the index does not move beyond 4,400 and gains all the more, if it falls. In case, the Nifty rises to say 4,600, he loses the premium paid for buying the ‘put’ and also the money received for selling the ‘call’. Several investors have existing long positions or use index futures as a hedge against this strategy.

For the counterparty, he will benefit, only if the index moves against the bets involving the call selling and put buying. But many investors are not comfortable being the counterparty to these trades, given the negative bias towards market direction. Though the Nifty has erased roughly 8% over the past five sessions, the index is still higher 65% over its low on March 9, even as corporate earnings are yet to indicate any improvement.

However, market participants said there is a pickup in activity in options trades in the OTC market, which happens outside India, especially in Hong Kong. Brokers said last week there were deals in options worth Rs 1,500 crore on a particular day.