The market has been on a rising spree for a while now. While all of us trend followers have capitalised on this move but doubt also creeps in, especially amid softness, that should we book profits and get out?
Such situations call for analysing the data especially for excess participation and extreme optimism. What better way to judge consensus than the trade data of Futures and Options. We will discuss four data points that have time and again coincided with extremes in the market, be a top or a bottom.
These indicators should not be used to go against the tide, short a relentlessly rising market or for catching a falling knife. However, one may use them to manage the intensity of the trades or for that matter, even invest in some hedges for those "just-in-case" scenarios.
1. Implied Volatility
Option premium has always been an insightful data point for judging the riskiness of the market. Implied Volatility is just a standard measure to compare one option with the other. The figure of implied volatility also indicates the riskiness in the market, with a higher number indicating more risk and vice-versa. Backed by my multiple studies, we can safely say that Implied Volatility of options has a mean reverting characteristic.
If the Nifty is the index one looks at for the performance of the entire market, Implied Volatility of the Nifty options could very well give an approximation of the risk assumption of the market.
Typically, in a rising market, one would expect the Implied Volatility to fall. However, once it starts making multi-month, multi-year lows, one may expect a respite if not a reversal, which can eventually be coincided with a pullback in the rising market.
Similarly, a falling market would have a rising Implied Volatility. However, even here a multi-month, multi-year high could mean that it may turn around and we may see it coinciding with a halt in the fall or a respite in the market.
Open Interest Put Call Ratio (OIPCR) is an indicator that gives the number of Put positions compared to Call positions. Considering the fact that option sellers have negative risk-reward, it is safe to assume that whichever kind of option is sold the most, a view depicted by that position could be seen as the consensus view. To judge the overall market activity, the Nifty OIPCR is best to analyse the market mood.
So, if there are more Puts than Calls, we could safely say that more risk- bearing positions are placed in favor of the market either rising or staying still. Similarly, if there are more Calls than Puts, then we can safely say that the risk capital is more invested in betting in favour of the market either falling or staying still.
In a rising market, we will have a rising OIPCR, with the reading in excess of 1 (more Puts than Calls). Similarly, in a falling market, we would have falling OIPCR (more Calls than Puts).
Now, just like Implied Volatility, OIPCR also shows mean-reverting characteristics. Hence, a multi-month, multi-year low on OIPCR in a falling market could indicate a lower extreme and similarly, multi-period high OIPCR could indicate a higher extreme for the market.
3. Market OI
This is a rather simple indicator that many of us must have observed in our trading life. Market OI is total Open Interest in value terms of all the futures and options. It is not very conclusive yet definitely an alarming indicator. Market OI making annual highs after a huge run in a single direction—either up or down—would be indicating alarming signals that a lot of money has been chasing a single direction.
Such situations make the entire participation vulnerable to any pullback or respite. So much so that it can trigger a deep correction or a sharp respite, depending upon the previous trend. The reason behind this is the sheer consensus unwinding drive, which usually is sharper than the consensus built-up drive.
4. Over Participation (Ban)
There are set rules defining the maximum positions that can be built in a particular underlying in F&O. Any excess participation inching towards 100 percent of such limit triggers a restriction for any fresh positions.
The number of securities in Ban does give an over-confident vibe. This is a bit pedestrian but comes in handy a lot of times. A very high number of stocks in the Ban List after a big move in a single direction could indicate extremist behaviour.
A single indicator if followed may not be enough to trigger unnecessary caution but if at least three of the four are pointing towards extremist mood, one may just be better off reassessing the trading plan or even indulging in a few cheap hedges.
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