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Positioning for QE2
The two key events lined up for the next week that the market is looking forward to are the
RBI rate decision on Nov 2 and the FOMC decision on Nov 3 wherein round 2 of Quantitative
Easing is expected to be announced.
While the market tries to figure out the likely impact of these decisions, it is useful to study the
impact of liquidity gushes in the past couple of years on the relative performances of low beta
and high beta stocks respectively. The conclusion (as explained below) is that the impact of
liquidity on beta performance is a little complex and difficult to call.
What is clear, however, is that the events are significant enough to keep the markets very
volatile going forward irrespective of the directional impact of the eventual outcome. We think
the current implied volatility levels aren't factoring this uncertainty appropriately and hence
being long volatility at these levels would be a sensible trading strategy. We would specifically
recommend the following,
1. Accumulating volatility in Nifty,
2. Long volatility in commodity stocks (which we surmise will be the most volatile of
the lot given their direct link to global liquidity).
A. Liquidity impact on beta
We divided the CNX100 universe into 5 groups based on their betas and looked at the
relative performance of the top pentile and the bottom pentile to asses the impact of liquidity
inflows into Indian markets since the October 08 lows. We found four subperiods of very
distinct relative performances for the two groups.
Conclusion- Long High Beta, Short Low Beta Strategy
There can be a multitude of factors that caused this strikingly different relative performance
between the two groups, even though the liquidity situation in the Indian markets has been
similarly robust in all of the latter three periods starting Mar 09 (please refer the chart below
on FII flows).
One of the factors at work here is the fact that commodity (and especially metal stocks) form a
good part of the high beta group (almost a third) and the relative subdued stock price
performance by this group can be attributed to ranged international commodity prices over
the last one year. In the event of a QE announcement that opens the liquidity tap further, the
international commodity prices can very well break out of their ranges on the upside and
hence contribtute to an outperformance by the high beta stocks in India. While this might be a
difficult call to take, a relatively straightforward call to take, in our view, is a bet on volatility
which we discuss in the next section.
B. Long Volatility- A Compelling Proposition
The two key events of the next week are significant enough to cause significant volatility in the
Indian markets and especially in the commodity stocks. Hence we suggest a long volatility
stance. This becomes all the more lucrative given that the current implied volatility levels are
still on the lower side compared to longer term history. Nifty IVs, for example, at 19-20%
currently are at a 16 percentile with respect to its last 4 year history and 36 percentile with
respect to its last 1 year history.
Given that implied vols are attractive at current levels, this then leaves the vol buyer with just
one risk which is the theta decay. However, given that we just kick started the current series
and expiry is still some time away, theta decay too should be not be a major issue.
To create vol long positions, while we would ideally recommend buying options (in the
underlyings listed below) and dynamically delta hedging these positions, even static long
straddle positions can be put to work.
Securities suggested for vega long
Nifty
Tata Steel
Hindalco
Reliance
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