To exploit this situation, foreign portfolio investors (FPIs), in a departure from their usual practice, have turned net sellers of Nifty call and put options in the past few days.
With the rupee plunging to a record low of 87.29 on Monday, a day after the pro-consumption Union Budget and President Trump’s imposition of fresh tariffs on imports from Mexico, Canada, and China, chances of a rate cut by MPC have become less certain, per analysts.
Moreover, the US Federal Open Market Committee kept rates steady last week at 4.25-4.5%, citing persistent inflation. This follows a 100 bps rate cut since September last year, they added.
FPIs have thus decided to exploit this uncertainty on the RBI rate action by selling both call and put options, an options strategy known as short strangle, on Nifty.
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On Monday, in a departure from their usual practice of remaining net long calls and puts, they were cumulatively net sellers of index calls, largely Nifty, to the tune of 185,332 contracts and of index puts to the tune of 12,032 contracts .
If the RBI cuts rates the markets could rise but any rally will be capped by higher FPI outflows due to narrowing of the interest rate differential between India and the US .
If RBI decides to hold rates the markets could correct, but the correction would be limited as the central bank has other tools to provide additional liquidity to the banking system, like buying bonds from banks or buying dollars from them in exchange for rupees.
Given the possibility of either scenario, FPIs are selling calls and puts expiring on Thursday within 22800-24000 levels of Nifty. As long as the index remains within the range by expiry of the contracts, FPIs will pocket the premium paid by the buyers of the calls and puts. If however the market falls or rises well beyond that range, the FPIs could face heavy losses.
Potential gains and losses for FPIs
For instance, if an FPI sold a 24000 call and a 23000 put when the Nifty was at 23500 he would have earned a premium of ₹42 a share (75 shares to a contract), based on Monday’s volume weighted average price. He would pocket this ₹42 if by expiry on Thursday the Nifty was unchanged at 23500. However, if Nifty closed at 22900, he would incur a loss of ₹58 (23000-42) a share as that would be the payout to the 23000 put buyer.
Similarly, for every point rally in Nifty beyond 24042, the option seller would be out of kilter, having to pay the 24000 call buyer.
Here the levels of 22958 and 24042 are known as the lower and upper breakeven points, below or above which the seller encounters unlimited losses.
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“A rate cut by RBI might not be a given, considering the Fed status quo last week and fear of higher FPI outflows in the event of a further compression of the spread between 10 -year US and Indian bonds,” said UR Bhat, co-founder of Alfaniti Fintech.
Compared to the historical spread of around 400 basis points, the current rate differential is 220 bps, which has resulted in FPI outflows of ₹2.4 trillion from the cash market to the safety of the dollar since October last year. This has resulted in a 11% correction in Nifty from a record high of 26277.35 on 27 September to 23361 as of 3 February.
As the rupee depreciates by around 3-4% to the dollar each year, the interest rate differential between India and the US should be roughly similar to the currency depreciation.
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Jay Vora, research analyst at analytics firm IndiaCharts said that, FPIs could have sold the options when market volatility was high and would get to keep the premium paid by the buyers if the volatility reduced.
The buyers of the calls sold by FPIs were high net worth and retail clients while the buyer of puts were proprietary traders as of Monday.