Stocks could bounce back when bears exit shorts

Analysts say the benchmark Nifty index could test the key 17,429 level in a short-covering induced rally, which, if breached decisively, could take it to 17,700-18,000.

Short covering rally occurs when traders buy securities to close short positions. For example, short index futures contract on Nifty is covered by buy back. Buying raises the price of a security. With their futures positions covered (buy back) on Tuesday, FIIs reduced their holdings of index put options to 275,000 contracts from 313,000 on the previous day. An index put gives the right to sell the index at a lock-in price at a future date.

The Nifty, which fell 1,209 points in 12 sessions through October 3, jumped 2.29% to 17,274.30 the next day amid a rally in the markets. These indices rose more than 2% on Monday after weaker-than-expected manufacturing data in September raised investor hopes on a less-than-expected US Fed. Besides, the dollar weakened against a basket of six currencies on a U-turn to sell bonds by the Bank of England, helping the rupee strengthen to 81.52 from a low of 81.95 last week.

This prompted FIIs to reduce their cumulative index short positions in India to 81 per cent on Tuesday from 87 per cent a day earlier. To be sure, they remain fairly low, making the relief rally more likely to expand.

In absolute terms, FIIs on Tuesday reduced their net bearish bets on index futures contracts from 35,677 contracts to 91,752, the biggest drop since May 20, when they covered 37,009 contracts.

The bearish situation from last month was extended further, with increased yearning due to rate hikes by global central banks, raising bond yields in India from the US, adding to risk-off sentiment, until the Dow and Nasdaq. 52-week low till then.

SK Joshi, Executive Director, Khambata Securities said, “What we are seeing here is short covering in line with the global market trend. Based on the global market cues, we can potentially move up to 17,700. If the rally ends, So we can test 16,700.”

Manoj Muraleedharan, Vice President (Derivatives), Religare Broking said, “Indices and stocks gained nearly 75% on Tuesday due to short covering. Given that significant shorts still remain, a possible revival of risk-on sentiment globally could propel Nifty to 17,600-17,700 in the short run.”

“Frankly, it’s hard to be certain because there are so many moving parts that open up space for data to turn around, as we just saw,” said Rohit Srivastava, founder, IndiaCharts. “However, if we break 17,429 without falling, our chances of a test drop to 18,000. If we falter, however, support of 16,750 could be followed by support of 17,100.”

FIIs have net sales of $7.7 billion in Indian equities in FY23 so far after selling $18.46 billion in the previous fiscal.

In addition, they cumulatively remain short index futures, which act as a hedge for their cash holdings of approximately $600 billion.

By selling a futures contract, an investor hedges his cash position against a potential correction. If the cash stocks decline, the short index position or put option compensates for the loss by increasing the price.

The hedger transfers the risk to a speculator who takes the opposite view.