Markets slip into correction zone as option sellers raise bearish bets

Mumbai: Correction came calling for Indian markets on Wednesday, as bearish bets built up after the surprise spike in inflation battered stocks.

The Nifty and its smaller cousins are now 10% below their peaks, while the BSE Sensex teeters on the edge. A fall of 5-10% from the peak is referred to as a pullback, 10-20% is a correction, and below 20% marks the beginning of a bear market. As leading indices plunged, traders' strategy to sell more calls than put options paid off.

Market veterans said the texture of the market has changed from 'buy the dip' to 'sell on rise'.

Signalling the rising bearish sentiment, the Nifty briefly tested its 200-day moving average of 23,545 and closed just above it, down 1.36% to approach a five-month low. The index had hit 23,537.85 on 24 June. The Sensex fell 1.25% to 77,690.95, also the lowest since 77,341.08 on 24 June.

The broader markets fared worse. The Nifty Midcap 150 fell 2.67% to 20010.75, while the Nifty Smallcap 250 shed 3.06% to close at 16,670.35. Overall, investors turned poorer by ₹7.93 trillion. Wednesday was also the last day of the Bank Nifty weekly series before the new regime of single weekly expiry per exchange takes effect on 20 November.

Triggered by inflation

"The immediate trigger for Wednesday's fall was the high CPI (consumer price index) reading, which pre-empts a rate cut by the Reserve Bank of India (RBI) in December," said Andrew Holland, chief executive officer, Avendus Capital Public Markets Alternate Strategies. "That took down the banks, but even so, the decline since September has been driven by poor earnings, uncertainty of what US President-elect Trump would do to make 'America First' and tensions in the Middle East," Holland added.

Retail inflation in October beat estimates to hit a 14-month high of 6.21%, erasing hopes of a December rate cut, even as the US Federal Reserve has already cut 75 basis points this year.

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After Wednesday's fall, the Nifty is now down 10.3% from its record high of 26,277.35 on 27 September, while the Sensex is down 9.64% from its record 85978.25. The Nifty Midcap 150 is down 11.12% from its record high of 22515.4 on 25 September and the Nifty Smallcap 250 has fallen 10.79% from its record 18688.30 on 24 September.

HDFC Bank, Reliance Industries, ICICI Bank, Mahindra and Mahindra and State bank of India contributed to nearly half of Nifty's 324.40 point decline on Wednesday.

What option sellers did on Tuesday

Sensing that the inflation data would hit banks the most when trading opened the next day, options traders sold more Nifty calls than puts, causing the Nifty put call ratio (PCR) to fall to 0.73 on Tuesday from 0.91 a day earlier. On Wednesday, the PCR fell further to 0.7, flashing a sign of nervousness and pushing markets near oversold zone, per data analytics firm IndiaCharts.

"There could be a bounce, but the texture of markets has changed to sell the rise from being buy the dip earlier," said Rohit Srivastava, founder, IndiaCharts.

The nervousness was reflected by fear gauge India Vix falling the most in three months to 15.44. Vix rises when uncertainty increases and falls when it reduces.

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In volatile markets, options traders prefer selling more calls than puts, since selling puts in such a market can backfire. When markets trend lower, call options become more affordable, attracting traders who anticipate a reversal. These investors buy call options in hopes that a market bounce will boost the option's premium (price), allowing them to profit from a potential upswing.

When such a scenario plays out, the PCR declines. Sentiment becomes particularly bearish if PCR falls sharply. From 1.07 on 1 November , the Nifty PCR has fallen to 0.70 on 13 November, IndiaCharts data showed. The Nifty PCR veers in a range of 0.7-1.3, with anything below 0.7 being oversold and above 1.3 being overbought.

Over this period, the Nifty has fallen 3% from 24304.35 to 23559.05.

Put contract value surges

The 24,300 put contract, expiring on November 28, saw its value surge from ₹361 per share (25 share makes one contract) on 1 November to ₹648 by 13 November, as market sentiment turned bearish. Meanwhile, the 24,300 call, expiring on the same date, plummeted from ₹449 per share to just ₹57, giving call sellers a substantial gain on the premium received. The comparison shows why traders sold more calls than puts. The put seller would be sitting on a notional loss of ₹287 (current premium minus ₹361 premium received from call buyer).

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In contrast, the call seller would have secured a profit of ₹392 a share from the premium paid by the call buyer, as the 24300 call price dropped from ₹449 per share to ₹57 amid the market's decline. That is what drives down the PCR when sentiment turns negative. However, a very low PCR also indicates markets are oversold.

"Indicators are favouring a bounce, but we aren't getting one, suggesting that we could keep correcting for now," said Srivastava.

Why are markets falling?

Markets are on a downturn as share supply in both primary and secondary markets surpasses demand, worsened by selling from foreign institutional investors (FIIs). Inflows from mutual funds are expected to fall short of this supply by an estimated factor of two-and-a-half times in the second half of the fiscal year, pressuring share prices further.

"The accelerating pace of equity supply is the key reason domestic equity markets are again developing a vulnerability to the volatility in foreign flows," explains Ashish Gupta, chief investment officer, Axis Mutual Fund.

The IPO pipeline for the second half of FY25 is nearly three times that of the first half, with 91 companies aiming to raise a combined total of $17 billion through listings, according to Gupta.

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Another 70 listed companies have taken board approvals to raise an aggregate $16 billion through qualified institutional placements (QIPs). Secondary stake sales from promoters and private equity is also likely to grow larger, given the expiring lock-ins and elevated trading multiples in the market.

"Assuming secondary sales (by promoters and PEs) at $22 billion in the second half stays similar to what we have seen in first half, the total supply will rise to $55 billion in the second half of the year or about 2.5x the estimated inflows into mutual funds. This could result in equity supply overwhelming domestic fund flows and market direction being subject to the vagaries of foreign flows," Gupta of Axis MF added.

FIIs have net sold shares worth ₹23571 crore in November so far, while DIIs have net purchased ₹24040.51 crore, depository and exchange data showed.

Why are FIIs selling?

Several factors explain the FII sell-off. For one, Indian corporate earnings have been lacklustre amid high valuations.

For instance, the aggregate net profit of 1,982 companies that reported Q2FY25 earnings grew just 2.5% year-on-year to ₹3.56 trillion. In contrast, the same quarter last year saw a substantial 38% growth to ₹3.47 trillion, underscoring a sharp slowdown in earnings momentum.

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Another major reason is the rising bond yields in the US. Fiscal deficit concerns are climbing as President-elect Trump has pledged corporate and personal tax cuts, coupled with tariff hikes, which could fuel inflation.

Despite three cumulative Fed rate cuts totalling 75 basis points since 18 September, the US 10-year yield has surged by 66 basis points to 4.37% as of Tuesday.

This anomaly, with bond yields rising despite rate cuts, has made US treasuries—widely considered the safest asset globally—more attractive, prompting FIIs to reallocate funds from emerging markets like India to US government bonds.