The bellwether stock Safaricom is now on a steady downward march. Since peaking at an all-time high of Sh43 (sometime in the second quarter of 2021), investors have been capitulating faster than one can say Machu Picchu.
To date, it has lost 39 percent of its value or a third of its value since the start of this year. Coincidentally, falling open interest in the third quarter of 2021 (compared to the previous quarter) of its single stock future also marked the beginning of its price reversal.
A sudden drop in open interest in December 2021 (29 contracts) compared to the previous five months, which averaged over 500 contracts in open interest, meant its bullish interest had evaporated.
From there, it was easy to expect that there was going to be a weakening of the underlying price trend or that the trend was going to be range-bound.
It didn’t matter that the volume of contracts traded in the same period increased by seven percent. Futures traders were determined to close out their positions more rapidly than new traders opening them.
So imagine Clever Amber sees the shrinking Safaricom’s open interest in December last year and decides to go short. She sells 2 March 2022 single stock futures contracts at Sh40 with Sh9,000 as the initial margin (Sh4,500 initial margin per contract).
The open position is worth Sh80,000. By the third Thursday of the same month, the price settles at Sh36 and she has to close her position. It’s a tidy Sh8,000 profit or an 88 percent profit gain.
On the other hand, Johnny Foolish sees the same scenario but decides to stay on the sidelines. He’s waiting for the stock to bottom out and then buy on the way up.
Between the two traders, one is more pragmatic than the other. But let's climb down from this abstraction.
What’s open interest? This is an important indicator often used as a confirming signal for the current price movement. Increasing open interest shows that there is strength behind the current price trend because the number of contracts in play is increasing.
In other words, activity is increasing, and there’s excitement about the move. It’s important to note that it’s not the same as volume.
With volume, both buys and sells cause the volume to increase. With open interest, buys cause open interest to increase; sells cause open interest to decrease.
Nonetheless, it’s got one major weakness though. It just shows how many contracts are currently open, but it doesn’t tell who is long or short. So, it’s possible that the 527 Safaricom open positions as at November 2021 were all long. But if they were all shorts, whoever made those bets is in the money.
This is the point. The market has been volatile (and it’s going to be a lot of volatility ahead) and things are uncertain. But I think traders are not hopeless. Money can still be made on the short side. Now, is there anyone ready to go short September 2022 NSE 25 contracts given the election?
The writer is managing director Canaan Capital
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Note: The results are not exact but very close to the actual.
