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| Be braced for 250-point swing | |
| DERIVATIVES | | Devangshu Datta / New Delhi December 29, 2008, 0:33 IST | |
The risk-reward ratios for close-to-money spreads are imbalanced with bearspreads having better return ratios than bear spreads.
The year ended with a low-volume settlement and traders abandoning positions as the market fell. The carryover was lower than normal amidst heavy FII selling. The market is poised at a key support.
Index strategies
It would be normal for volumes to spike over the next week. It's a new fiscal for most FIIs and either way, their derivatives commitments are liable to increase. Their attitude is crucial. The market could move about 8-10 per cent in the next two weeks but the direction of movement will vary with FII input. As a group, they have been massively negative in the past 12 months and negative for the second half of the December settlement.
The market is balanced at the 2,850 mark. Technically, if the support holds, there is a clear run of +250 points till around 3,100. However, if the 2,850 support is broken, the market could slide till 2,600 – a minus 250 movement. These are minimal expectations if a new trend develops. The charts suggest that 2,500 and 3,200 are achievable on respective breakouts.
Other signals are mixed. Key index futures are all running at small premiums to the underlyings. Technically, we have seen an unusual situation where the BankNifty and CNXIT have lost ground in tandem though the BankNifty has lost more. Technically, both CNXIT and BankNifty present a puzzling picture with downtrends having landed most industry pivotals at strong support levels.
As a direct result of the FII sell offs, the rupee has lost ground to the dollar, dropping from Rs 47 to around Rs 47.9 in terms of the RBI reference rate and the currency futures on Nifty was last traded at Rs 48.4. If the rupee does weaken further, the CNXIT will probably work as a hedge. However, if there is a rise in the general market trend, the rupee will probably rise. Bank shares will move with the Nifty – which in turn, will move with the rupee. In fact, bank shares could be the most volatile component of the derivatives market – as they were last week.
The Vix has dropped somewhat despite the downtrend in the past four sessions. The current reading of the Vix at 45 still indicates high volatility but it has dropped from 70 and that suggests lower volatility expectations and a likely turnaround. But the Vix has proved unreliable in the past and it's not backed by other signals. If there is a downside breakout, volatility will jump. In any case, a breakout session in either direction would probably generate a 200-point intra-day swing and it could provoke several high-volatility sessions.
The Nifty PCR in terms of open interest is at around 1.1 and the overall PCR is also around 0.87, which is bullish. However, PCRs have dropped from healthier levels. One would say that the PCR levels are neutral.
The risk-reward ratios for close-to-money spreads are imbalanced with bearspreads having better return ratios than bear spreads. Incidentally there's no liquidity in the call chain above the 3,300c level, which is another indicator of pessimism. If there is an upside breakout, premiums on calls would see sharp rises.
A standard bullspread at long 2,900c (134.75) and short 3,000c (90.75) costs 44 and pays a maximum 56. A standard bearspread with long 2,800p (124.5) and short 2,700p (91.9) costs 32 and pays a maximum 68. While the bearspread has a good return-risk ratio, it would be sensible to go further from the money to improve the bullspread returns if you take an optimistic view. For example, a long 3,000c and short 3,100c (57.65) costs 34 and pays a maximum of 66. As mentioned above, call premiums are liable to spike on an upside breakout.
Strangles are tempting given the likelihood of a breakout. A long 3,000c and long 2,700p costs about 183 and can be laid off with short 3,200c (34.6) and short 2,500p (46.95) for a net cost of about 102. The maximum return on either breakout would be about 98. This is a fair risk-return ratio. This long-short strangle position could be taken and held till the end of settlement with a fair possibility of at least one strike and perhaps double strike.
The other possibility here is to take a futures position in one direction and deep option spread in the opposite direction as a hedge. For example, if you're pessimistic, go with a short future and lay it off with a bullspread. Alternatively, go with a long future and lay off with a bearspread. If you choose this mode of operation, take a tight stop of 50 points or less on the futures position. For example, with a short future, keep a stop at 2,900 and a bullspread of long 3,000c-short 3,100c. Or with a long future, take a stop at 2,800 and a long 2,700p-short 2,600p.
In such a position, the returns would be maximised if the futures goes into the money. But there could be small profits from a swing in the "wrong" direction as well. Specifically the losing futures will add 50 to the cost of the option spread and if the option spread has maximum realisation, there will be a profit.
STOCK FUTURES/ OPTIONS
In the stock futures market, there will be a lot of focus on Satyam, which has been in the headlines and hammered for the last few weeks. The stock (CMP Rs 136) could be close to a period of short-covering because even the possibility of Raju's resignation has been factored into the price.
Alternatively, it could plunge again to around the Rs 120 level or lower. If you're correct with your view, there are massive profits but there is directional uncertainty. A safer prospect is Reliance Petro, which seems to be picking up support from lower levels and looks like a good long position, Keep a stop at Rs 80.
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