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| Expect high volatility to continue | | DERIVATIVES |
| Devangshu Datta / New Delhi Aug 04, 2008, 05:46 IST |
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Risk-reward ratios are better for the bearspreads.
The settlement witnessed excellent carryover and rising prices despite extreme volatility through the last week. The FII presence made itself felt on Thursday and Friday as the “firangis” substantially expanded derivatives exposure.
Index strategies
The July settlement logged decent volumes and the carryover pattern was very strong with momentum maintained on Friday. As usual, the FIIs were key players. They have increased overall exposure considerably in absolute terms to hold around 43 per cent of all open interest. This could maybe presage a reversal in attitude. Volatility has stayed very high and this is unusual in a market where we have seen net gains over the past fortnight. The Vix has hit 60+ and at the current levels of 39, it is still very much in the danger zone. This is odd – the Vix is usually negatively correlated with prices and we haven’t seen this earlier in its admittedly short history.
Since the Vix is based on premiums, this could mean that Nifty option premiums are currently overpriced for the historic volatility, which itself is high. Another possibility is that somehow, the Vix is anticipating another crash and premiums are bid up out of nervousness. This would be unusual since the VIX is not known to be a leading indicator. Bear it in mind however because this signal is out of whack with the rising market.
Other signals are more straight-forward and well correlated with the short-term uptrend that seems in force. For example, all the available index futures are trading at premium to their respective underlyings. The Nifty has seen good carryover as mentioned and added a lot of OI on Friday as well. There isn’t much of a difference between the three futures so arbitrages are not available.
There’s also been healthy OI expansion in subsidiary indices such as the Bank Nifty and the CNXIT. Technically speaking, both these indices possess short-term upside. While the BankNifty underperformed last week, it ended on a strong note on Friday. The CNXIT outperformed last week and it could continue the trend this week as well. In both cases, long positions can be combined to hedges in the form of short stock futures in key components like Infosys, TCS or SBI, ICICI and PNB.
In the index options market, apart from good carryover and high OI, the put-call ratios are in the neutral or bullish zone. In terms of OI, the overall Nifty PCR is around 1.35 with the August PCR at 1.25. About 55 per cent of OI is in August and around 21 per cent is in December 2008 and beyond. This is healthy enough.
Technically, the market seems slightly more likely to go up than down in the short-term. However, whichever direction it does move, 200-point sessions (high-low ranges) will remain on the cards. Broadly speaking, a move between 4,150-4,650 is entirely possible within the next five sessions though you can make a case that 4,250-4,550 is more likely. However, a move of 4,650 (4,150) implies just two big trending sessions in the same direction so the trader should include the possibility in calculations.
The exceedingly high premiums and volatility makes the concept of option selling fraught with risk. If you are an option-seller, go very wide with say, a short 4,000p (48.5) or a short 4,800c (35). Even then, one would suggest covered positions with reversed spreads such as short 4,000p, long 3,900p (35) etc.
This is early into a long settlement and it makes sense to examine wide spreads for that reason as well as the high volatility. A conventional bullspread could be something like long 4,500c (130.15) and short 4,700c (58.65) which costs 72 and pays a maximum of 128. The equivalent is the long 4,300p (114.1) and the short 4,100p (65.1), which costs 49 and pays a maximum of 151. The bullspread is quite a bit closer to the money of course (the August future was settled at 4,432) but the risk-reward ratios are definitely better for the bearspreads. Both these positions fall on the edge of our near-term expectations and look unlikely to be fully realised in the next five sessions at least.
If you took both these positions, you would get a set of long-short strangles, which costs 121. The payoff is a maximum of 79 in either direction. This is quite tempting if you can hold till end of settlement since both ends of the strangles could be struck. A trader with a very short-term outlook should consider close to money, narrow spreads like long 4,500c and short 4,600c (89.65) which will pay around 60 maximum for a cost of about 40. The long 4,400p (149.5) and short 4,300p would cost 35 and pay a maximum of 65. So even here, the bearspread appear to have a better risk-reward ratio.
STOCK FUTURES/OPTIONS
Liquidity has improved across a wide range of stocks though this is only in futures of course. As usual, very few option positions are available. There are many tempting positions including highly speculative long futures positions in the PSU refiners BPCL, HPCL, etc, on the assumption that crude prices will continue to fall.
Sugar is another industry which has seen an upsurge. We recommended Renuka last week and it still looks good.
Two positions that look especially interesting are long futures in DLF and GMR Infra. Both are pulling back strongly from lows. GMR has the higher potential payoff simply because it’s lower-priced and the percentage gains may be more. But DLF has the better technical outlook. Keep a stop at 505.
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