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| Short covering could drive bulls |
| Devangshu Datta / New Delhi May 18, 2009, 00:57 IST |
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The index call-option chain suggests that there will be a scramble beyond 3,800 level.
In the wake of a mandate for stability, the market could zoom over the next two weeks. Call premiums are liable to reflect that expectation by jumping on Monday.
Index strategies
As of Saturday evening, with results yet to be formally declared, rumours are abounding that there will be a relief rally of 15 per cent. That may be an exaggeration but the mood is more bullish than the Friday closing numbers suggest.
Technically speaking, charts suggest a breakout past resistance at Nifty 3,700 and will set up a target of around 3,950-4,000. The index call-option chain suggests that there will be a scramble beyond 3,800 level and short-covering could increase north bound momentum.
In the past two weeks, the markets have been range-bound between 3,500-3,700. The hedge ratio has increased with a high percentage of open interest (OI) in Nifty futures and Nifty options. If the market opens with an upside gap on Monday, short futures-holders will have to cover.
The Nifty option chain has 2.6 lakh contract OI at 3,700c and 3,800c. There is only 2.2 lakh contract OI above 3,800, spread between 3,900c and 4,300c. That means a lot of uncovered calls at 3,700-3,800 and that bulge has interesting implications.
If options at 3,700c and 3,800c go into the money, naked option-sellers will cover in a hurry. That could lead to a short squeeze. There are only nine sessions till settlement and the last four are full margin so, option sellers and short futures holders will have to cover without waiting for a break in the upwards trend.
Both the leading subsidiary indices, the CNXIT and the Bank Nifty rose last week. The Bank Nifty rose much more sharply, however, and the sector is full of stocks that look individually bullish, The CNXIT is inversely correlated to the rupee.
Strong FII inflows is likely to have a braking effect on the rise of IT stocks if the rupee strengthens as a result. The Bank Nifty definitely looks worth a long position and it could outperform the Nifty since it has a high-beta relationship with the Nifty.
The likely turmoil in the options market makes it difficult to believe the current premiums, or the differential between successive premiums on either of the put or call option chains will hold on Monday.
If the market opens with a upside gap, calls are likely to appreciate across the entire chain. That makes the calculation of bullspread risk and return ratios a task fraught with error. At the same time, put premiums will depreciate. There could be quite a dramatic drop in put premiums below the 3,500-level.
As it stands, even the Friday statistics were quite bullish. About 66 per cent of all option OI was concentrated in May, which is a high ratio. The May put-call ratio (PCR) was 1.4 while the overall PCR was 1.2 and both fall comfortably in the bullish range.
Although the short-term trend looks bullish, several potentially negative factors must be borne in mind One is that the trend has already been up for 10 weeks and it may be nearing exhaustion. In fact, it will need buying power to come off the fence to keep it afloat. Most intermediate trends run out of steam between 6-12 week so this run is nearing its end. It could however, explode up in a final fortnight of frenzied buying.
Another point is that the PCR is likely to drop on Monday if the market opens high. A lot of calls will be bought and a lot of puts will be extinguished. That could alter the PCR and push it below the 1 mark where it will start looking overbought. With settlement to come, a lot of long traders may prefer to book profits. So a short sharp correction could occur in settlement week from above 4,000 levels.
A swing between 3,600-4,000 would therefore not be unlikely in the next two weeks and the prudent trader would be prepared for that much movement. For the sake of benchmarks, here are the close-to-money (CTM) spreads and their return-risk ratios. As mentioned above, expect the R-R ratios of bullspreads to get worse and that of bearspreads to get better.
A CTM bullspread of long 3,700c (145) and short 3,800c (100) costs 45 and pays a maximum of 55. A CTM bearspread of long 3,600p (118) and short 3,500p (86) costs 32 and pays a maximum of 68. A strangle of long 3,500p and long 3,800c costs 186 and can be laid off by a short 3,300p (44) and short 4,000c (40), reducing the total cost to about 102. That offers a maximum return of 98, which is not very attractive.
One possible route for a trader is to take a long Bank Nifty future with a stop-loss at 5,600 or 5,650 coupled to a bearspread on the Nifty. The Bank Nifty future will work if the market zooms. The Nifty bearspread is a hedge that will offer a great return-risk ratio if the market drops.
STOCK FUTURES/ OPTIONS
Most sectors are looking bullish and most stocks in the F&O market will move in the direction of the overall trend. Metals are however looking bearish across the globe so you could short Tata Steel or SAIL if you wanted a contrarian position.
If you want to go long, financials appear to be the best bet. While every F&O banking and financial stock looks bullish, IDFC has an interesting profile. IDFC saw profit-booking on Friday and it could be all set for another upsurge from slightly lower levels. Keep a stop at Rs 92 and go long.
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