| Despite overselling signals, wide bearspreads offer better risk:reward ratio.
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| The settlement was accompanied by a volume surge and a rise in volatility as prices showed a bearish trend. Carryover was good and the market is intriguingly poised at the beginning of the June settlement.
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Index strategies
Although volumes were high on settlement day and there was a strong carryover trend, prices were low. On Friday on the other hand, although prices rose a little, volumes dropped sharply in the F&O segment.
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| Indian operators seem to have exited the market because the cumulative FII positions rose to 43.5 per cent of all outstanding derivative positions despite lower volumes. The FII dominance of F&O open interest is coupled to a trend of continued selling by them in the cash segment.
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| Carryover was excellent with nearly Rs 60,000 crore of OI when settlement ended. That's the best since January 2008 when the market was at an all time peak. Since the carryover is 1.6 times normal daily volume, it is a significant overhang. The options part of the carryover comes at a pretty high put-call ratio, which suggests there are more short positions than normal.
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| There were some signals that indicated the market may be oversold but the consensus expectation is of continued bearishness. Notably, index futures were running at significant discounts to the cash levels. This is partly due to a rise in cash prices at the end of Friday's session.
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| The Nifty for example, closed at 4870 in cash while the June and July contracts were settled at 4850 and 4847 respectively. The Bank Nifty closed 6584 while the June contract was settled at 6538. The CNXIT closed at 4688 while the June contract was settled at 4634.
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| These discounts are quite significant in historical terms and reflect bearish expectations. Are they overly pessimistic? Arbitrageurs could be selling against delivery in Nifty stocks while going long in futures. The discount is especially surprising in the CNXIT, which has been an outperformer and generated positive returns in a weak market.
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| Incidentally, the Junior and Midcaps-50 futures' contracts are completely illiquid and worth mentioning only in passing.
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| The volatility as measured by the VIX spiked beyond 34, an oversold level, as the Nifty dropped to 4800 and then the VIX eased to a neutral value of 26. This is partly due to the settlement situation but it also suggests that volatility expectations are down. That is a divergence which doesn't gel with the high discount in futures where one would expect the VIX to rise due to the bearish outlook.
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| The PCR in index options as well as in the overall market is quite high, In terms of OI, the June Nifty PCR is 1.96 while the July +August OI is 1.68. While the far + mid OI is actually on the low side for this early in the settlement, the June OI is quite high at 32 per cent of all Nifty OI.
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| Coupled to the futures' discounts, one would say the PCR indicates a somewhat oversold market and the VIX, which is a sensitive indicator, is also signalling an oversold situation by its divergence from expected high levels. This could mean some sort of pullback.
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| Another way of judging market expectations is to examine the Nifty option chain for discontinuities in OI liquidity. On the downside, OI drops below the 4700p. On the upside, OI drops at the 5300c compared to the 5200c OI. This suggests that majority expectations are that the market will stay within 4700-5200 with a substantial minority split between the hopes of a potential rise to 5300 or of a drop till between 4500-4600.
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| If we look at standard spreads, a bullspread close to money such as long 4900c (107.65) and short 5000c (66.5) costs about 41 and pays a maximum of 59. A bearspread of long 4800p (117.6) and short 4700p (84.85) costs 32 and pays a maximum of 68.
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| Early in the settlement, we can also look at wider spreads further from the money. A long 5000c (66.5) versus short 5200c (20.6) costs 46 and pays a maximum of 154. A long 4700p (84.85) versus short 4500p (40.4) costs 45 and pays a maximum of 155.
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| A combination of these two spreads is the equivalent of a wide long strangle at 4700, 5000 and a covering short strangle at 4500 and 5200. This will cost about 91 and pay about 109 if either position is fully realised. It's a reasonably tempting position.
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| The option premiums suggest that the risk:reward ratio is much better in wider spreads and the wide bearspreads offer marginally better payoffs compared to the wide bullspreads.
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| For the profits to accrue would require swings in the range of 400-points within the next four weeks. So, the odds favour going with wider spreads and my personal judgement inclines me to a bearish bias despite the signals of overselling.
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STOCK FUTURES/ OPTIONS
Short the auto sector, short banks, short cement, go long on IT and pharma. That seems to be how most traders' positions are aligned at the moment. I am uncomfortable with IT long positions because the RBI seems to be pondering intervention and it could force the rupee up to less than 42.
The pharma stocks are solid and a long Ranbaxy for instance, may work well. Bank shares have started being differentiated – HDFC Bank, J&K and Corporation are looking quite strong while PNB, SBI and ICICI continue to look weak.
The energy sector could go through another extended bout of shorting once decisions on the petro-diesel price front filter through. | |
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