Far from money bearspreads promising

Premiums are expensive, risk-reward ratios are better away from the money.

An exceedingly volatile and low-volume settlement week ended with strong price gains across the F&O segment. However, the signals suggest that wild swings will continue to be the order of the day.

Index strategies

Rollovers across the stock F&O universe were well below the 6-month average and the Nifty and other indices also generated low rollovers. Hedge ratios remained high with index instruments attracting significantly more interest than stock futures. The FIIs continued to dominate the F&O segment, holding around 43 per cent of outstandings.

The rising FII component (normally they contribute about 38-39 per cent of OI) is due to the extremely low volumes generated in November. The festive period traditionally sees diminution of trading volumes and this trend is exaggerated by the bearish sentiments.

The last week saw extreme volatility as indeed, the whole of October did. The Nifty lost over 30 per cent in October and it moved through a range of almost 700 points last week. The VIX is at a level of 69, which is close to a historic high. While it hasn’t been a great directional indicator so far, the VIX has been fairly accurate at predicting impending volatility.

The VIX signal suggests that the volatility will continue. As a result, option premiums have also spiked. This gells with a low-volume scenario where small trades can result in huge price swings and wide bid-ask spreads. Assume that the huge 200-250 point sessions will continue.

Low volume usually means that price rises are unsustainable so, it tends to have a bearish effect in the long run. However, the market has fallen so far, so fast, that a significant bounce is possible before lack of volume becomes an obstacle to an uptrend. So it’s very difficult to come up with a directional take on trends over the next week or two.

Index futures provide no clues. Although there has been loss of volumes, most index futures are trading very close to their respective underlyings. There are no calendar arbitrages available in the Nifty and the Bank Nifty and CNXIT are both at negligible differential to their respective underlyings. The BankNifty has a tough-to-determine trend while the CNX IT seems somewhat bullish.

Technically, the Nifty could easily swing between 2550-3075, moving different ways in alternate sessions and not taking a clear direction. It could hit either end of that 20 per cent range within a single session if volatility doesn’t ease. The most useful takeaway from a technical analysis is that option traders can afford to buy puts and calls far from money and they shouldn’t be interested in naked selling, except outside 2500-3100.

Looking at the options market again, the put-call ratio has corrected somewhat from extremely low, bearish levels. In terms of open interest, the Nifty PCR is now at over 1, while the OIPCR for November is at 0.97. These are close to neutral values or only slightly overbought. About 50 per cent of option volume is December and beyond, and 22 per cent is in January and beyond. A fair number of winning December puts have been cashed out but despite that, Nifty OI has risen across all series and both calls and puts.

Premiums are expensive close to money and the risk: reward ratios are clearly better as we move further away from the money. A bearspread with long 2800p (189.3) and short 2700p (151) costs 38 and pays a maximum of 62 while a long 2700p and short 2600p (124.7) costs 26 and pays a maximum of 74.

Similarly a bullspread with long 2900c (218.3) and short 3000c (169.05) costs 49 and pays a maximum of 51 while a long 3000c and short 3100c (127.35) costs 42 and pays a maximum of 58. Again it’s obvious that the bearpreads offer better risk:reward ratios than the bullspreads.

Contemplating strangles, the premiums will make sense only with wide strangles that are set up far from the money. A long 3300c 60.55 and long 2500p (101.45) for instance, costs 162 and breaks even if the market moves beyond 2338-3462.

If it’s laid off with short 3500c (23.8) and short 2300p (66.15), the initial cost is 72 and the maximum return on a single-ended move is 128. In practice, if the current volatility lasts, you would hope to reverse this entire long-short quartet set with some profit even if the market didn’t move enough to put it in the money.

Summing up, the best option positions appear to be either far-from-money bearspreads or far-from-money strangles. However, strangles would have to be very wide to make the pricing work and they would also require clever timing on reversals.

STOCK FUTURES/OPTIONS

The stock segment presents several problems. The loss of volume and OI is significant. Also we have just seen a short-term uptrend in the middle of an intermediate downtrend. That makes it tough to judge direction. Most stocks have gained over the past three sessions and it’s hard to ascertain which ones can maintain an uptrend. In the absence of directional clarity, avoid low volume underlyings. Stay with the 20 most active stocks and their derivatives.

NTPC and Bhel are two unusual names in that list. Both have the potential to rise further. SBI is generating large volumes with very little price change and could breakout unpredictably in either direction. Infosys is testing the upper end of a trading range and will probably move up if the rupee stays below 49 for a few more weeks. Go long with a stop at 1350.