Stay braced for a bearish breakout

DERIVATIVES

Bearishness is more likely to continue since the few oversold signals are mild compared to the clear danger of plunging prices.

Large discounts in Nifty futures versus the spot Nifty. A cash market that's looking weak. Continuing bad news, doom and gloom (unemployment, high oil prices, inflation) from all round the globe. The portents suggest another bearish week in the offing.

Index strategies
There have been marginal increases in volume in the futures market, but these have been associated with a large increase in open interest. The FIIs hold around 42 per cent of all outstandings "� and this is interesting given that they have net sales of over Rs 3,000 crore in the past week.

A fairly high proportion (over 30 per cent) of these FII positions consists of index options. This usually occurs when the "firangi" portfolio investors are intending to switch attitude or when the hedge funds believe that the portfolio investors are looking to switch attitude. Either way, if the selling stops, there would be some relief.

The Indian traders don't expect the selling to stop, or at least, they don't believe that the market will rise. Most Indian traders concentrate their attentions on Nifty futures.

Those index futures contracts are trading at larger discounts than usual to the spot Nifty, which is a sign of bearish expectations. Incidentally, liquidity in other index futures contracts is quite low and that narrowing is also a sign of bearish expectations.

The Nifty options put-call ratio is around 1.5 in terms of open interest (OI) and that is mildly oversold, but only at the upper end of the "normal" zone. It is not the sort of level that one would expect an automatic pullback from. The Vix is at 26, which is also mid-zone and neutral.

At the same time, the vast majority of stocks have lost ground last week and the majority looks as though the bearishness will continue. Other indices (except for the CNX IT, which is being seen as a hedge against a weak rupee) have lost even more ground than the Nifty.

A broad overview therefore suggests that bearishness is more likely to continue since the few oversold signals are mild compared to the clear and present danger of plunging prices. We also cannot expect that there will be much short-covering in the futures market since there is three weeks to run before settlement and no compulsion for traders to immediately book profits.

The technical support and resistance levels are fairly well defined. The chart patterns suggest there is key support in the 4,500-4,550 zone and that was tested last week. There is also strong resistance at 4,750 and that could be a barrier even if there is a change in sentiment.

When we examine the option chains, there are massive bulges in put OI at 4,500p and 4,600p and also plenty of outstanding in-the-money puts at 4,700 and 4,800. Below 4,400, liquidity evaporates. In calls, OI is similarly bunched at 4,700 and 4,800 and disappears above 5,000.

In the context of next week, the trader would expect the Nifty to most likely remain inside 4,500-4,800 with the possibility of a drop till 4,400 if the market breaks. In the context of the June settlement, the market could perhaps test 5,000 in a rally.

The downside if 4,400 breaks will be significant in terms of sentiment. The minimum targets would be in the range of 4,200 and the absence of liquidity at that distance from the money means that the market may respond with panic.

This could be a situation where taking wide spreads in the Nifty options market with a two-week perspective makes sense. If there is a downside breakout, we can cater for it with a bearspread of long 4,600p (119.7) versus short 4,400p (59.65) costs about 60 and pays a maximum of 140.

If there is an upmove, the bullspread of long 4,700c (74.9) and short 4,900c (24) costs 51 and pays a maximum of 149.

The risk-reward ratio is better for the bullspread but it is somewhat further from money and the directional view is against market expectations. Incidentally if you are assuming that an upmove is likely, a long Bank Nifty future makes sense.

The banking sector has been among the hardest-hit and a recovery in banking stocks would trigger a rise in the overall market.

If the trader doesn't want to take a directional view at all, and decides to go with strangles, he could pick the long 4,500p (83.1) and the long 4,800c (43.2) and cover with a short 4,300p (40.65) and short 5,000c (14).

The resulting position costs 72 and breakeven would come at 4,872 or 4,428. The maximum payoff if there is a breakout in either direction would be 128. That is an excellent risk-reward ratio for a long-short strangle combo. This is a very tempting position in the circumstances.
 

STOCK FUTURES/OPTIONS

The futures market is overloaded with down-trending stocks that offer attractive short positions. There are very few scrips apparently capable of moving up. It is more a question of finding stocks that have bottomed versus stocks that are still going south.

Cairn continued to generate massive volumes and it is one of the few bullish counters. Essar Oil and RCom are two others that seem to be generating both high volumes as well as showing some bullish potential. Cement shares were early losers and they could also be bottoming.

A seriously contrarian trader would also consider going with a long RIL position since the Mukesh Ambani flagship has been losing ground as well. But the best shot appears to be long Mahindra & Mahindra, which appears to have finally bottomed and turned around.