Attractive risk-reward ratios

It appears that the current month premiums are under-estimating the likely volatility ahead of the Budget.

Carryover into the next settlement is already strong and an expiry effect is apparent. Excellent payoffs are available as a result.

Index strategies
The Budget comes right after the next settlement so the carryover is understandable. However, the expiry effect is a little puzzling. A fair number of February index positions have been extinguished while March open interest (OI) has risen considerably. The second and more important symptom is that February premiums far from money have dropped considerably. Although it is a short settlement, there’s two weeks left.

 

The market is offering an opportunity. The Budget is traditionally high volatility. Historical volatility in the current settlement has been reasonably high. Yet implied volatility appears low. Hence, spreads reasonably close to money are offering good risk-reward ratios.

In terms of movements, one could expect swings between 4,600 and 5,100 in the next two weeks, assuming no change in the major trend. If the major trend goes bearish, the market could drop till around 4,400 while a strong upsurge could push north to 5,300.

So be prepared for a 500-point swing (4,600-5,100) at the least. That is, a movement of 5 per cent in either direction. A trader carrying over into March should be braced for a 900-point swing (4,400-5,300). The Budget often sets off 10 per cent moves. In the very short term - two or three sessions - there is more chance of weakness. Put-call ratios (PCR) are hovering on the edge of bearish and there is not too much volume in cash or derivatives. The Nifty PCR is 1.01 for

February and 1.04 overall. The gains last week came from short-covering.

A fair number of calls were cashed on Thursday and about 42 per cent of Nifty option OI is in March and beyond. Overall Nifty futures OI has grown but volume has been extinguished in February with new positions opened in March. About 15 per cent of Futures OI is in March.

The Nifty futures and CNXIT futures settled at very nominal premium to the respective spots. The Bank Nifty futures settled at significant premium. It is possible the Bank Nifty will outperform early next week while the CNXIT and Nifty both slide. February option chains show a wide range of OI, which makes premium decay more surprising. The put chain has maximum OI at 4,800p (79) but there is also ample OI at 4,500p (16), 4,600p (27) and 4,700p (47). The call chain has maximum OI at 4,900c (58) but there is lots of OI from 5,000c (28), through 5,100c (13), 5,200c (5) to 5,300c (3).

A CTM bullspread of long 4,900c and short 5,000c costs 30 and pays a maximum 70. The CTM bearspread of long 4,800p and short 4,700p costs 32 and pays a maximum 68. The bearspread is much closer to money (Nifty closed at 4,827). The return-risk ratios are excellent.

Since there is a fair chance the market will hit either 4,700 or 5,000, the combined positions are worth considering. A long-short strangle combination cost 62 and pays a maximum of 38 for a move to either 4,700, 5,000 with breakevens at 4,738, 4,962. Moving away, a long 5,000c and short 5,100c costs 15 with a maximum pay off of 85. A long 4,700p and short 4,600p costs 20 and pays a maximum 80. The combination is a long-short strangle with a total cost of 35 and breakevens at 4,665, 5,035. The return would be 65, if it hits either 4,600, 5,100. This may be the strangle-combination of choice.

A third possibility, assuming high volatility, is a long 5,100c and long 4,500p strangle at a total cost of 29. The breakevens are 4,471, 5,129, and there is unlimited upside. This naked long strangle is not very likely to be struck. If you want to sell options, take the reverse position of short 5,100c, short 4,500p but be prepared to bite your nails if the market is volatile.

Some of the carryover includes traders taking horizontal spreads at the same strikes across different months. For example, a short February 5,000c (28) and long March 5,000c (93) costs net 65. If this expires without being struck in February or March, the cost is the maximum loss. In general, if the position is struck, there will be some gains. If the position is struck after February settlement, both transactions gain. If it’s struck prior to February settlement, the gains will depend on contrasting sensitivity to time-decay (“theta”) and changes in the underlying price. Summing up, it appears as though the current month premiums are under-estimating the likely volatility. Spreads close to money have good risk-return ratios. Strangles a little further from money have good ratios as well. Instinctively one would prefer to look for two-way positions rather than guess direction just ahead of the Budget.
 

STOCK FUTURES / OPTIONS

               Trends in stock futures seem to be moving according to sector. This is normal before Budget since the industry-risk (changes in excise rates for example) outweighs company-specific risk at the moment. Avoid stock-futures in the IT sector and banking-finance. The CNXIT and Bank Nifty will fetch similar returns to any stock future while probably carrying less risk. Real estate will move in line with banking and finance. 
               Metals are difficult to read but appear mildly bearish in a 10-session perspective while cement appears mildly bullish. Interesting possibilities arise in automobiles, where both Hero Honda and Tata Motor have charts that make long positions appear tempting. Another bullish sector is sugar, which is just starting to come off a recent bottom, Here, either Bajaj Hindusthan or Renuka could make for a good long position. A third possibility is oil where Cairn and ONGC are both responding to bullish speculation based on a trend of rising crude oil prices.