Hedge to profit from 10 per cent moves

Volatility will make unhedged positions risky.

After a volatile week, the markets closed on Friday with signs that suggested next week will be equally volatile. The direction is likely to be settled, temporarily at least, by the result of the confidence vote. Either way, there will be a big swing.

Index strategies
Derivatives volumes rose. On Friday, F&O logged over Rs 50,000 crore trading, which is a high volume, 10 sessions from settlement. At the same time, cash volumes were on the low side of normal. This combination of high F&O and low cash volume usually means high volatility.

The confidence vote is an obvious trigger. Many background signals are bearish despite recovery in the Nifty over the past three sessions. Other broader indices did not move up. The Vix soared to well above danger mark.

The consensus is gloomy. But there are also contrarian signals. One is a lot of carryover into August futures. The August Nifty saw open interest expand by over 34 lakhs (OI rose 10 per cent on Friday including 5 lakh in July Nifty). OI expansion and carryover of that order suggests optimists are in the game as well.

The Nifty option put-call ratios are in the normal zone rather than at extremes. There has been put build up and calls have been cashed but the overall PCR (in terms of OI) is 1.24, while the July PCR is 1.15 and non-July contracts are 1.4. About 23 per cent of OI is in December 2008 contracts or beyond. Again, that argues long-term interest, which is inconsistent with total bearishness.

The FIIs have been buyers in the past two sessions. The composition of their derivative exposure, (which is at a normal level of around 40 per cent of all OI) has changed.

FII index option OI is now around 38 per cent of all FII OI, up from its normal share of 30-32 per cent. Rising index option exposure could be due to hedging associated with a switch in cash market strategy from bearish to bullish.

Most importantly, the market is working on incomplete, flawed information so the bearish consensus doesn't mean much. It is one thing to follow market consensus on the Budget. There, a lot of people know what's been drafted and, given India's leaky governance, it's possible that useful intelligence is reflected in market positions.

In the confidence vote, not even the principals can tell for certain what the result will be. If the gloomy consensus is wrong, there would be a likely spike in prices as short positions are closed out. On the other hand, if the government does fall, there will be a big drop.

Technical chart-based expectations are in the range of about 3700-4500, which means the market could move about 10 per cent either way. The option chain also suggests the above range is likely. If we take a weighted average of all premiums by volume outstanding and calculate breakevens, the average put breakeven is at about 3770 and the call breakeven is at about 4270. Add 200 point for a fuzzy "limit of expectation" inside this settlement and we get a range of 3570-4470.

That's a big range to traverse in 10 sessions. The first instinct was to consider a long straddle at 4100c (127) and 4100p (150), which would breakeven at 3823, 4377. If this is capped with a short strangle of 3700p (40) and 4400p (26), the breakevens reduce to 4311, 3890. The maximum profit on a single trending move is 89, while the initial cost is 210. The risk:reward ratio is not good enough.

A bearspread of long 4100p (150) versus short 3900p (81) costs 69 and pays a maximum of 131. A bullspread of long 4100c (127) versus short 4300c (46) costs 81 and pays a maximum of 119. If you combine the two, you get a long straddle "�short strangle within a narrow range. The upside would be 49 while the maximum loss would be 151.

This is a very difficult situation to judge. Another possibility is either a long or short Nifty future (settled at 4077) taken with a tight stop at 4050 and 4100 respectively. Hedge that future with the appropriate bearspread (if long) or bullspread (if short).

A long Nifty future (stop at 4050) and bearspread combo loses a maximum of 47 and hits breakeven at 4147 and 4003. A short Nifty future (stop at 4100) and bullspread combo loses a maximum of 104 and breaks even at 4204 and 3096. The long Nifty future and an associated bearspread is therefore, better since it's in the money outside a narrower range.

Premiums are likely to shift quite a bit on Monday but you will have to do your calculations along these lines. This is too dangerous a situation to enter unhedged because you can reasonably expect 150-200 point session ranges.

STOCK FUTURES/OPTIONS

All the F&O stocks are likely to move in tandem on Tuesday but there are some interesting possibilities. One thought is a short Satyam since the IT major is taking a hammering and will probably under-perform.

Another is a long ICICI future on the basis that this is a high-beta proxy for the Nifty. A third possibility is a short Ranbaxy future"� the news factor hasn't played out.

A fourth possibility is long ONGC. Due to the warped subsidy mechanism, India's largest oil and gas producer may gain from a drop in oil prices without being as badly exposed as refiners if crude rises again.