Try to cover both directions

There is a possibility that the market could switch direction suddenly and violently during this settlement.

An extraordinary settlement ended with a high volume week. The Nifty rose an amazing 28 per cent in May and it surged again on the first day of the June settlement.

The market is testing resistance at 4,500 levels. There was little profit-taking on Thursday but the trend got more bullish immediately post-settlement. Volumes remained consistently high and the daily volatility was quite high with the Nifty swinging through almost 4 per cent daily.

The Vix has settled down at about 40 after spiking to 90 in the post-election result stage. Premiums are almost uniformly high. The historical volatility implies that the Nifty could continue to move around 175-200 points a day.

 

The FII influence seems to have got more pronounced. They are holding around 42 per cent of current open interest (OI). This is unusually high and worth remarking upon in a high volume market where Indian traders are certainly also enthusiastic participants. The FIIs were net buyers in May to the tune of Rs 20,000 crore in the cash market.

The rise in their derivatives exposure may mean that they are hedging more. It may also mean that they are getting ready for a collective switch in attitude. We have seen a pattern earlier where FII attitude reversal in the cash market was preceded by larger F&O exposures, especially in the Nifty options segment.

Hedge ratios have also risen in general. A larger proportion of overall OI is composed in Nifty futures and options positions. This may correct a little further into the new settlement as single-stock positions pick up volume. But, it is also possible that the high hedge ratio is a symptom of wariness with long equity position-holders hedging their exposures.

Directionally, if the market breaks out of last week's range of 4,100-4,500, it is likely to move at least another 200-300 points in the direction of the breakout. Given the patterns of April and May, a breakout in June is quite likely and a correction is more likely than a continuing upmove. But, the Nifty is also very close to engineering an upside breakout and if it does so, it could still move up quite sharply.

The subsidiary indices don't offer directional clues. Both appear somewhat over-extended and perhaps capable of moving up a little more for what it's worth, both were settled at some discount to the cash price.

The CNX IT remains reverse correlated with the rupee and its moves rather than with the Nifty itself. Trading volumes in the IT index is quite low. The Bank Nifty is liquid, high-beta and better correlated. If you wish to take a Nifty futures position, consider taking a BankNifty position instead. It is very likely to move in the same direction and to move more than the Nifty itself.

In the options market, one can lay down some simple rules for traders, Premiums are high and so is volatility. Don't sell uncovered options. Preferably, don't sell options close to the money even if you are covered. Be prepared for the market to switch direction suddenly and violently during this settlement so investigate ways to cover both directions of movements.

Vanilla spreads with long option closer to the money are offering good risk to return ratios in both directions. Strangles are offering reasonable ratios as well, especially if you can cover, judiciously creating long-short strangle pairs.

A bullspread with long 4,500c (157) and short 4,600c (114) for instance, costs around 43 and pays a maximum of 57. A wider bullspread such as long 4,600c and short 4,700c (82) or short 4,800c (59) pays maximum of 68 and 145, respectively on initial costs of 32 and 55, respectively.

A bearspread with long 4,400p (157) and short 4,300p (119) costs 38 and pays a maximum of 62. A long 4,300p and a short 4,200p (91) or short 4,100 (68) costs 28 and 51, respectively and offer maximum payoffs of 72 and 149, respectively.

These are quite good risk-reward ratios from the perspective of a market that is swinging by over 150 points in every session. A long strangle such as long 4,700c and long 4,200p would cost about 173. If it is laid off with short strangle at say, short 4,000p (50) and short 4,900c (41), the net costs drop to around 82. Then the return on a move till either limit would be 118.

Again, this is quite a decent risk-reward ratio for a long-short strangle combination. There is a fair chance that both sides of the strangle could get in the money if the June settlement sees a correction as well as an uptrend.

Another possibility that covers both directions is a long Nifty future with a stop loss combined to a bearspread. This seems slightly better than the mirror position of short future plus bullspread. That's because the bearspreads have somewhat better risk-reward ratios.

My gut-feel suggests that any hedge combination is likely to work out better than an unidirectional position. The uptrend has gone for almost three months and it is going with the odds to assume June will see some correction.

 

STOCK FUTURES/OPTIONS

The most sensitive set of stocks appear to be real estate where DLF, HDIL, Unitech, Indiabulls Real Estate, etc are going through sharp moves.

Banking is also quite sensitive and so are metals. Beyond that, there are various infrastructure related scrips like JP Hydro and GMR. Of the lot, metals are the least correlated to the major market index.

Among ferrous metals, Sail looks slightly more bullish than its peers – Tata Steel is losing volume for instance. But Hindalco looks most interesting. It could deliver returns of another 20 per cent.