Look at straddles

The market has gone into the new settlement in a bearish mood. The Nifty June, July and August futures are trading at 1482, 1476 and 1475 respectively with the cash Nifty poised at 1508.

This in itself indicates a substantial level of backwardation, which is confirmed by similar behaviour in the cash stocks and stock futures markets.

The Nifty put-call ratio is around 0.38 which is neutral territory. Not much can be read into this indicator because the new settlement has just kicked in.

Implied volatilities remain high - a reflection of the big price swings we've seen over the last six weeks. Open interest is building up rapidly and actually derivatives have registered much higher trading interest than the cash volumes in the past few days.

It's difficult to read the direction of trend for the next month. The market could settle down into a broad range between 1475 and 1620 Nifty.

It could plunge below 1475 and test the Black Monday levels around 1300 all over again. Or, and this seems the least likely at the moment, it could move up past the 1620 levels. An upmove would bring a lot of comfort to long-term investors since it would offer an assurance that the bull market isn't dead.

The looming Budget in early July would be a major factor in everyone's calculations and it seems that the market doesn't expect much despite the A team of Chidambaram and Singh being back in charge. At current prices, we could try to exploit the backwardation in Nifty futures in certain ways.

If we assume that the Budget will actually enthuse the market (because it will exceed the current low expectations in terms of actual provisions), we would hope for a rise in July.

In that case, we should sell June Nifty futures and buy July. This would work if the market continued to fall until the last Thursday in July. That would increase the level of backwardation. We would then benefit when the market actually climbed in July and our long Nifty July future worked.

Sometimes when there is no clear course of action, we can look at the risk-reward ratio for bear-spread versus risk-reward ratio for bull-spread for a clue as to the best direction of trades. Then we try to go with the trades that give us a highest reward-risk ratio. Unfortunately, there's little to pick here.

Let us say, we take a bear spread with long 1500 Nifty put (69) versus short 1480p (58). We pay 11 and we could receive a maximum potential return of 9.

Let us say, we take a bull-spread with long 1510c (48) versus short 1530c (38). We pay 10 and we could receive a maximum return of 10. Not much of a difference.

We could try looking at straddles and strangles instead since those will pay off whenever there is a big move away from current levels. The high implied volatilities suggest that we should actually look to sell close to the money.

A strangle with long 1510c (48) plus long 1500p (69) costs an expensive 117 and it will be profitable only if the market moves outside 1380-1630. A long straddle with long 1510c (48) plus long 1510p (75) costs even more at 123 and is profitable outside roughly the same range. While such big moves are possible, betting on them is risky.

What about short straddles close to money combined to long straddles at a fair distance? Effectively this is like taking a combined reverse bull and bear spread.

It consists of something like short 1510c (48) and short 1500p (69) yielding 117 in premium. This is covered with something like a long 1600c (19) and a long 1400p (29) where we pay 48.

The net premium yield is 69. This position offers profits between 1440 and 1570 and restricts the maximum possible loss to 31. The naked short strangle offers more profits but theoretically unlimited losses.

It is possible however to take a naked short strangle and only cover one side of the position as and when a clear market trend develops. That is probably the most practical option.

In the stock futures market, it's difficult to find any obvious winners. None of the stocks in the F&O segment appears to be poised to behave much differently from the rest of the market.

While there would be more rewards if we bet correctly on stocks going up, the technical positions don't offer very much scope for optimism.

Hindalco, L&T and Dr Reddy's appear to be fair hedges against a further fall - all three stocks have fallen a fair distance and appear ready for a technical bounce.

HDFC and Infosys may also show a certain amount of bullishness and so might ITC. In each of these cases, buying June futures may pay off. The only PSU which seems capable of rising against the bearish PSU-sector sentiment is BEL and even that seems highly risky.

The two refiners - HPCL and BPCL - are both likely to trade close to current prices. SBI may provide a decent short since the stock was hard-hit on Monday.

In the stock options market, most counters still lack liquidity restricting our possibilities even further. Hindustan Levers offers good reward-risk ratios in terms of bull-spreads.