DERIVATIVES
Since the markets may see a correction this week, it will be wise to go for bear spreads
Our view is that the market could undergo a correction next week on the basis of poor breadth, low volumes and other weak technical signals.
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The correction could lead to support followed by a turnaround at either Nifty 1035 levels or even lower at Nifty 1020 levels. This view is supported by the backwardation in Nifty Futures.
Nifty Futures have been consistently trading at some level of backwardation, which is normal during a bull-run. But the backwardation has now increased quite substantially.
The June Nifty is trading at 1045.65 with the underlying spot series placed at 1056.2 and only nine trading sessions to go before settlement. The July (1042.45) and August Nifty (1042.9) are also trading at nominal backwardation to June.
In normal circumstances, we would expect a strong correction with the underlying and near-term series weakening while the more distant futures strengthened. This makes the calendar bear-trade of Sell June Nifty and Buy July Nifty possible.
In general terms, we would like to be on the short side next week. This is despite continuing to hold a long-term bull perspective in terms of July and August.
So we must be prepared to settle our bear-spreads quickly if there is a profit available.
Let's look at possible Nifty bear spreads. There are two basic bear-spreads possible.
One method is to Buy Near-The-Money (NTM) Puts and Sell Out-of-Money (OTM) Puts. This will result in initial premium outflow, with an improving potential for profits as the market moves downwards.
The other method is to Sell NTM Calls and Buy OTM Calls. This results in initial premium inflow with a potential for loss if the market actually moves up. In both cases, OTM spreads seem safer and possess better risk-reward ratios.
The Put-premium chain for the first type of spread is the 1050P (premium: 15.70), 1040P (10.75), 1030P (6.60), 1020P (4.05) and 1010P (2.50). If you Buy 1050P and Sell 1030P, the outlay is around 9.10 with a potential upside of 10.90.
Stretching the chain to Long 1050P versus Short 1020P requires an outlay of 11.30 for a profit potential of 18.70.
If instead, we look at OTM Puts, we could take a spread of Long 1040P versus Short 1020P for an outlay of 6.35 and a profit potential of 13.65. That's a better risk-reward.
The Call-Premium chain for the second type of bear-spread is 1050C (Premium:10.35), 1060C (7.35) and 1070C (4.15). (The first instrument is in the money.).
We can Sell the 1050C and Buy the 1060C for a initial inflow of 3 and potential loss of 7. It is safer to Sell 1060C and Buy 1070C for an inflow of 3.20 and a potential loss of 6.80.
The risk-reward equation improves a little and the spread is further from spot.
Stock positions: Potential stock winners in the Futures segment include Bhel, BSES, Digital Equipment, HCL Tech, HDFC, Hero Honda, Ranbaxy and VSNL.
In each case, the stock is mildly to strongly bullish, and the Futures could be worth buying. Unfortunately BSES doesn't possess sufficient liquidity to trade in the options segment since this seems to be quite a strong uptrend.
Digital is an interesting case. There was a bloodbath last week following merger with the stock dropping from 500 to around 355. The stock could now be settling into a new range between 350-400 with Friday close at 385.
Alternatively it could have an upside till about 435. Since the fundamental assessment of the company has changed sharply, and there isn't a technical history of trades in this price range, there is a large element of unpredictability and risk.
If you don't mind the large risk, there are two possibilities, depending on the view. One is to look at OTM Calls and Puts straddling or strangling the 350-400 range.
If you expect range-trading, sell these instruments and take the premium. If you expect further high volatility, buy these instruments and hope for breakouts.
For example, the 350P is at 10.80 and the 400C is at 13.45. The premium for a combined position would be 24.25. This would be profitable if the stock stayed within the range of 325-425.
If we took a combined position of 390C (17.50) and 390P (15.25) instead, the outlay would be about 32.75. That would be profitable if the stock stayed within the bounds of 358-422. As such, the OTM 350P versus 400C is safer for a short-seller.
We could also combine these positions. That is, Sell the 350P and Sell 400C to collect 24.25 premium. At the same time, Buy the 390P and Buy 390C, paying 32.75. The total outlay for the four-instrument position is 8.50.
In effect, we have a bull spread of Long 390C Vs Short 400C and a bear-spread of Long 390P versus short 350P. This will now be profitable if the stock moves outside the range of 381-399, which is very possible.
Bhel offers an arbitrage position, which will probably not last. With Friday spot at 267.15, the 260C is at 11.20. The 270C is at 5.65. Buy 260C and Sell 270C. The outlay of 5.55 can be immediately covered with a small profit. Keep an eye out if this arbitrage remains possible.
More likely, the bullishness in Bhel can be exploited by taking a Long 270C (5.65) versus Short 280C (2.80) for an outlay of 2.85 and a potential profit of 7.15.
Ranbaxy is an extremely volatile stock that has been covered this week in the Microtechnicals section.
Given the extreme daily fluctuations, it's difficult to stop-loss an equity trade. We can take a bull spread of Long 720C (13.9) versus Short 740C (6) instead. That would mean an outlay of 7.9 with a potential profit of 12.
Infosys is offering long arbitrage positions similar to Bhel. With spot Infy at 2970, a Long 2900C (150) can be combined with a Short 3000C (95). The outlay of 55 would be instantly profitable