Bear spread advisable

Bear spreads have provided good returns over the past few weeks.

RBI's announcement of a tighter monetary policy on Friday sparked a sell-off. It's anyone's guess whether this will turn into a significant correction or find support within the short-term. Volumes in the derivatives market remain good but the change in perspective was instantly reflected in background indicators.

Index strategies
The Spot Nifty has declined to 3962, while the December futures contract is held at 3965, January is at 3972.75 and the February Nifty is at 3978.20. This could get very interesting. The futures contracts are still at premium with respect to each other and to the spot price. This is very unusual, even in a bull market.

In a mildly bearish short-term scenario, we would expect a move by the January future into discount and also the spot to start trading at premium to the December contract.

That makes a calendar bull spread worthwhile: go long in the December futures contract and sell the January contract. The position will gain if the December contract rises with respect to the January contract and the differential either lessens or reverses.

Of the other tradeable indices, the Bank Nifty is at 6234 in spot and the December Bank Nifty futures contract is also trading at almost exactly the same levels.

The CNX IT closed at 5244 in the spot segment and it was settled at 5245 in the December futures. This is the first time in several months that the index futures have not traded at substantial premium to the spot levels and that suggests that expectations have become more bearish.

It's difficult to make a call on the future direction of the CNX IT but the Bank Nifty is almost certain to lose a little more ground next week. The knee-jerk reaction to any rate hike is negative where the banking sector is concerned.

Over next week, major banks will almost certainly start to raise their lending rates and that will probably lead to a further bearish impact on bank stocks. A naked sell of the Bank Nifty is risky and high-margin. But it could work very well.

In the options market, the Nifty put-call ratio has dropped but it's still well above the oversold mark at around 1.3. That means the balance of expectations is still bullish.

Technically, we see it as likely that the index will turn around somewhere between 3875-3915 and on the upside, it has strong resistance above 4015. Option traders should probably stay focused inside this fairly narrow range.

A standard options bull spread with a long Nifty 4000c (63.65) and a short 4050c (41.15) costs about 22.5 and offers a maximum pay-off of about 27.5. This is a fairly decent risk:reward ratio "� much better than the Nifty bull spreads have offered in the last few weeks.

A standard options bear spread with long 3950p (76.65) versus short 3900p (54.55) costs 22 and pays a maximum of about 28. The risk-reward equation is just about the same as for the bull spread and the bear spread is significantly closer to the money.

We've advocated bear spread consistently for weeks on the basis that they've offered far better risk-reward ratios even though the market has risen. Last week, the bear spread paid off handsomely. We'd suggest holding a bear spread this week as well in preference to a bull spread.

One good thing about the correction is that the option chain is now well-populated both above and below the money. This gives us potential straddle and strangle options. A long 3900p and a long 4000c collectively costs about 118.

This strangle will pay off if the market moves beyond 3780-4120. If the strangle is covered with a short 4100c (23.85) and a short 3800p (29.65), the position costs about 65. This would be profitable outside 3835-4065 but the maximum pay-off is 35 versus 65. The adverse risk reward ratio makes it a poor position.

A trader who is looking for cheap if unlikely positions with high reward:risk ratios could also seek a strangle at long 4050c (41) and long 3850p (40.8). The key to this is that the index will burst a critical barrier if it does close outside either of these marks. If you do go with such a position cap it with the widest short straddle you can get a counter-party for.

STOCK FUTURES/OPTIONS

Most Nifty stocks look quite bearish. If you decide to go short, set smart stop losses and in my opinion stick to bearish auto or banking stocks. There are several Nifty Junior stocks which look as though they could offer some relief to bulls. Polaris and i-flex are both strongly bullish and the Polaris future is likely to spurt.

Naturally the rate hike could throw the bank and housing finance sector into turmoil. The Bank Nifty declined 1.5 per cent last week - far more than the Nifty did. However the net trader perspective on the "big boy", SBI, still seems to be bullish.

There is huge open interest in the SBI 1380c. SBI is trading at 1355 in spot and 1361 in the December futures sector. The futures premia lead one to suspect that the call volume is not a hedge against futures short positions. Now a brave position trader would seriously consider going short on the SBI future. Settlement is on December 28, offering ample time for SBI to react.

There are a couple of other potential arbitrages. Tata Steel is trading at 486 in the futures segment and at 480 in spot. You could lock in the differential of buying spot and selling the future.