Bearish mood post settlement?

The bull and bear spreads offer excellent risk-reward ratios if you can live with expiry dangers.

The crash on Friday led to a huge and probably temporary increase in derivative volumes. A lot of June futures positions were cashed out probably due to settlement considerations and margin calls. However, there is a good trend in terms of July carryover.

Index strategies
The FIIs continue to be heavy sellers but they have not increased their derivatives exposure, which continues to hover at around 39 per cent of outstandings.

They also continue to hold just about 32 per cent of positions in index options and this is a "normal" ratio. It is when the FII index option exposure spikes to about 40 per cent that we usually see a change in the FII cash buy-sell trends.

Margins considerations would have had a significant impact in a falling market. From Monday, we're talking full margins so traders with clearly losing positions or big profits would have extinguished on Friday. That seems to have happened with over 4 lakh June Nifty futures open interest (OI) being cut and over 9.5 lakh Nifty puts being extinguished as well.

The carryover trend is quite interesting. In Nifty futures, the total OI is about 4.5 crore with about 20 per cent placed in mid+far contracts.

In Nifty options, the far+mid OI is around 31 per cent. That's healthy without being outstanding. The mid and far put-call ratio (in terms of OI) is incidentally around 1.32, which seems rather low for this stage of settlement where 1.8 or higher is often registered.

Overall index PCR (OI) is around 1.37, which is in the normal range but we saw lower intra-day values on Friday. The stock option PCR was abnormally high at 0.4 given that it's rarely above 0.2. Stock option volumes were also fairly high. This could mean that sophisticated traders have finally started using these instruments to hedge in preference to options. Or it could mean that the fear factor is quite prevalent and even bulls in specific stocks are hedged. Perhaps it means a bit of both.

The VIX hit an amazing intra-day high of 57 before settling back to 29. We're already into the last 8 days of settlement when the near+mid Nifty option component in VIX calculations is replaced by the mid+far option component. This leads to some distortions in VIX calculations as the liquidity of the far month options is well below that of the near-month until even settlement day. For what it's worth, the Vix closing value is near the top-end of its recorded closing range and that signals bearish expectations.

The bearish expectations are also echoed by index futures' levels. In the liquid Nifty futures and in the BankNifty which is also fairly liquid, there are visible discounts. The June Nifty settled at 4335 "� about 12 points below the spot closing and the July Nifty was at 4318. The BankNifty closed at 5758 while the June contract was settled at 5717 and July at 5700.

In both cases calendar spreads of long July, short June are possible though the arbitrageurs will pick these up in the opening minutes of Monday. The discount of BankNifty June future to spot levels indicates that the bearishness in the sector is liable to continue. Rate hikes are guaranteed in July and they could be quite large given the latest inflation numbers.

Sector-wise, the one silver lining could be IT since the rupee has lost ground due to continuous selling by FIIs. On Friday, the RBI intervened and that could stabilise the rupee somewhat. However at beyond Rs 42.5, the IT sector stays attractive. The CNXIT could see some long positions created but this is more likely to happen post-settlement since the July contract is illiquid.

Our target ranges for the Nifty in settlement week are between 4200-4600. There is likely to be one big pullback session but the overall trend is likely to be down. The expiry factor means that any wide spreads should ideally be taken in the July series, which is of course, more expensive.

However, narrow 100-point spreads close to money will probably be struck in both directions if we are right in our reading of the likely Nifty volatility. There is an asymmetry of premium pricing due to the bearish expectations.

A bullspread of long June 4400c (47.55) versus short 4500c (18.55) costs about 29 and pays a maximum of 71. A bearspread of long June 4300p (68.2) and short 4200p (43.65) costs 25 and pays a maximum of 75. Both these spreads are likely to be struck and both offer excellent risk:reward ratios if you can live with expiry dangers.

If you're looking for wider spreads, a long July 4500c (105) and a short 4700c (52.6) offers a potential maximum return of 146 on a cost of 54. Similarly a long July 4300p (189) and a short 4200p (149) offers a potential maximum return of 60 on a cost of 40. The July put chain is short of liquidity below the 4200 mark.

STOCK FUTURES/ OPTIONS

The stock derivative trader should concentrate on a short-list of most actively traded contracts and if possible, focus on July instruments and look to short in the weakest looking counters. In the short-run, there could be a phase of short-covering. But by Friday, the market may be heading down again.

Among the most promising looking shorts are Parasvnath, Tata Steel, several banks and of course, the whole range of Reliance and ADAG counters. Renuka is also generating volumes but the trend of the stock is indeterminate.