Bet on rising volatility

Another week of tight range trading saw volumes dissipate in the derivatives segment. Open interest rose and premiums far from money dropped.

Index strategies: There are two weeks to settlement. Premiums are down due to the lack of volatility since the Budget session. Since then, the market traded through a daily high-low range of less than 100 points. As a result, option premiums far from money have dropped considerably. Open interest (OI) has built up despite low volumes. FII derivatives exposure has risen in absolute terms but fallen in terms of all OI.

This situation is unlikely to last. As and when there is a breakout, premiums will spike and so will volatility. That leads to one possible strategy. Rather than directional views, the trader can buy options hoping for a rise in volatility. The other strategy is to assume that the market will continue to range between roughly Nifty 5,000-5,200 until settlement.

Directionally, it is difficult to take a call. The market has been stuck between 5,050-5,150 through all March and figuring out direction of breakout from a range is among the most difficult things to do. A bullish intermediate trend offers hope that any breakout will be upwards. Among other bullish signals, the market has tested 5,150 more often than it has tested the downside of the range. All three highly traded index futures settled at nominal premiums to respective underlyings on Friday. However, the lack of volumes and poor breadth indicators could make this a flash-in-the-pan. It is true that the Nifty is unlikely to make a move that will not be backed by the Bank Nifty and CNXIT and if you wish to take a long futures position, a long Bank Nifty could serve as a high-beta proxy for the Nifty.

For directional traders, the Nifty put-call ratios seem firmly in the bullish zone. Carryover has been fair in Nifty futures as well as options. Around 12 per cent of futures OI is in April and beyond while about 32 per cent of option OI is in April and beyond.

But a look at the Nifty option chain reinforces one belief that betting on rising volatility is a better play than betting on direction. The OI is tightly bunched. The Nifty call chain for March has a little OI at 5,000c (163), the maximum OI is in-the-money at 5,100c (87) with some OI at 5,200c (36) and 5,300c (11.5). The March put chain has some OI at 5,100p (45) with the maximum OI at 5,000p (22) and some OI again at 4,900p (10) and 4,800p (5).

The close to money (CTM) bullspread and CTM bearspread have excellent risk-returns ratios. A long 5,200c coupled to a short 5,300c costs 24.5 and pays a maximum of 75.5. A long 5,100p coupled to a short 5,000p costs 23 and pays a maximum of 77.

Somebody expecting a rise in volatility could combine these two CTM spreads. The ensuing long-short strangle combination costs 47.5 with breakevens at 5,052.5 and 5,247.5. If this is struck and the market moves to either limit of 5,000, or 5,300, the return is 52.5. If the market hits both limits, the return would be close to 152.5. This combination is a reasonable way to play for higher volatility since it has a positive risk-reward ratio and a good chance of at least one limit being hit. .

Another method is to take a wider long strangle with long 5,000p and long 5,300c. This costs about 33-34. It has breakevens at 4,966, 5,334. The returns are in theory, unlimited. A short strangle of say, short 4,800p (5) and short 5,500c (1.5) could further lower costs and bring breakevens to 4,972.5, 5,327.5. That would limit maximum return to 172.5 on a one-sided move. Rather than the theoretical return, the key to profit on this long strangle would be a jump in premiums for one long option, if there is a breakout in either direction.

The other trading possibility is to assume there will not be a breakout and take a long call butterfly to exploit range-bound trading. Last week, we suggested a butterfly with long 5,000c (premium for March 5 was 140), two short 5,100c (79) and a long 5,200c (38). The cost was approximately 20.

This position is about 43 in the money at the moment. It could be allowed to run or it could be settled by reversing all outstanding options. If it's settled, the profit is approximately 25.

A new call butterfly could be opened with long 5,100c, two short 5,200c and a long 5,300c. That costs about 26-27, which is the maximum loss at 5,100, 5,300. Breakevens are at 5,127, 5,273, with the maximum profit of 73 at 5,200. This is in the money. If the market moves up slightly but not too much, this position could be highly profitable.
 

STOCK FUTURES/ OPTIONS

The stock market continues to be extremely choppy with very little in the way of clear sector-specific trends. Most stocks have seen alternate sessions of bullishness, followed by profit-booking. The absence of credible hedges makes stock futures positions look very dangerous and my instinct would be to stay out of stock futures until a clearer trend is established. 

A short position in Hind Unilever is possible as it is in Bajaj Hind, Renuka and Triveni. Long positions could involve Hindalco, Sesa Goa, Sterlite, IDFC and Cairn. Another possibility is paired trades, such as long DLF, short HDIL or long ICICI, short SBI. Paired trades of opposed positions in two stocks in the same sector, limit risk to some extent. One of the positions is always likely to be profitable.