Buy put options

DERIVATIVES

The market trend has definitely weakened. We expect net lower prices with continuing high intra-day volatility over the next week.

The build-up of open interest (OI) in the new settlement is impressive but there isn't a big overhang yet. The Nifty put-call ratio is mildly overbought at around 0.32. This is a little surprising given the declines.

As far as Nifty futures go, the February Nifty is at 1814.85 points, March Nifty at 1816 and April Nifty at 1813.35 with spot Nifty placed at 1809.75. The mild premium on February versus spot will probably disappear fairly soon in a bearish market.

The implication: spot will dip further and February will dip even more so as to eventually stand at backwardation versus spot.

A player with a long term perspective might buy March and sell February, expecting the differential between those two months to widen as February dips.

This is technically a bear-spread but we are suggesting it less on the basis differential and more on the grounds that a recovery in March versus February prices is reasonably likely since the intermediate downtrend could have played itself out by then.

However, any long-term player would have to take note of the election schedule, which affects any such 'common sense' approach.

So far as Nifty options are concerned, there are several possibilities. One is the standard bear-spread: buy put options close to money and sell puts further from money.

Another is the bear-spread created through the use of calls. Sell calls close to money and buy calls further from money.

A third is to try and exploit continuing volatility by various straddles and strangle combinations of both puts and calls.

Intra-day volatility is likely to remain high with the Nifty doing daily ranges in excess of 30 points. This affects our creation of positions since option prices have been swinging wildly along with the market.

As such, all prices in this market are subject to more rapid change than normal. Expect a fall in call prices and a rise in put prices.

The good side of high ranges is that a profitable position will pay off very quickly and that makes positions with wider spreads possible.

But it makes possibility two, that of call-based bear-spreads dangerous. These combinations pay a fixed amount and have large downside risks if they are triggered adversely.

If you must build such positions head for something like a short 1830c (premium 50) versus long 1860c (40) where the far-from money situation could offer some safety. The risk is that the position stands to lose upto 20 if it's triggered adversely versus a maximum pay in of 10.

The other type of put-based bear-spread offers less risk and fair chances of reward. For example, we could take a long 1800p (51.65) versus a short 1780p (44.65) when the position costs an initial 7 and the potential payoff is around 13.

The classic tool for handling volatility is straddles and strangles. A consideration of such possibilities leads to us to the realisation that Nifty option prices are imperfect because a perfect arbitrage is on offer.

Consider a long 1810p (56) plus long 1810c (63.6). This costs 120 and would be profitable if the Nifty moved beyond 1690-1930. Even in a volatile market that's unlikely.

It can be laid off with a short 1780p (44.65) and short 1840c (45), which pays 90. The net position costs 30 and can never be profitable since it is closed out beyond 1780-1840.

We could reverse this position and take a short 1810p and short 1810c. Now you get the 120 premium. Cover with long 1780p (44.65) and long 1840c (45) for a payout of 90.

You net a premium of 30 which stays profitable between the range of 1790-1830 and there is no risk of loss. Obviously prices will correct but similar arbitrages may exist with reduced profit/range.

In the stock futures market, most February futures look like shorts. If you wish to cater to possible recoveries, you can buy March futures.

There are several stocks where the trader could short the future and simultaneously buy bull-spreads using options. That way, if the stock moves up, the option position will payoff.

These are cases where the stock has already fallen by a distance and may have hit supports. The February options market is still not liquid enough to yield reliable indicative prices.

The possibility of creating straddles also exists in these stocks since we expect prices to move away from current spot but once again, it's impossible to give indicative trades for lack of prices.

This possibility of short future and long option positions appears possible for Bhel, HLL, Hindalco, i-flex, IPCL, Infosys, L&T, Nalco, NIIT, ONGC, Polaris Software, Ranbaxy, Shipping Corp, SBI, Tata Power, Tisco and Wipro.

Make no mistake - our technical perspective on these stocks is net negative for early February at least. However, cheap hedges are available in bull-spreads.

There are very few stocks which seem likely to move up against the market in the F&O segment. Tata Motors, M&M and Mahindra would complete this list.

Here it would be best to buy the February future rather than head for option-based bullspreads. Bhel has dropped to 513 and could perhaps drop to around 485.

It could recover till around 545 levels on a bounce. Liquidity hasn't developed much yet in February options. Consider buying a 520c and selling 540c if the premium difference between the two is less than 10.

I-Flex is currently at 612 and it could drop till 565. It could also rise till 660. Assuming liquidity, take long 640c and sell 680c.

IPCL has a possibility of falling till around 165 from the current spot of 178. It could also rise above 200. Once again, sell the future and buy a 180c (13) and selling 200c (6) - that trade has a potential - reward-risk ratio of 13:7.

Infy could fall till 5050 or rise till 5700 from its current price of 5213. Short the February future and buy a long 5300c (211) and sell 5400c (190). The reward-risk ratio is an excellent 77:23.