Create long positions

TRADING DESK/ DERIVATIVES

The F&O market always guarantees excitement in a settlement week. The changes to the proposed turnover tax may have been sufficient to have addressed traders' fears. The equity markets have already responded to the rollbacks with a perceptible improvement in volumes and price rises.

For the past several weeks, the market has been stuck inside a narrow trading range without a clear trend. Now there is a possibility that a clear uptrend may develop.

If an uptrend does develop over the next couple of sessions, the impact of rising equity prices on the F&O markets will be magnified. We will see a sharp rise in call-premiums, open interest (OI) and implied volatility (IV), coupled to a drop in put-call ratios (PC ratios) as traders try to go long in August instruments.

As of now, the F&O market is exhibiting a neutral Nifty PC ratio of around 0.41 and futures prices are generally at backwardation compared to spot. There is also backwardation in August prices versus July. The spot Nifty is at 1601.6 points while the July Nifty futures is trading at 1595; August Nifty is at 1583 while September Nifty is at 1575.

The backwardations are likely to be corrected only in August, since there is very little time left for July expiry. We may reasonably assume that most short July positions will be closed out while most July long positions will be carried over.

The standard trade for exploiting Nifty backwardation would involve selling July Nifty and buying August Nifty. This calendar spread would pay off if the backwardation eases by either July Nifty losing ground or August Nifty rising.

In terms of the options market, it is very difficult to make concrete projections and offer specific trades. There isn't enough liquidity in August instruments and liquidity is only likely to develop after Thursday. But in general terms, a strong demand for calls and a dropping PC ratio appear likely. This should result in higher call-premiums and IVs.

The trends in the equity futures market are similar to that in index instruments. Equity prices have risen in the past two sessions and look set to rise further. The futures are, by and large, in backwardation compared to spot prices. Optimists will want to stay long in August and that should result in a correction of the backwardation.

Investors who hold current equity positions could try to exploit this process of backwardation-correction by selling in the equity market and buying August futures. Pure futures traders with July positions should sell those and buy August. The uncommitted trader could also enter into long August futures.

In terms of specific stock futures, Infosys, Wipro and Satyam seem interesting. Most IT stocks are rather bullish after the declaration of good results. Reliance and L&T also appear to have long side potential. Other equity futures would be more in the nature of arbitrage plays although, of course, the generally bullish projections of the Nifty make it more likely that pivotals will rise rather than fall.

In general terms, creating long positions seems better. In terms of July futures, the imminent expiry date makes it more attractive to try and sell options, especially far-from-money options. The seller would hope to swallow the premium and, in the worst case, close the positions at lower prices due to the wasting characteristics of the assets. However, there are more than normal dangers involved in this particular settlement. If there is a sharp rise in the indices and in equity, far-from-money positions could be adversely triggered against sellers.

Selling July options may still be a viable strategy if we are creating a long position through far-from-money puts. However, it would be difficult to find counter-parties for these and the risks may be huge.

For example, we could try and sell the July 1580p (11.5) and buy the July 1550p (5) to get an initial premium of 6.5. This bull-spread has an enormous potential maximum loss of 23.5 but we could hope that a) the market doesn't dip before Thursday and b) the premium on the 1580p drops sharply as we get closer to expiry, allowing us to reverse the position with a profit.

The risk-reward ratios are better with calls. We could create a conventional bull-spread. For example, a long 1620c (7.15) versus short 1640c (6) costs 1.15 and it could yield a maximum of 18.75 - if the market moves that much by Thursday. This might happen only if there's a clear uptrend. If there isn't, this position could lose 100 per cent because premiums decline very quickly this close to expiry.

Spreads like straddles and strangles carry risks due to the time-expiry factor. A straddle of long 1600c (15.3) and 1600p (20.5) cost around 35.5 - so, it will be profitable if the market moves outside 1565-1635. A strangle like long 1580p (11.5) and long 1620c (7.15) costs 18.65 and it's profitable if the market moves outside 1560-1640. These ranges are just too big for comfort. Perhaps we can sell them but the chances are, liquidity will decline in options that are far from money.

In August options, we have very little liquidity. It is possible to buy a long 1600c for 42 but we may not be able to immediately get counter-parties for a 1630c. It is probably better to simply wait for Thursday before taking August positions.

Otherwise, we could be stuck with taking naked positions at prices that will change unpredictably when liquidity becomes available.