Early signs of short covering

The bear spreads have better risk-reward ratios

The dramatic crash has set up an interesting situation with volatility spiking. The focus will be on foreign institutional investor (FII) attitude because it's clearly at the root of the bearish sentiment. Liquidity is good with high open interest and daily turnover.

Index strategies

Since the Nifty fell about 8 per cent last week, it's understandable the derivatives market is buzzing. Indian players remained active holding a collective 64 per cent of outstanding positions. Interestingly, FIIs wrote a lot of index options on Friday "� they are usually index option buyers at times when they are heavy spot sellers. This could mean short covering is due.

There are other signs that suggest short-covering. Index futures saw enhanced liquidity and expanding open interest across most indices, which normally means a bullish undertone. This was confirmed when most index futures settled at significant premiums to the spot levels. This is usually a short-term bullish signal.

Unusually two weeks before settlement, there was liquidity in the mid-term futures of most indices. Normally there is zero mid-term open interest except in the Nifty. This could mean high carryovers across the entire futures and options (F&O) segment.

The Nifty closed at 5,705 in spot and it was settled at 5,730, 5,729 and 5,740 in the January, February and March contracts respectively, with open interest expanding across all three series. The MiniNifty was held at 5,732 (Jan), 5,744 (Feb) and 5,764 (Mar) with good open interest in all three series. There is a calendar bull spread in the Mini with long Jan-short Feb.

The Junior closed at 11,497 in spot and it was held at 11,582 (Jan) and 11,402 (Feb) though February liquidity was token. The Midcaps closed at 3,442 and it was held at 3,483 (Jan) and 3,474 (Feb) with little February open interest. The BankNifty closed at 9,740 and it was settled at 9,812.6 (Jan) and 9,869 (Feb) with decent open interest in both series. The CNXIT closed at 4,060 and it was settled at 4,074 (Jan) and 4,098 (Feb) with good open interest.

The BankNifty offers a calendar bull spread with long Jan-short Feb. The CNXIT has a similar percentage differential but the IT index has a more bearish feel technically. The underlying weakness makes one hesitate.

In the options market, a lot of Nifty puts were cashed out. The put-call ratio (PCR) has dropped to 1.04 in terms of open interest, which is low and it's been dropping through the week. Normally, a high PCR is a sign of bullishness (since the market is oversold when puts far exceed calls). So a low PCR should mean bearishness. However there is a lower limit, which is usually hit on a market bottom. That ratio sometimes descends to 0.95, - perhaps 1.04 is low enough?

In terms of liquidity, there's no problem with both chains possessing open interest till the 6,550 level. Close-to-money premiums have risen but calls are more expensive. This is again, usually a sign of bullishness. Technically, the market could easily swing anywhere between a downside of 5,600 and a top of about 6,000. A bull spread with long 5,700c (193.7) versus short 5,900c (104.3) costs about 89 and pays a maximum of 111. A bears pread with long 5,700p (160) versus short 5,500p (82.85) costs about 78 and pays a maximum of 122. If you examine these wide spreads, the bear spreads have better risk-reward ratios.

Less wide positions have more equal ratios "� the long 5,700c versus short 5,800c (150.05) costs 44 and pays 56 while the long 5,700p versus short 5,600p (115.05) costs 45 and pays 55. Both these positions are tempting because they could both be hit inside the week "� in fact, inside two successive sessions.

If you combine both however, you effectively create a long straddle at 5,700 offset by a short strangle of 5,600p and 5,800c. The position costs a net 89 and pays a maximum of 22 if both sides are hit. Since that's unattractive, you must take a view on direction. I'd be inclined to go with the bull spread but there isn't much in it.