Go for bull-spreads

DERIVATIVES

Our perspective is that the market could move up till around the Nifty 1730-1740 mark before seeing any correction.

The first support level on a correction would be around the 1680 level, which is not too far below current spot at 1699. It is quite likely that the week will start with a rise and there will be a correction towards the weekend.

This view implies that the derivative trader should be focused on the 1680-1740 range. The Nifty put-call ratio is around 0.39, which is a neutral zone.

In the recent past, it has tended to be oversold at around 0.45 while it has tended to be overbought at around 0.25.

The trader should be primarily interested in bull-spreads in this situation. There is too much support close to spot for the trader to find bear-spreads very interesting.

As far as the option chain is concerned, there is little liquidity above 1720 "� neither puts nor calls are available above that point. What's more, by the week-end, settlement pressures will be seen and time decay will pull down most December option premiums.

It's very tempting to be a seller in these circumstances. It's easy enough to construct bull-spreads by selling puts that are close to the money and buying puts that are further away. That's probably the most paying strategy in this situation.

The other thing worth considering are straddles and strangles. We are considering a position where, within settlement period, large movements away from spot don't look likely. This suggests a seller is more likely to be successful with straddles or strangles.

A standard call-based bull-spread would involve something like buying 1700c (23.8) and selling 1720c (14) for an outlay of 10 and a possible return of 10. A smaller range of buying 1700c (23.8) and selling 1710(19) costs nearly 5 and returns a maximum of 5. Not great risk-reward ratios.

If the trader sells the 1690p (23.25) and buys the 1670p(16), he collects 7 and could lose a potential 13. If he comes closer to the money, selling 1700p (28) and buys 1680p (19), he collects 9 and could lose a potential 11. The wider spread has a poorer risk-reward ratio but the chance of it being adversely triggered is also less.

A 1700p+c position costs a total of 52. That means it would start showing profits only outside the range of 1650-1750. We don't anticipate either side of that range being breached by settlement day (December 24). It's possible to sell that position and cover the downside with say, a 1660p (12) and 1720c (14).

This would yield a maximum of around 26 and limit potential losses to around 14. It's also possible to wait for liquidity to develop at around the 1730-1740 level before covering the upside of that position.

This position can be improved on however. Suppose the trader sells a 1690p (23.25) and also sells a 1710c (19). He collects 42 and incurs a potential loss outside 1640-1760.

Another key factor is that the return is flat inside the range of 1690-1710 as opposed to the 1700c +1700p position where the initial return is higher but the return drops as the price moves away from 1700.

If this short position of 1690p + 1710c is taken, and covered by long 1660p + 1720c, the initial return is 16.25 and the losses are limited to below 14. The two positions can be compared in the given Nifty graphs.

In the Futures segment, December Nifty is trading at a slight premium to January Nifty and February Nifty. By the weekend, it may be worth buying January and selling December hoping that this situation will reverse by settlement.

Among F&O stocks, BPCL, HPCL, Gujarat Ambuja, HDFC, HDFC Bank, L&T, ONGC and Tisco look quite bullish. Infosys also looks as though it may have bullish possibilities.

The December futures are worth buying in each of these stocks. There isn't enough liquidity to trade options in HDFC and HDFC Bank. In several cases, bull-spreads are really cheap offering high reward-risk ratios.

In BPCL, the stock has the potential to move till around the 415-420 mark. A long 400c (6.7) coupled to a short 410c (4.7) would cost 2 and offers a potential return of 8.

In HPCL, a position of long 410c (9.8) versus short 420c (6.8) costs 3 and could yield a potential 7. In ONGC, a position of long 700c (11.55) versus short 720c (8) would cost 3.55 and yield a possible 16.45 for a terrific risk-reward ratio.

In Gujarat Ambuja Cement, a long 310c (7.15) versus a short 320c (4) could pay a maximum of 6.85 for a cost of 3.15. In Larsen, a long 440c (8) versus a short 450c (4.5) would cost 3.5 and offer a possible return of 6.5. Out of all these, the energy stocks look to be offering the most in the way of potential returns.

In Tisco, the technical perspective is more mixed. If Tisco's closing price breaks 380, it could move till around 410. If the resistance at 380 holds, the stock could slip back till the 355-360 level.

Tisco, in fact, has a wide daily range of 360-380. It may be worth taking a bear-spread with a long put at 370p (5.5) and short 360p (3.15) for a cost of 2.35 and a potential return of 7.65. It may also be worth a bull-spread of long 390c (6.35) and short 410c (2) for a cost of 4.35 and a potential return of 5.65.

In effect, this combination is a long straddle of 370p+ 390c and a short straddle of 360p + 410c. It costs 6.7 and it could pay a maximum of 13.3.