Look at bull spreads

TRADING DESK/ DERIVATIVES

There wasn't much change in spot prices last week. Everybody's waiting for the completion of the election process.

The coming week is likely to see massive swings as the composition of the 14th Lok Sabha becomes obvious. There aren't too many obvious technical indications of the likely direction of swing in the spot market.

But there is an interesting indicator in the derivative market itself and we do have a take on the possible magnitude of a move, once a clear trend develops.

The May Nifty futures were last traded at 1876 with spot Nifty at 1804. The backwardation is worth commenting on. It suggests there's been a lot of hedging in a market where operators have sold futures to guard against a possible crash.

Given the backwardation in the index, it's enlightening to examine spot prices versus May futures prices in the stock derivatives segment. An interesting point is that most stocks are also in backwardation. This suggests that there's a significant amount of pessimism in the market.

If there's a crash, the Nifty could dip till 1690 levels before it finds support. That's a possible downside of around 7-8 per cent.

On the upside, a rise would probably have enough momentum to reach 1925 levels quickly. That's possibly 6 per cent up. Please note that one end of this +6/-7 per cent range is likely to be tested within five-seven sessions. By settlement day, prices could have moved much further in either direction.

As far as the futures market is concerned, the backwardation of May also offers several interesting strategies. We can be contrarian and buy the May futures.

This would be fairly risk-free, provided we simultaneously sell the June Nifty (which is at a small premium to May futures). In that case, we will gain if either May goes up or June falls or both these events occur.

We can also construct strategies where we go long in various constituent stocks of the Nifty while selling May Nifty futures.

For example, we could go long in May options or futures of big stocks such as Reliance, Infosys, Levers and ONGC while selling May Nifty futures. This creates hedged positions, which would help preserve capital regardless of the direction of market movement.

Options are designed to deal with large moves in either direction. We can look at straddles and strangles, which could exploit any such large moves. We can also look at standard bull-spreads and bear-spreads as well as reversed spreads where we are trying to exploit premiums that are higher than normal.

Let's run through the whole gamut of these positions. We should note that close to money (CTM) puts are currently much more expensive than calls - the 1800p is priced around 60 while the 1810c is at 41. This makes it tempting to build positions by selling puts.

We'll examine those, but first let's look at the classic strangle-spreads. A long 1810c + long 1800p costs around 101 - it would become profitable if the market moved outside 1690-1910. A wider strangle such as long 1830c (34) + long 1780p (47) costs 81 and becomes profitable outside 1700-1910. Hence, we could sell a short 1800p + short 1800c while buying a long 1830c and long 1780p.

The resulting combination nets around 20 in premium at current prices. The profit function is illustrated in the graph on Nifty straddles.

While a pre-commission profit is guaranteed at current premiums, it is only worthwhile inside the narrow range of 1790-1820. A risk-taker may prefer to take long straddles with far from money options and gamble on a large move.

Now let's look at simple bull-spreads and bear-spreads. We can build a wide bull spread with a position like long 1810c (41.25) and short 1850c (27.5).

This costs 13.75 and could pay a maximum of around 27, which is an excellent return-risk ratio. We could also build a bull-spread with a short 1800p (60.25) versus long 1770p (43.25).

This yields about 17 in premiums and it could lose a maximum of 13, which is also an excellent return-risk ratio. It's tempting to take this position upfront and reinvest the 17 premium in some other instrument.

Where bear-spreads are concerned, the current prices are not very useful. Reference to the above positions shows that return-risk ratios aren't good for either a standard long put CTM coupled to a short put far from money or a short call CTM versus long call far from money (FFM).

If we wish to take bear-spreads, we would have to start with something like a long 1770p (43.25) versus short 1740p (30) where we pay 13.25 for the prospect of making a maximum of 16.75.

In stocks, the most obvious positions are long futures coupled to selling shares in the stocks which are showing marked backwardation. That way, an arbitrage could be locked into stocks such as Infosys, Lever, Dr Reddy's, HDFC and Reliance Energy.

Of course, such positions are only possible for those who already hold stocks or can arrange sharelending. Other traders would have to simply take long futures positions, which they could attempt to hedge by selling Nifty futures as mentioned earlier.

The backwardation in the market suggests that there is surprisingly little interest on the long side. When this is coupled to markedly more expensive puts versus calls, the impression gets stronger.

Since the money appears to be mainly deployed in expectation of declines, there aren't decent returns available on the short side.

However, the overall technical indications across both spot and futures markets suggest that there is a fair chance the market will actually move up.