Nifty bear spread offers good pay-off

Although the Nifty put-call ratio remains close to the 1.5 level, the bear spread risk to reward ratio is a lot better.

The market continued to register gains albeit at a slower pace than before. Sooner or later, there will be a correction but it hasn't happened yet. The current expectations seem to be short-term gains followed by medium-term correction.

Index strategies
The spot Nifty closed at 3834 on Friday's high-volume action in the cash markets. Derivatives volumes spiked as did open interest.

The November Nifty future was held at 3842, December at 3884.5 and January at 3847. There are high levels of OI in all three contracts and it's extremely unusual to have positive carry across the series.

The differentials aren't enough to arbitrage. If the market breaks inside this settlement, a calendar bullspread of long November-short December will gain because the cost of carry is liable to turn negative again.

A continuation of the uptrend will mean that the premium on the December contract will rise and a calendar bearspread of short November, long December will gain.

The other two tradeable futures also closed at premium but this is not unusual. The CNX IT is at 4910 in spot and at 4913.5 in the November futures series.

The Bank Nifty is at 5758 in spot and at 5759 in the futures. In these two indices the differential between spot and future has, in fact, narrowed. The Bank Nifty is worth a long position perhaps but the view on the IT index is neutral.

An interesting point arises if we look at volumes in the F&O segment versus spot. Due to rolling settlement, all spot positions are either intra-day settlement or delivery. Hence, almost every overnight position is long. Most stock traders don't seem to hedge.

There is enormous OI in many stock futures contracts but futures aren't the best hedge against delivery. The symmetrical nature of a futures contract means that a short future will lose about as much as a long spot position gains. It's reasonable to conclude that most stock futures volume is speculative.

The ideal hedge for delivery is an option bearspread or a naked put. Options are asymmetric; the loss is capped at premium outgo. Hence if the delivery gains more than the premium, the option is an effective hedge.

But there is very little option volume in the stock derivatives segment. That leads one to conclude that most stock traders don't bother to hedge.

In the Nifty, however, there is almost as much contract volume in the options segment as in the futures segment. The chances are, a lot of people are using the index to hedge deliveries in a sophisticated fashion.

The Nifty put-call ratio has remained close to the 1.5 level throughout most of the last four weeks. A high PCR suggests again that the market expectation is bullish in the short-term.

If we look at spread pay-offs, this impression is strengthened. A close-to-money bullspread such as long 3850c (60.45) versus a short 3900c (35.6) costs 25 and pays a maximum of 25. A bearspread with long 3800p (51.5) and short 3750p (36.8) costs about 15 and pays a maximum of 35. Although there are more puts out, the bearspread risk:reward ratios are a lot better.

For the past few weeks, I've been advocating holding bearspread even in a rising market for precisely this reason. The bearspread is lower probability but the pay-off is so superior that it compensates.

I'd say, stick with a bearspread if you want to dabble in Nifty options. Use a long Nifty future in preference to bullspreads if you want to bet on the upside.

There is still a lack of liquidity at higher strikes on the call-option chain. So we can't create hedged straddles. A combination of long 3900c and long 3800p costs about 87.

There is a positive payoff only if the market moves outside 3700-4000. This range of movement is quite possible but it's really not an attractive position.

STOCK FUTURES/OPTIONS

As mentioned above, stock futures far outrun stock options in volumes and open interest. This means unfortunately that our ability to create hedged stock-derivatives positions is low. You have to take a view on the basis of technical factors and gamble on that.

There are a lot of F&O stocks exhibiting fairly marked trends "� look at page 10 for a comprehensive list. While there are differentials apparent between futures and spot prices, these aren't big enough to arbitrage in most cases.

BPCL and HPCL are being hammered hard "� the price of crude is coming down but so are administered retail prices. The PSU refiners won't make windfall profits in Q3 after suffering massive losses for two years. Short positions here may be useful.

The Reliance Industries accident and the dynamics of lower retail prices also seem to be translating into a downgrade for RIL. The RIL November future (1286) is priced lower than spot (1292) and the 1260p (13) is generating high volumes as is the 1230p (7.25). The ratio on a bearspread of long 1260p and short 1230p would be a maximum return of 24 on a premium outlay of 6.

Apart from a RIL bearspread, look out for a long ICICI Bank future and a long Siemens future. Siemens rarely generates high volumes except when it's about to jump in price "� it's a top 10 contract at the moment.

ICICI Bank last traded at 825 in the futures segment versus 835 in the spot. If you've got delivery, you can arbitrage by selling ICICI spot and buying the future.