Sell short straddle

DERIVATIVES

Settlement went smoothly enough despite an extremely volatile market and that's a tribute to the trading system.

A long-awaited recalculation of contract sizes back down to the Rs 2 lakh minimum limit should bring cheer to every trader since it will enhance liquidity in stocks, which have seen multiple gains and developed unwieldy lot sizes.

Our perspective on the market remains bearish in the short-term. Even if the rally that started on Friday afternoon continues through the early part of the week, the Nifty should continue to trade within the range of 1760-1850 where there is a clearly defined support at 1850 and resistance at 1760. Right now, it's almost bang in the middle at 1800 points.

The March Nifty futures is at 1804.8 and April is at 1805.8 with May at 1810.95. The Nifty put-call ratio is pretty close to neutral at around 0.33.

In the last 10 months, we've usually we've seen it move into overbought territory around 0.28 or lower and it's tended to be oversold above 0.5. So there aren't any obvious trading signals.

The implied volatility is fairly high which is not surprising given the gyrations that the market has witnessed in the last couple of weeks.

If the market goes seriously bearish again, it will penetrate 1760 on the downside while it could rise above 1850 only on a sustained trend reversal. More likely it will tend to trade between these two points.

Given the high implied volatility, the temptation to create positions by selling options is more. But there are reasonable return-risk ratios available for standard positions as well.

A standard bull-spread of long 1810c (46.4) versus short 1830c (37.8) costs 8.6 and it could pay upto a maximum of 11.4. A standard bear-spread of long 1800p (47.5) versus short 1780p (38.5) pays a maximum of 11 versus an outlay of 9. Both moves could pay off in case of range-trades.

A straddle of long 1800c (50.75) + long 1800p (47.5) costs 98.25 initially, which means that it would be profitable only outside the range of 1700-1900.

That's way beyond our expectations of movement. If we create a strangle of long 1830c (37.8) versus long 1770p (34.5) it costs 72 and offers profitability roughly outside the same range of 1700-1900.

So we could try and sell a short straddle and buy a long strangle as cover. This has a positive payoff if the market stays between 1780-1820.

We could also take a short strangle close to money with short 1810c (46.4) + short 1790p (45.6). This yields an initial 92 and it would lose money if the market moved outside roughly 1700-1900 once again.

If we cover this with our proposed long strangle of long 1830c + long 1770p, we get a payoff, which is profitable between the same 1780-1820 range.

However, our downside is much more limited if this position moves out of our desired range although the maximum payoff if there is little movement is somewhat less. This short strangle versus long strangle would be a better way to exploit a high implied volatility (IV).

Although the market appears to be limited to range movements, there is considerable scope for plays in the stock F&O section.

Several of our available stocks have chart patterns which suggest that they could break out and outperform the market on the long-side.

ACC, BPCL, BSES, Gujarat Ambuja Cement, GAIL, HCL Tech, Infosys, Oriental Bank and Satyam all look capable of breaking out further than the market if there's a bullish move. In each case, the March future is likely to be a good buy in the short-term.

In the options segment, liquidity will be a constraint in several of these. ACC has good return ratios for bull-spreads such as long 260c (12.15) versus short 280c (5.15) which costs 7 and could pay 13.

Gujarat Ambuja looks somewhat less bullish but it also has excellent return ratios for a long 310c (12.9) versus short 330c (4). This costs 9 and pays 11.

There is some mispricing evident in the money in GAC for the 300c costs 18.5 - that price is likely to change given the easy arbitrage versus 310c since the spot is at 308. This will probably affect the entire call-premium chain.

BPCL has not yet developed liquidity above the 470 option level with spot around 460. There is hardly any indicative price at 470/ 480. The naked 460c costs 14.2 and the stock could perhaps move till around the 480 level before hitting resistance if there is any uptrend.

It may be worth taking a position if the differential between pricing of 460c and 480c is less than say, 8-9 leaving a possible return. If the 460c remains at current premium, that means the 480c should cost 6 or more for the trade to be worthwhile.

BSES has moved into a very steep uptrend. There is mispricing across the entire call chain and no liquidity in instruments above 740 levels. The 740c (32) is worth buying if say, the 760c could be sold for around 24.

The other possibility here is to build a bull-spread using short 720p (25) and long 700p (15). This yields 10 in premiums and could cost a maximum of 10 if the situation suddenly turns bearish.

In Gail, the long 200c (12.5) versus short 220c (5.15) costs 7 and it could pay a maximum of 13. That's a decent return ratio and the stock seems to be capable of such a movement.

Infosys is around 5060 in the spot market and it could perhaps move to around 5200 before hitting resistance. A bull-spread of long 5100c (188) versus short 5200c (150) costs 38 and could pay 62.

Satyam also offers a good bull-spread ratio of long 310c (17.8) versus short 330c (9.8) where the payoff could be a maximum of 12 versus an outlay of 8.