Stay hedged in both directions

One way to cover the range of 2,550-3,150 is to combine Nifty futures and options.

Volumes stayed low in a derivatives market with lower than expected volatility. Carryover into February has started, but the trend is not very pronounced yet. There are some bearish signals.

Index strategies
Hedge ratios have risen with index futures and options accounting for almost 75 per cent of total volumes. That is a sign of caution. The FIIs, who have continued to be heavy sellers, are low in F&O exposures, holding 35 per cent of outstanding open interest.

In the index futures market, apart from the Nifty itself, there has been activity in the BankNifty and some activity in the CNXIT. The Nifty is seeing the start of carryover period with January positions extinguished and February opened.

About 6 per cent of Nifty futures open interest is in February or beyond. That open interest (OI) ratio should be close to 15 per cent on January 23. The January Nifty (2,815) is at a discount to the underlying (2,828) and the February Nifty (2,816) is at a small premium to January. The carryover trend makes calendar bearspreads tempting. The February Nifty should gain. If you short January Nifty and go long in February, there should be a little profit.

The January BankNifty future (4,584) is trading at a small premium to the underlying (4,581) though there is no carryover. The Banking sector is interestingly poised with most bank stocks at key supports after a week-on-week decline of over 6 per cent.

A recovery in banking stocks on Friday appeared to be driven by short-covering on extremely low volumes. The perspective is still negative. An example is HDFC Bank, which delivered decent results and got hammered anyhow.

The CNXIT held firm. Infosys and TCS delivered results on the higher side of expectation and the index lost very little ground. The rupee didn’t move much last week. HCL Tech and Wipro will be the driver for the CNXIT. The trend is slightly negative though it could change if the rupee slides. Going beyond fundamentals, if Obama mentions “outsourcing” over the next fortnight, it could have a disproportionate effect.

The technical outlook for the Nifty is also negative. Low volumes and negative advance-decline ratios are both bearish signals. The recovery on Friday was driven mainly by short-covering ahead of the weekend. It stopped below the critical resistance levels of 2,850-plus. If there is no surge on Monday, the market will slide again, definitely till 2,700 and probably till 2,550-2,600.

Historic volatility in cash remained at normal levels so we can expect a couple of big sessions next week. The VIX has slid till 44, which implies lower volatility going forward. But, the VIX has so far, proved rather unreliable.

The put-call ratios (PCR) in the overall market have dropped to 0.8 and that is bearish. The PCRs in terms of OI for Nifty options is at 0.93, which is also clearly bearish and deteriorating. About 34 per cent of option OI has moved to February and beyond. There is a lack of quotes above 3,350, so the market expects a cap at 3,300-plus.

The 2,850 level has proved to be a pivot point in the past three months. The market generally moves about 300-points in either direction from that zone. In the absence of any obvious trigger, assume that pattern will continue. The option trader would, therefore, have to cover the range of 2,550-3,150.

One way to do this is to combine Nifty futures and options so as to cover both directions. Use a Nifty future with a 50-point stop-loss in the direction of movement you expect. Combine that with an option spread in the opposite direction. Before we examine this, let’s look at vanilla spreads and strangles.

A bullspread with long 2,900c (52.85) and short 3,000c (24.9) costs 28 and pays a maximum of 72. A bearspread with long 2,800p (85.8) and short 2,700p (51.15) costs 35 and pays a maximum of 65. A strangle with long 2,700p (51.15) and long 3,000c (24.9) can be capped with a short 2,500p (16.1) and a short 3,200c (4.45). The net cost of this position is 56 and the maximum return on a one-sided move is 144 with breakevens at 2,644 and 3,056. The danger is expiry.

The bullspreads have better risk-reward ratios. Let’s assume that you take a bullspread with long 2,900c (52.85) and short 3,100c (10.65). This costs 42 and pays a maximum of 158. Couple this to a short Nifty future with a stop at 2,880. The maximum loss from this is 50. In the worst case, the loss is 92 if the Nifty hovers between 2,880 and 2,900. If there is an upwards movement till the cut off at 3,100, the gain is 108. If there is a down move, the position has breakeven at 2,786, where the cost of the option spread is compensated. Below 2,786, the position has unlimited gains. It compares quite favourably to the vanilla strangles because the payoffs require less volatility.

 

STOCK FUTURES/OPTIONS

This market possesses a combination of both long and short possibilities in stock futures. Focus on the top 10 stocks in terms of volumes. Satyam will see frantic action until January 29 when it is pulled from the F&O list. But, the direction is impossible to predict and you could lose your entire margin in 15 minutes if you pick the wrong side.

Two long positions that look tempting are Reliance Infra and Reliance Communication. Another possible “long” is Tata Steel. But, NTPC seems to be the safest “long” position. The stock is generating massive volumes coupled to an uptrend in both cash and futures. Keep a stop at Rs 174 and go long.