Straddles are safe

DERIVATIVES

The market goes into the settlement week in an indecisive manner. The portents are slightly bearish. The Nifty put-call ratio has risen to above 0.6, which is definitely in the oversold zone.

In a normal week, one would assume that this meant the conditions for a short-term technical rally existed on this ground alone. However, with settlement around the corner, it's more likely that the market will hold close to current levels.

The Nifty appears to be stuck inside a fairly narrow range of 1575-1630 with the current spot around the 1600 mark. There is some backwardation in the September Nifty futures (1579) versus August Nifty (1586). It may be worth taking a standard calendar spread of sell August Nifty and buy September hoping that this gap will close.

We have the usual problems of time-decay, liquidity and carryover to contend with in the settlement week. August option premiums will dip drastically, there isn't enough volume or liquidity in September options yet and there are large positions that must be either liquidated or carried over. Also the technical situation suggests that market won't move a huge amount in either direction.

In such circumstances, it is always tempting to try and build positions through the sale of options. Premium decay should reduce the risks in case of an adverse movement.

Also due to the indecisive nature of the market, we could try to take straddles and strangles rather than look for direct bull-spreads or bear-spreads.

Any short straddle or short strangle which goes into the red outside Nifty 1570-1630 is probably safe. We could try selling the straddle at 1600 with 1600c (9) and 1600p (22). This pays 31 and it will lose only if the market moves outside almost exactly the 1570-1630 range.

However, it may also make sense to sell a short strangle with short 1610c (6) and short 1590p (17.5) to get an initial premium of 26.5. This position is profitable unless the market moves outside 1565-1635 and it has slightly higher profitability compared to the short straddle if the market is outside 1590-1610. The comparable profit functions are given in the graph.

Staying with a naked strangle which has these 1565-1635 limits is quite tempting. But it may be prudent to cover with a far-from-money 1560p (5) and 1640c (1.65). That cuts the initial profits to around 19 but the risks in case of a big movement are minimised. The covered strangle position is featured in a separate graph.

Note the asymmetrical pricing where put premiums are considerably higher than call premiums. This has important implications if we wish to build bear-spreads or bull-spreads. The risk-reward ratios for both conventional bull-spread and conventional bear-spreads are positive but the ratios are much better for bull-spreads.

For example, assume we wish to construct a bull-spread with option sales. Sell the 1590p (17.35) and buy the 1560p (5.35). We get an initial premium of 12 and we could end up paying a maximum of 18. Reversing this position would give us a normal bear spread with the opposite ratios.

If we wish to construct a bull-spread with option buys we should buy 1610c (6) and sell 1630c (2.5), paying an initial 3.5 and getting a potential maximum of 16.5. If we wish to construct a bear-spread we should probably not sell calls to create the reverse of the above position "� the risk-return ratio is against this.

Apart from index instruments, there is very little in the way of obvious plays in the stock F&O section. The lack of liquidity in September options is a crippling factor.

Also most major stocks are in range-trading mode just as the indices are. Going long in Hindalco and Grasim futures may be a worthwhile play but then we should probably buy the respective September futures.

In terms of possible sells, Gail, Maruti and Dr Reddy's look to be the most promising candidates in the F&O segment. Gail and MUL August futures are probably worth selling despite the short period left before expiry.

DRL is interesting for traders since it has already lost a lot of ground. Perhaps we could try a calendar spread here. Buy September DRL and sell August DRL hoping to make money both ways.

The implications of the asymmetrical option pricing extend to next month's OI considerations. The normal post-settlement pattern sees calls priced comparatively higher.

Here we could see a big surge in call pricing if the situation normalises - that is, the market doesn't move a great deal and the September Nifty PCR comes down. It is also possible that September put premiums will decline somewhat.

My gut feel based on the high PCR and the asymmetrical prices is that a lot of traders are expecting significant declines across the board in the next two weeks.

That has led to a situation where the risk-reward ratios are skewed heavily in favour of bull-spread players. If that expected decline doesn't happen, we would have the perfect conditions for a technical bounce.