Strangles could be lucrative

The most probable directional movement in the rest of the settlement appears to be sideways.

A low volume, low volatility week ended with a session where a new 52-week high was followed by a sharp correction. Carryover has been low so far into the settlement.

Index Strategies
The last two weeks have seen tightly ranged-trading with the market bouncing from resistance at 5,180 plus levels and finding support at around 5,050-5,075. Trading volumes have been low in both cash and derivatives segments and so has carryover. Just over 5 per cent of Nifty futures volume is in January and beyond, and just 30 per cent of option volume is beyond the near-month.

However, open interest (OI) has been growing week on week. The FIIs remain committed participants. They are net buyers of around Rs 3,500 crore in December and hold around 35 per cent of OI. This is encouraging since FII interest tends to taper off in December, which is year-ending for most of them. An easing of FII exposure could still happen. One expects December-January carryover to be low for that reason. Many Indian traders and operators will prefer to sit on the fence until they have an inkling of 2010 FII attitude in January.

The most probable directional movement in the rest of the settlement appears to be sideways. However, 5,000-5,180 is a relatively narrow zone and a breakout in either direction could lead to a quick move till around 4,800-5,400. A successful breakout will require strong volume expansion, given trading congestion within 5,000-5,180.

The subsidiary indices are exhibiting unusual behaviour. The BankNifty underperformed last week and it is under pressure due to expectations that the RBI will tighten monetary policy. The CNXIT outperformed. Both indices corrected on Friday. The BankNifty will almost certainly underperform next week because every financial stock appears hard hit. The CNXIT is more puzzling – the heavyweights in the sector appear almost neutral in trend. The rupee could strengthen if rates rise and this would retard IT valuations.

Traders can adopt several different strategies. One is to focus on the narrow trading range and keep switching direction. A second is to plan for breakouts in either direction. A third is to assume there won't be a major breakout and sell far from money (FFM) options.

Each strategy has pros and cons. Switching direction inside the trading range requires narrow stop losses and many short-ranged day trades, which always implies slippages. Selling FFM options could set up large (if not unlimited) losses if there is a breakout.

Looking for breakouts appears to be low-probability. But premiums are not expensive and hence, positions that gain on breakouts have reasonable risk-reward ratios. For what it's worth, an upside breakout seems a little more likely. Put-call ratios are somewhat bullish at about 1.3 for the Nifty in terms of OI. The risk-reward ratios for spreads close to the money are also good.

An examination of option chains also tells us where trading expectations lie. The put chain has very high OI at 4,800p (33), 4,900p (50) and 5,000p (74) with some OI at 4,500p (9) and again at 5,100p (109), which is very close to the money. In terms of value, the put OI is overwhelmingly concentrated between 5,000p and 5,200p. The call OI is clustered between 5,100c (117), 5,200c (70) and 5,300c (36) and tapers off beyond 5,400c (16). If we ignore some high value in the money positions at 3,600c and 3,800c, the call value is also focussed between 5,000c (181) and 5,200c.

Taken together, one would read this data as the “pessimists” seeing possible moves down to 4,800 with some hedges from outright bears at 4,500. At the same time, the “optimists” don't expect the market to move beyond 5,400 at the outside. The range of 4,800-5,400 is the limit of most expectations even on breakout. The market's recent historic volatility has been less than 2 per cent a day – that means high-low ranges of roughly 100 points. A close to money bullspread like the long 5,200c and short 5,300c costs 34 and pays a maximum of 66. A close to money bearspread of long 5,100p and short 5,000p costs 35 and pays a maximum 65. The bearspread is much closer to money (the index closed at 5,117) so the equal risk-reward ratios are deceptive. A further from money bearspread such as long 5,000p and short 4,900p would cost 24 and pay a maximum of 76.

A long straddle at 5,100 would cost 226 with breakevens at 4,874, 5,326. A long strangle of long 5,300c and long 4,900p is much cheaper at a total cost of 86 and breakevens at 4,814, 5,386. This can be further reduced with a short strangle of short 4,800p and short 5,400c that is worth 49 in premium inflows.

The net cost of the long-short strangle combination is 37 with breakevens at 4,863, 5,337. The potential maximum return on a one-side breakout is 63. If the market touches both 4,800-5,400 which is highly unlikely, the return could be around 163. So this position that depends on a breakout offers a very decent risk-return ratio.
 

STOCK FUTURE/ OPTIONS
Apart from banking and financial sector shares, which have seen universal selloffs, the patterns at the moment are not very sector-specific. Quite a few heavyweights such as HUL and RIL are in neutral territory. Among the more interesting short positions outside the banking space are sugar counters like Renuka and Balrampur. 

Airtel and Moser also look weak. Among potential long positions, Sail, Bharat Forge and Larsen are looking promising. However, BHEL looks like the best to go long since its developed huge volumes as it has climbed. Go long with a stop at Rs 2,360.