Take strangles

DERIVATIVES

The new settlement promises massive volatility.

The elections will conclude and a new government will be installed in the latter half of this period. As of now, the Nifty put-call ratio is quite low - it's in the overbought zone at just below 0.3. But not much can be read into this because the settlement is just one session old.

Our perspective is that the market is likely to remain range-bound until the next bout of polling on May 5. It could see a sharp movement in either direction after that. Once the elections are concluded and the party positions become clear, there is a strong probability of the market moving up. Thus late May could see a surge in prices.

The futures position is quite interesting. Spot Nifty is placed at 1796, the May Nifty is at 1783 and June Nifty is at 1786, while July is at 1793. This is an interesting position - spot is at premium to futures but June and July are at premium to May. The spot versus May backwardation suggests that the market is braced for a short-term dip but the May-June-July premium positions suggest that it's also braced for a recovery in a fairly rapid order.

A possible calendar spread would be long May Nifty versus short June Nifty. This would profit if May rose or June fell or ideally, both these moves occurred. If there is a rise in the third or fourth week of May, this situation will come about. The calendar spread reduces the risks of taking a naked long May position. It offers exposure only to the extent of the difference in spread between the two months. This may prove important in terms of both margins and ultimate losses or gains.

The classic way to exploit a range-bound market where we expect a move in either direction is to take straddles or strangles. Since we do expect a big move, the trader can look for positions that are far from the money. Long strangles on the Nifty appear to be the best theoretical possibility but we must be prepared to hold these positions until settlement (May 27) or close to it.

While there's liquidity above and below current spot, prices have still not settled down so, the suggested positions are only very roughly indicative. There could also be turmoil in the futures markets starting on May 5 or May 8, after various conflicting opinions on the next phase of polling is received. There may be ways to exploit that which we'll examine later.

Let's look at strangles close to the money first. Suppose we take a long 1800c (42.65) versus long 1790p (50.35). The position costs a total of around 93. It will be profitable only as and when the market moves beyond 1700-1895.

Let's look at positions further from the money. Suppose we take a long 1830c (32.8) and long 1770p (44). The position costs 77 and it will be profitable if the market moves beyond 1693-1907. We get almost the same range as with a close-to-money position.

We can look at even wider strangles such as long 1850c (26) and long 1750p (35) "� this costs 61 and it will be profitable outside 1690-1910. The last and widest strangle would be my personal choice. If you're betting on a big move, you may as well get it at least cost though the losses on a wide strangle will be larger in case of a small move. The three relative profit functions are illustrated above.

As to the short term of May 5 and beyond, what methods can be used to exploit probable volatility? Expectations would be a bout of likely bearishness between May 5 and 10 and consolidation followed by a recovery starting after May 15.

In these circumstances, we could look for short-term bear spreads and bull-spreads. These positions are likely to be closed out by reversing rather than being held till settlement.

A typical bear-spread would be long 1790p (50.35) coupled to a short 1760p (40). The trader pays around 10.35 and could receive a potential 19.65. The return-risk ratio is so good; one is afraid of mispricing! Positions further from the money such as long 1780p (48.6) versus short 1750p (35.35) also have decent return-risk ratios. This position would cost 13.25 in terms of premium and pay around 16.75 maximum. Obviously the CTM position is best however, assuming there isn't a rapid change in premium prices.

A typical bull-spread could also fetch decent returns at current prices. Let us suppose we combined a long 1800c (42.65) versus short 1830c (32.8). The position costs just less than 10 and could pay a maximum of around 20. Again the return-risk ratios are so good, there is almost bound to be price changes. Since the bull and bear spreads are offering decent return-risk ratios, we could try to maximise our profits by setting these up rather than taking strangles. If you do this, be wary of sharp price changes and be prepared to switch quickly.

There are no obvious stock specific positions available in the futures and options segment. In circumstances where the market is being driven by political instability, most pivotals will move in the same direction regardless of individual fundamentals. Apart from Hindalco, which seems likely to stay down under most circumstances, the other F&O stocks are only useful as possible surrogates for the market. We could try and pick high-beta stocks as plays but this is an unnecessary process.

But there are no obvious advantages in terms of leverage or volatility either. For the next couple of weeks, stick to the Nifty.