Try bull spreads

TRADING DESK/ Derivatives

The new settlement has coincided with a bullish trend and the promise of a breakout from the range-trading that has ensued since late May.

This in turn has led to a trend of generally rising open interest (OI) and premiums. The overall view for the next couple of weeks ought to be in favour of bull-spreads.

The August Nifty futures series (1623) are still at a discount to the spot price (1632) and September (1615) is at a discount to August. The Nifty put-call ratio (PCR) has moved down from above 0.40 to around 0.35.

This is closer to the overbought zone but it's still neutral territory if the previous Nifty moves are any guide. Usually the Nifty has gone into technical correction only when the PCR has dropped below 0.26.

It probably makes sense to buy a long August future. Buying September and selling August is a possibility but it will be more worthwhile to wait until closer to the next settlement before making this trade.

Our perspective is that the market may do one of two things: it might range trade between roughly Nifty 1600 and 1700 or it might move up beyond the 1700 mark looking for targets in the range of 1800.

We don't see a big chance of declines below the 1600 level and even if that happens, there is solid support around 1575. So, we can expect an upside of upto 70-odd points versus a downside of perhaps 35 points.

The standard trading tool in these circumstances would be the bull-spread. In these circumstances, it makes more sense to look for call-based spreads rather than selling puts to create a spread.

There is a possible downside and the profits from a put-based bull-spread would be more limited since we would have to create it by selling far-from-money options. We would prefer to pay premiums upfront and create positions that could give us better returns.

But there is a difficulty. A close to money put-based bull spread would be something like sell 1630p (45), buy 1600p(32). This position pays 13 upfront and it could lose a maximum of around 17. A close-to-money call-based bull-spread would be buy 1640c (33), sell 1670c.

Unfortunately, there isn't sufficient liquidity to get quotes for the 1670c or indeed anything above 1640. Presumably liquidity will develop as soon as the market opens on Monday.

But if we take a naked position with a long 1640c, we will need to eventually book a premium of around 17-18 for the 1670c to make the risk-return equation worthwhile. We can use a minimum premium of 17 for a 1670c as a rule of thumb level to decide whether to take this position once liquidity develops.

Until then, we can try and take bull-spreads using puts. If we do this, it's safer to move away from the money. Try taking a bull-spread with a long 1600p (32) versus short 1580p (24).

This yields a premium of 8 and it carries a potential maximum loss of 12. The risk-return ratio isn't good but the distance away from the money adds to the safety. Given the ample time till expiry (August 26), we will have to reverse the position and take a profit if the market moves up, rather than wait for the settlement.

The lack of liquidity above the current spot prices makes it impossible to compute straddles or strangles with any degree of accuracy. At current premiums, a straddle of long 1630p (45) plus long 1630c (32) costs 77.

This will be profitable only if the market moves outside 1550-1710. This seems wider than likely. We can try and take the reverse position, selling a short straddle at 1630. In that case, we will have to cover with a long 1550p (15) and a long 1700c, as and when we can get quotes for that.

It's impossible to give reasonable risk-return projections on this position. In general terms, once there is sufficient liquidity, any long straddle or strangle which yields positive returns inside the range of 1600-1700 seems worthwhile.

There are several possibilities in the stock options market. Quite a few F&O stocks appear to be bullish. In the futures segment, long positions in Bajaj, IPCL, Infosys, L&T, Mastek, Reliance, Satyam, Shipping Corporation and Wipro could prove profitable.

That's a fairly long list of large-cap stocks that are on the threshold of an upmove - an indication that any Nifty uptrend is likely to be backed by breadth.

In the options segment, liquidity is always more of an issue than in futures. Among liquid options, Infy appears to offer a fair risk-return ratio for slightly-out-of-money calls. A long 1590c (25) versus short 1620c (16) costs 9 and it could pay upto a maximum of 21.

In RIL, with spot at about 490, a bull-spread with long 500c (13) versus short 510c (9) costs 4 and it could pay a maximum of 6. We could also take a naked long 500c and wait for liquidity to develop at 520 and above before covering the position.

Satyam features on our watch-list after a break. Spot is trading at around 340 and we see a possible short-term target in the range of 370 or more. We can take a long 340c (14) and sell a short 360c (6). The position costs 8 and it could pay a maximum of 12.

In SCI, spot is at 125 and we can expect a target in the range of 135 before there is selling pressure. A long 125c (8) versus short 135c (4) costs 4 and it could pay a maximum of 6. In Wipro, a long 550c (22) versus short 570c (12) costs 10 and it could pay a maximum of 10.