Try bull spreads

DERIVATIVES

On Friday, the market started a reaction from 1900 Nifty levels and it could continue this reaction until it hits either primary support at around 1850 or lower down at about 1820 if the selling pressure is very severe. There is a fair chance that the movement through next week will be narrow, with prices oscillating between 1865-1900 Nifty levels.

The Nifty put-call ratio (PCR) has started to climb and reached 0.41 levels by Friday. This is still neutral territory as far as we are concerned - PCR would need to be above 0.5 for a clearly oversold signal to be visible. However, an uptrend in PCR can be read as a somewhat bearish signal.

This bearish impression is reinforced by the behaviour of the Nifty Futures market. While spot prices registered nominal gains on a week-week basis, the futures prices showed a negative trend on the same timeframes.

The November Nifty is now running at 1871.3, December Nifty is at 1872.25 and January Nifty is at 1871.55 with spot Nifty placed at 1872.

There is no obvious calendar spread in the futures market unless one is willing to bet on the view that further declines are likely. In that case, we should sell November Nifty and buy December Nifty.

This would gain in the case of declines in the near future and it could also work because of the standard settlement factor where there is normally a trend of carrying over positions into the next settlement.

In technical terms, stock-by-stock technical analysis suggests that the index will indeed further decline even if the general market trend is closer to neutral. This is because most of the heavyweights are in bearish mode and the likely gainers are not stocks with a high index weightage.

Let's look at the option chain with that perspective in mind. We should note that with settlement due on Thursday, there is likely to be the usual volatility and a general drop in premiums away from the money.

We can try conventional bull-spreads such as long 1880c (10.3) versus short 1900c (4.35) - this costs 6 and it could pay a maximum of 14. So the risk-reward ratio is good. A conventional bear-spread with long 1860p (9.7) versus short 1840p (4.25) costs 5.45 and it could pay a maximum of 14.55 so the risk-reward ratio is equally good.

Reversed spreads don't offer great ratios but the expiry factor could make these a reasonable proposition if they are far away from the money.

A straddle at 1870 with long 1870c (15.1) and long 1870p (13.85) costs 29. So this position would be profitable only if the market moves outside 1840-1900 and that doesn't seem likely within the next week. A strangle with long 1860p (9.7) and long 1880c (10.3) costs 20 and offers similar profits if the index moves outside 1840-1900.

We can try and arbitrage this situation by selling a short straddle and buying a long strangle. But the profit function for that combined position would be useful only if the index stayed within a very narrow range.

We can try to improve this by taking a wider strangle with long 1900c (4.35) and long 1840p (4.25). The function for this combined position is wider, the trade gains if the index stays within the limits of 1850-1890, which seems fairly acceptable.

In practice, we may gain more with this combination of short straddle and wide long strangle since premiums for the long strangle positions will probably decline with settlement on the way.

In the stock futures and options market, there are very few apparent long positions. However, there are a few likely short positions. We suggest considering short positions in Dr Reddy's and in Reliance and Reliance Energy.

The DRL short suggestion is based on the news that the company faces criminal charges in Russia. Reliance group companies are likely to face higher than normal volatility given the public statement about differences by Mukesh Ambani and both RIL and Reliance Energy appear bearish.

However, the Reliance group has a well-deserved reputation for knowing how to manage challenging situations and its quite possible that the Ambani brothers will manage to soothe investor sentiment. Which leads us to the possibility that the stocks will find support next week. One can make a case for going long as well!

Perhaps the smartest thing to do would be to sell the futures and buy bull-spreads creating a hedged position. A long RIL 530c (8.35) versus short RIL 540c (4.45) costs nearly 4 and it could pay a maximum of just over 6 if the market does rebound.

It seems better to take this combination of a short November RIL future and a bull-spread rather than look for a strangle with long 530c (8.35) and long 520p (5.7) because that position costs 14.25 and it would be profitable only if the stock moves outside 505-545.

In Reliance Energy, the spot and November futures are both at around 620. Our view is that the stock may drop to 605 levels or alternatively, if the stock rebounds, it could climb until 630.

Once again, a combination of short future and bullspread seems appropriate. A long 620c (8) versus short 640c (4) costs 4 and it could pay a maximum of 16.

NTPC appears to be trading inside a narrow range of 70-75. A long 75c (85) and long 70p (0.25) costs a total of 1.1 and it could pay if there's a breakout in the next week.