Try bull-spreads

DERIVATIVES

Expensive close-to-money options coupled to a drop in premium away from money suggest that the market doesn't expect much movement in the immediate future.

The sharp correction that came mid-week has led to questions marks about the immediate future. The Nifty made a small recovery on Friday to close at 2015.5 points in the cash market.

In the futures markets, the January futures was placed at 2019.8 points while February was at 2019.85 and March was at 2022. The Nifty put-call ratio was held around 0.38 on the weekend after moving between 0.3 (overbought) and 0.47 (oversold). Volumes and open interest remained high.

There is little inference to be gleaned from the current PCR (put-call ratio) or OI (open interest) - both are inside normal range and in fact, in neutral territory.

However, the fact that the futures are still trading at a perceptible premium to the cash price, after two sessions of catastrophic loss, suggests that the market expects a further recovery by the settlement.

Other technical signals suggest a period of range-trading between 1990-2100 so the futures premium may well be a pointer in the right direction since this would give us a bullish perspective in the immediate future.

In the options market, there is plenty of liquidity available in various chains up until the 2090 level. What are the risk-reward ratios of various typical Nifty option positions?

A conventional short-range bull-spread like long 2020c (48.25) versus short 2030c (42.15) costs around 6 and it could pay a maximum of 4. But a longer conventional bull-spread like long 2030c (42.5) versus short 2050c (34.5) costs 8 and it could pay a maximum of 12. If you're expecting a reasonable bounce from these levels, buying deep bull-spreads make better sense.

A standard bear-spread such as long 2010p ( 44) versus short 2000p (39.35) costs 4.65 and it could pay 5.35 so the risk-reward ratio is slightly less interesting than with the close to money bull-spread.

But a deeper bear-spread such as long 1980p (29.7) versus short 1960p (25.4) only costs 4 and it could pay a maximum of 16. Obviously the deep bear-spread also makes better sense than a close-to-money position.

The expensive pricing of close-to-money options also makes it tempting to take reversed bear-spreads. A short 2020c (48.25) versus long 2030c (42.15) brings in 6 and it could lose a maximum of 4 which is a good risk-reward ratio.

The implications of expensive close-to-money options coupled to a sharp drop in premium away from money is that the market doesn't expect a great deal of movement in the immediate future.

This seems odd given the gyrations of last week. My instinct would be to look for far-from-money spreads even if these are reckoned unlikely.

If we look at straddles and strangles, some other possibilities emerge. The straddle at 2020 with long 2020c (48.25) and long 2020p (47.35) costs 95.5 and it could be profitable only in a market that moved beyond 1920-2120. A strangle with long 1980p (29.7) and long 2050c (34.55) costs 64 and it could be profitable beyond 1915-2115, which is approximately the same range.

We can take a short straddle, picking up 95 premium and cover with a long strangle costing 64 and thus pick up approximately 31 in excess premium.

The profit function suggests that, if the market stays range-bound close to current levels, we stand to make substantial gains. If the market moves up, the position always gains at current premium differentials. If the market moves down however, there would be losses below 1980.

In the stock futures market, cement shares such as ACC, Gujarat Ambuja and Grasim are worth taking long positions. There seems to have been a slowdown in the momentum of bank shares so, it may be worth selling futures in BoB and SBI.

However this is riskier since the bank sector's consistent performance may also trigger a sharp bounce. Among other stocks, TCS and RIL both seem worth long futures. Telecom stocks will show two-way movement depending on the respective impact of ADC cuts. MTNL definitely seems bearish while other telecom stocks could move up.

In the options segment, ACC which is trading around 350 in the cash segment could be the best play in terms of bull-spreads. A long 360c (11.5) versus short 370c (7.5) costs 4 and it could pay a maximum of 6 while a wider spread of long 350c (15.9) versus short 380c (4.65) would cost 11 and pay a maximum of 19.

Grasim is short on option liquidity but GACL also offers option spread possibilities. A long 430c (18.4) versus short 450c (9.5) costs around 9 and it could pay a maximum of 11. Acc has better risk-reward ratios than GACL.

The Reliance group scrips are all likely to see consolidation now that the crisis seems to be over. The REL share has the potential to climb to 560 levels from the current 525-530 level before the settlement ends.

Apart from long January futures, a bull-spread such as long 540c (20) versus short 560c (10) costs 10 and it could pay 10. This risk-reward ratio is just about equal.

In RIL, the 'relief rally' could pull the stock upto around 570 from the current 540 levels. This obviously makes it worthwhile to look for a long January future. A bull-spread consisting of long 540c (22.2) versus short 560c (13.55) costs nearly 9 and it could produce a maximum payoff of around 11.