Bear spread to pay more

Turnover stayed lacklustre in the derivatives market despite the successive trading triggers of settlement and Budget. However February went through smoothly and there was a reasonable amount of carryover and some improvement in sentiment.

Index strategies

The foreign institutional investors (FIIs) are now de facto market-makers in the derivatives market because they hold collective outstandings of over 45 per cent. However the settlement saw reasonable carryover given very thin open interest until Wednesday. Daily volatility in the indices dipped despite the settlement and Budget.

The Nifty's historical volatility was high last week but lower than it's been since mid-January. The Nifty traded through last week at a daily historical volatility of around 2.65 per cent. It was consistently above 3.25 per cent earlier "� that means the index has settled down to swing through a daily range of 30-50 less.

There are several background ratios, which taken together are generally good sentiment indicators "� these are emitting somewhat contradictory signals. The put-call ratio in terms of open interest closed around 1.3 yesterday. That's back in a bullish zone from overbought levels of below 0.9. Open interest itself across both futures and options is at a reasonable level considering it's early in the settlement. Those are both positives.

The premiums/ discounts of index futures to underlyings is however, showing a slightly bearish signal because the key futures are trading at premiums to their futures and that indicates somewhat bearish sentiment. There was also a total lack of liquidity in the mid-contract and that again, is unusual.

The cash Nifty closed at 5,223.5 while the Nifty March futures was held at 5,181, April was settled at 5,161 and May was settled at 5,161. There is negligible open interest in May which is another bearish signal. The Junior was settled at 9,587 while the cash index closed at 9,636 "� there is no open interest in April and May. The CNXIT closed at 3984.5 and the futures settled at 3,960.1.

There is a potential calendar spread in short March Nifty versus long April Nifty but it's too early in the settlement to take this on. In terms of technical positions, most of the indices are locked into trading ranges.

The BankNifty could move up "� PSU banks did well on Friday. This is paradoxical because of the Rs 60,000 farm loan write-off, which will be borne by PSU banks and where the Government of India's compensatory mechanism is unclear. All the FM would say about the modalities was "credit me with some intelligence!"

My reading would be that the Nifty is due for a possible short-term dip but it will bounce back from around 5,000-5,100 and probably swing above 5,300 again. The chances of daily volatility spiking up is also extremely high.

Given that the FIIs are market-makers in futures and options (F&O) at this instant, their posture becomes exceedingly important. For what it's worth, they were net cash buyers till Thursday when they sold in cash and reversed F&O positions.

On Friday, anecdotal evidence suggests that they were modest sellers and they increased derivatives exposure. Their derivatives open interest is currently pretty evenly divided between stock futures (47 per cent), index futures (43 per cent) with the rest (9 per cent) being index options. The high index exposures suggest that they continue to be solidly hedged as a group. That has usually been the case when they are net cash sellers.

In the index options market, as already mentioned the put-call ratio is at healthier levels than normal. Early into the settlement it seems to make sense to hold relatively far-from-money positions. You can confidently expect that 5,000 and 5,500 will be hit within the next month and if there's a breakout, the index will move at least 250 points beyond the 5,000-5,500 zone in the direction of the breakout. The chance of a breakout is why the premium pricing doesn't seem too expensive "� if the current historical volatility holds, then the implied volatility is high.

A bull spread with long 5,300c (158.65) and a short 5,500c (80.15) costs about 79 and pays a maximum of 121. A bear spread with long 5,100p (193.35) and short 4,900c (127.2) costs about a net 67 and pays a maximum 133. Thus, although put-premiums are individually higher, the spreads are tighter and the risk-reward ratios for staying short are better. Both spreads could be hit and in absolute terms, the bull spread ratios are also attractive.

As mentioned earlier, we reckon that any breakout that may occur will trigger a trending move till either 4,750 or 5,750. A strangle of long 4,900 and 5,500 which costs about 207 could therefore make sense. You can layoff with a short strangle at say, short 4,600p (62.45) and short 5,800c (21.4).

The net cost of this combined position is about 123; breakeven occurs at either 4,777 or 5,623 and the maximum return is 177 if either side of the position is fully realised. Quite likely, both sides will be profitable at some stage in the settlement "� but both will not necessarily be very profitable and the returns will certainly be asymmetric.

Stock Futures / Options

We've already mentioned that PSU banks seemed to be surprisingly strong, given the Budget write-off. Auto stocks, private refiners and above all, pharma stocks seem to be interesting plays. SBI has the most liquidity among PSU bank futures and may be worth a long position.

In the auto segment, Maruti and Hero Honda seem to be good long picks. Among refiners, Essar Oil has more F&O activity than Reliance Petro. Cipla is likely to offer the best combination of liquidity and bullish potential among pharma shares. Outside this space, there's SAIL.